CHARLES D. DELORME, JR.

University of Georgia
Athens, Georgia

HERBERT G. THOMPSON, JR.

Maryland Public Service Commission
Baltirnore~Maryland

RONALD S. WARREN, JR.

University of Georgia
Athens, Georgia

Public Infrastructure and Private

Productivity: A Stochastic-Frontier
Approach*
We estimate an aggregate production frontier using time-series data for the private U.S. econ-
omy and show that estimated technical inefficiency is negatively correlated with the stock of
public capital, or infrastructure. We then estimate a production frontier which includes a public-
capital variable and report that this variable has no statistically significant effect on private
productivity. Our results suggest that public capital affects private productivity indirectly by
reducing aggregate technical inefficiency rather than directly by increasing output. Conse-
quently, previous evidence indicating a positive, direct effect of public capital on average private-
sector output may have been obtained from stochastically misspecified models.

1. Introduction
Since the classic analysis of public infrastructure by Arrow and Kurz
(1970), a number of empirical studies have examined the role of public
capital as an input in the production process. 1 Many of these studies have
reported estimates of the marginal product of infrastructure that are positive
and statistically significant, but often implausibly large. In particular, As-
chaner (1989b) and Munnel] (1990) generated a lively debate on the ira-

*We thank two anonymous referees, the editor, participants of the Georgia Productivity
Workshop II, Kevin Fox, Cliff Huang, and David Robinson for helpful comments on an earlier
version of this paper. We also thank Dale Jorgenson and John Tatom for making their data
available to us.
1For examples, see Ratner (1983), Aschauer (1989a, 1989b), Munnell (1990, 1991), Tatom
(1991), Holtz-Eakin (1994), Nadiri and Manuneas (1994), Andrews and Swanson (1995),
Garcia-Mil~, McGuire, and Porter (1996), Mullen, Wilfiams, and Moomaw (1996), and Otto
and Voss (1996).

Journal of Macroeconomics, Summer 1999, Vol. 21, No. 3, pp. 56:3-576 563
Copyright © 1999 by Louisiana State University Press
0164-0704/99/$1.50
C. D. DeLorme, Jr., H. G. Thompson, Jr. and R. S. Warren, Jr.

portance of public infrastructure by reporting output elasticities with respect

to public capital of 0.39 and 0,34, respectively, which were higher than the
consensus output elasticity for private capital of 0.30. These findings were
then used to explain the decline in private-sector labor productivity in the
1970s and 1980s as a result, in part, of alleged disinvestment in the public-
capital stock.
These initial studies have stimulated much additional research, some
of which has been criticized for various econometric problems. For example,
Gramlich (1994) points out that a number of time-series studies failed to
consider the presence of common trends, which would bias upwards the
estimated coefficient on public capital. Indeed, when Tatom (1991) first-
differences his aggregate time-series observations, as a response to nonsta-
tionarity, he obtains much lower estimates of the marginal product of public
capital, and some of them are not statistically significant or even positive.
Another econometric problem noted by Gramlich (1994) involves the omis-
sion of potentially relevant variables, such as energy. However, when Tatom
(1991) includes energy price in the production function, he confounds a
production function and a cost function, for which he was properly criticized
by Gramlich (1994). Finally, Holtz-Eakin (1994) argues that many panel-
data studies do not include controls for unobserved, state-specific produc-
tivity effects. When such controls are included, he finds no role for public
capital in directly affecting private-sector productivity.
A standard assumption in this literature is that public infrastructure
shifts an average production (cost) function upward (downward) in a neutral
manner, z However, theoretical considerations suggest that at least some
forms of public infrastructure are neither under the direct control of(shrink-
able by) private-sector firms nor easily substitutable with private labor and
capital. This argument implies that such infrastructure capital should not be
modeled as an explicit input in a production function determining private
output.
An alternative view is that public infrastructure reduces the technical
inefficiency of private-sector production, or the difference between actual
and best-practice output. In this vein, Mullen, Williams, and Moomaw
(1996) specify a translog stochastic production frontier, and employ panel
data to estimate the direct (output) and indirect (efficiency) effects of public
capital in manufacturing across U.S. states and over time. Their empirical

~Recent exceptions to this generalization are provided by Nadiri and Manuneas (1994) and
by Morrison and Schwartz (1996). Both of these studies examine the effects of public capital
on manufacturing-sector productivity in the context of a system of cost and input-demand
functions. As a consequence, both the technical (neutral) and allocative (biased) efficiency ef-
fects on private output of public infrastructure could be estimated.

564
 Public Infrastructure and Private Productivity

results suggest that public capital increases both output and productive ef-
ficiency in manufacturing. However, the estimated, direct output elasticity
of public capital is quite small.
In this paper, we also specify and implement a test of the role of public
infrastructure in reducing technical inefficiency in the production of private-
sector output. Our study differs from Mullen, Williams, and Moomaw
(1996), however, by using aggregate time-series data. Consequently, our em-
pirical results pertain to the entire U.S. private economy, rather than just to
the manufacturing sector.
The paper is organized in the following way. First, we replicate the
findings of previous empirical studies by estimating an average production
function that is augmented with public capital as an input. We then estimate
a stochastic production frontier without public capital. These latter estimates
are used to establish the presence of aggregate technical inefficiency. Sub-
sequently, we show that the estimated level of technical inefficiency is nega-
tively related to the stock of public infrastructure. Finally, we estimate a
production frontier which includes public capital, and report that its esti-
mated coefficient is not significantly different from zero. Therefore, we find
that public capital affects U.S. private productivity only indirectly, by re-
ducing aggregate technical inefficiency, rather than by directly increasing
private-sector output. Our results, then, provide only mixed support for the
empirical findings reported by Mullen, Williams, and Moomaw (1996). How-
ever, we affirm the conclusions of Tatom (1991), Evans and Karras (1994),
and Holtz-Eakin (1994) that public capital does not directly increase private
productivity.

2. Analysis
The starting point for our analysis is the commonplace empirical fnd-
ing that public capital affects aggregate, real private output in the U.S. econ-
omy_ Following Ratner (1983), Aschaner (1989b), Munnell (1990), Tatom
(1991), Gramlich (1994), Andrews and Swanson (1995), and Otto and Voss
(1996), we represent aggregate technology by a constant-returns-to-scale
Cobb-Douglas production function augmented by Hicks-neutral technical
change. Because the dependent variable in this model (output per worker)
varies procyclically over time, a control for the phase of the business cycle
is included, a This also facilitates a comparison with studies such as Aschauer
(1989b), which attach importance to declining capacity utilization in explain-

aFor an illustrationof the use of a control variablefor the phase of the business cyclein a
time-seriesmodelof production,see Lovell,Sickles,and Warren (1988).Aschauer(1989b) and
Tatom (1980) also employthe capacityutilizationrate to controlfor business-cycleeffects.

565
C. D. DeLorme, Jr., H. G. Thompson, Jr. and R. S. Warren, Jr.

TABLE 1. Means and Definitions of Variables and Sources of Data

Variable Mean Definition and Source
Q 2031.525 Real Gross Private Domestic Product, in
billions of 1982 dollars; Jorgenson, p. 74,
series C802.
L 1319.099 Private Domestic Labor Input Index
(quality-adjusted private domestic
man-hours scaled to labor income in 1982);
Jorgenson, p. 34, series C394.
K 815.137 Private Domestic Real Capital Input, in
billions of 1982 dollars; Jorgenson, p. 52,
series C700.
G 1003.413 State, Local, and Federal Government
(non-military) Real Stock of Equipment and
Structures, in billions of 1982 dollars; Bureau
of Economic Analysis, U.S. Department of
Commerce, from Tatom (1991); see also
Musgrave (1988) and U.S. Department of
Commerce (1993).
GAP 82.215 Out-put as Percentage of Capacity in
Manufacturing; Board of Governors of
the Federal Reserve System. Economic Report
of the President (1992), Table B-49, p. 403.

ing the productivity decline of the 1970s and 1980s. Annual data from the
period 1948-1987 are used in the empirical analysis, and are described in
Table 1.
The model can be written

In(Q/L)t = 130 + ~lln(K/L)t + 132 ln(G/L)~

+ ~3aln(GAe) t + ~4T + [35T2 + v t , (1)

where Q, L, K, and G are defined in Table 1, and GAP is the manufacturing-

sector capacity utilization rate, which is our measure of the phase of the
business cycle. We follow Aschauer (1989b) and Munnell (1991) and assume

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 Public Infrastructure and Private Productivity

that the flow of public-capital services is proportional to the stock of public

capital, G. 4 The variables T and T 2 are, respectively, linear and quadratic
time-trends which, following Darby (1984) and Tatom (1991), proxy nonlin-
ear technical change, vt is a normally-distributed error term, and t indexes
the N observations.
It is well known that aggregate time-series variables are frequently
nonstationary in level form. This feature of such data may result in a spuri-
ous-regression bias that would lead one to conclude that there are causal
relations among the variables when in fact no such relations exist (see
Granger and Newbold 1974). In the present context, if nonstationarity exists
one might infer from estimates of the parameters of the model in (1) that
public infrastructure affects private output even if it does not.
To determine the integrated properties of the data, we performed
augmented Dickey-Fuller (D-F) tests for unit roots in levels and in first
differences of each variable in Equation (1) using two lagged differences.
Each augmented D-F regression was estimated with and without a constant
and a linear time trend. The evidence from the D-F tests is consistent with
a unit root in levels but no unit root in first differences. We are therefore
justified in assuming that the levels of the variables are integrated of order
1, which means that these variables must be differenced once to achieve
stationarity.
To examine the relationships among the variables, we used the coin-
tegration tests developed by Johansen (1988) and Johansen and Jusefius
(1990). We conducted both the trace test and the maximum eigenvalue test
to determine the presence of cointegrating vectors in the nonstationary time-
series data. As with the unit-root tests, two lagged differences were used for
the cointegration tests. The critical values for the appropriate test statistics
are provided by Johansen and ]uselius (1990, 208, Table A2). The results of
these tests support the null hypothesis of no cointegration, since the values
of the relevant test statistics are less than the 5% critical values. Thus, the
production function to be estimated is correctly specified in first differences
since the variables in Equation (1) are integrated of order 1, but are not
cointegrated. 5 Consequently, we estimated a first-differenced version of (1):

5Detailed results of the D-F unit-root tests and the Johansen cointegration tests are available
from the authors. A discussion of the Johansen test procedure can be found in Dickey, Jansen,
and Thornton (1991, 73-75).
4This assumption explains why, in Table 1, the mean of G (the stock ofpubfic capital) exceeds
the mean of K (our measure of the flow of public-capital services). Because the estimating
Equations (2) and (3) are specified in logarithmic first differences, this method for measuring
public capital does not affect the estimated coefficients, which are interpreted as elasticities.

567
C. D. DeLorme, Jr., H. G. Thompson, Jr. and R. S. Warren, Jr.

TABLE 2. Average Production Function a

Equation (2)
Variable Coefficient b
G=G~ G=G,_I
Intercept 0.0024 0.0016
(0.345) (0.225)
Aln(K/L) 0.6099 0.7482
(3.763) (4.695)
Aln(G/L) 0.2762 0.1759
(2.246) (2.348)
Aln(GAP) 0.4122 0.3371
(5.069) (4.290)
T 0.0001 - 0.0001
(0.450) (0.327)
D.W. 1.8407 1.7433
/]2 0.49 0.48
NOTE: aOrdinary least-squares estimates, bAbsolute values of estimated t-statistics are in
parentheses under the coefficient estimates.

Aln(Q/L)t = 7o + 71Aln(K/L)t + 7zAln(G/L)t

+ 13Aln(GAP)t + 74T + v ' , (2)

where v; ~- Avt is a normally distributed random variable. 6

Ordinary least squares (OLS) estimates of the production function in
first-differenced form are reported in Table 2. Column 1 contains estimates
obtained by using the contemporaneous value of public infrastructure. Col-
umn 2 presents estimates with G lagged one period, as suggested by Munnell
(1992, 194), to reduce the possibility of any feedback effect of private-sector
output on the stock of public capital. Estimates of the coefficients on the
private-capital variable and the capacity-utilization rate are positive, as ex-
pected, and significantly different from zero, while the coefficients on the
trend variable are positive but statistically insignificant. 7 The estimated co-

6The first difference (v') of a normally distributed random variable (v) is also normally
distributed.
7The estimate of 3'1 in Table 2 is somewhat higher than typicallyreported° but nonetheless
falls within the range of estimates recently provided by Evans and Karras (1994)_There are two

568
 Public Infrastructure and Private Productivity

efficients on the public-capital variable are positive and significantlydifferent

from zero, thus replicating the widely reported empirical finding that public
capital increases average private-sector real output in the U.S. economy.
The estimated coefficient on private capital is more than twice the size of
the estimated coefficient on public capital, and the null hypothesis of equal-
ity of the two coefficients can be rejected at the 7% level of significance
(t = 1.454).
The foregoing results, as well as those from previous empirical studies,
were obtained by estimating an average production function, rather than the
best-practice or frontier technology. Suppose, however, that public infra-
structure reduces technical inefficiency, but no allowance has been made
for the latter in the specification of the production function. Then it is pos-
sible to infer from estimates of an average production function that public
capital should be included as a conventional input when, in fact, the way in
which public capital affects real output is by reducing the gap between actual
output and potential output.
Schmidt (1986) has discussed a type of specification test which can, in
this context, be used to determine whether or not public capital has a sta-
tistically significant effect on aggregate private output because it reduces
technical inefficiency in production. Suppose we estimate the stochastic pro-
duction frontier

Aln(Q/L)t = 60 + 61Aln(K/L)t + 62Aln(GAP)t + 6aT + v[ - gt, (3)

where v' is a normally distributed error term, and I-t > 0 is a one-sided error
which represents technical inefficiency in production, s The argument dis-
cussed above, that public capital reduces technical inefficiency, implies that
there is an auxiliary relation

~tt = ~o + ~IAIn(G/L)t + w t , (4)

in which ~1 < 0 is predicted, and where w -> - [~0 + ~IA ln(G/L)] since
the distribution of the dependent variable, g, is truncated at zero.

possible explanationswhy the estimatedcoefficientson T in Table 2 are not significantlydif-

ferent fromzero. First, the labor-inputvariableL is adjustedfor improvementsin laborquality
so (Hicks-neutral)technicalchange may be embodiedin that series. Second, the estimating
equationsare specifiedand estimatedin first-differenceform,implyingthat productivitygrowth
maybe unaffectedby neutraltechnicalchange.
SAmongthe admissibleforms for the distributionof g, the half-normalis the most widely
used and is employedhere. Aigner,Lovell,and Schmidt(1977) introducedthis stochasticspec-
ificationof the productionfrontier.

569
C. D. DeLorme, Jr., H. G. Thompson, Jr. and R_ S. Warren, Jr.

The specification test proceeds in two stages. First, we estimate the

production frontier by maximizing the log-likelihood function

ln~ = Nln(~/2/]-n) + Nlncr -1

+ ZlnN[1 -- F*(q)~¢r-1)]
(1/2a 2) Z [ A l n ( Q / L ) t - 60 - 5~Aln(K/L)t
-

- 52Aln(GAP)t - 5aT], (5)

where F*() is the standard-normal distribution function, or2 = cyn2

= ry~z + cy~ is the variance of the composite error q = v' - ~, and
= ry~/~ is the ratio of the standard error of technical inefficiency to the
standard error of statistical noise. Estimates of the one-sided error compo-
nents gt are calculated as the expectation of the gt conditional on the fitted
values of v; - g,, according to the formula provided by Jondrow, et al.
(1982). These estimates are then used as the values of the dependent variable
in the auxiliary equation given in (4) above. Equation (4) is specifed as a
truncated-normal regression model, which is then estimated by maximum
likelihood.9 If the estimate of {t is not significantly different from zero, then
we accept the null hypothesis that public capital does not affect technical
inefficiency. On the other hand, if the estimate of {1 is significantly less than
zero, we reject the null hypothesis and conclude that public capital indeed
reduces technical inefficiency, thereby narrowing the difference between
potential output and actual output in the private sector for any given levels
of private capital and labor.
Table 3 reports maximum-likelihood estimates of the stochastic pro-
duction frontier. As before, the estimated coefficient on private capital is
positive and significantly different from zero. The estimated coefficient on
the capacity-utilization variable is also positive and significantly different
from zero, reflecting the procyclical behavior of output per worker. One
indicator of the presence or absence of technical ineffieiencyin the aggregate
private economy is given by the estimate of )~. Under the null hypothesis of
no inefficiency, )~ = 0 and all of the variance in the estimated equation
would be attributed to statistical noise. In this ease, E(gt) = 0 and there
would be no gain relative to ordinary least squares from modeling the pro-
duction function as a frontier and estimating it by maximum likelihood. Ac-
cording to conventional test criteria, the estimated t-statistic on )~ implies
that there is no technical inefficiency, at least at the 5% level of significance.
This inference is suspect, however, since, as Greene (1993b) has noted, the
usual t-test of statistical significance is invalid in this ease because the value

9For a discussionof the truncated-normalregressionmodel, see Greene (1993a, 687-90).

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 Public Infrastructure and Private Productivity

TABLE 3. Production Frontier a

Equation (3)
Variable Coefficientb
(1) (2)
Intercept 0.0216 0.0146
(2.773) (1.738)
Aln(K/L) 0.6777 0.6270
(4.041) (3.592)
Aln(G/L) -- 0.2127
(1.6o8)
AIn(GAP) 0.3201 0.3835
(3.579) (4.093)
T 0.0001 0.0001
(0.245) (0.404)
)~ 2.4879 2.0150
(1.387) (1_284)
0.0185 0.0167
(5.227) (4.670)
NOTE: aMaximum-likelihoodestimates, bAbsolutevalues of estimatedt-statistics are in
parentheses under the coefficientestimates.

of L under the null hypothesis (zero) is at the boundary of the admissible

parameter space.
An alternative test for the presence of technical inefficiency, discussed
by Schmidt and Lin (1984, 351), can be constructed as follows. If there is
no inefficiency, then the distribution of the disturbances in the production
frontier is symmetric. Consequently, deviations of the sample estimates of
the disturbances (the OLS residuals) from symmetry can be used to infer
the extent of technical inefficiency. Specifically, symmetry implies that the
third moment of the disturbances is zero. Deviations of the OLS residuals
from symmetry can be measured by the sample estimate of the skewness
coefficient

~11 = m3/m3/2 ,

where m2 and ma are, respectively, the second and third moments of the

571
C. D. DeLorme, Jr., H. G. Thompson, Jr. and R. S. Warren, Jr.

TABLE 4. Technical Inefficiency Equation a

Equation (4)
Variable Coefficientb
G = Gt G = Gt-1
Intercept 0.0141 0.0153
(9.429) (10.618)
Aln(G/L) - 0.0479 - 0.1182
(2.114) (5.494)
Ow 0.0089 0.0083
(8.944) (8.832)
NOTE: aMaximum-likelihood estimates, bAbsolute values of estimated asymptotic t-statistics
are in parentheses under the coefficient estimates.

OLS residuals. The distribution of ~/~ is widely tabulated, and Bowman and
Shenton (1975) provide the 10%, 5%, and 1% critical values for various
(small) sample sizes. For the problem at hand ~ = 0.623, which exceeds
the 5% critical value for the present sample size. As a consequence, we reject
the null hypothesis of symmetry of the OLS disturbances and from this result
infer the presence of technical inefficiency in the U.S, economy.
The results of estimating (4) by the truncated-normal regression pro-
cedure, in which the one-sided residuals from the estimated production fron-
tier were regressed against the "omitted variable," the ratio of public capital
to labor, are presented in Table 4. As before, estimates were obtained using
both contemporaneous G and G lagged one period. The estimated coeffi-
cient on public capital is negative in each case and significantly different
from zero at the 5% level. These results show that the one-sided residuals
(the estimates of private-sector technical inefficiency) are negatively related
to public capital, regardless of whether public capital is defined contempo-
raneously or with a one-year lag. This finding is consistent with the hypoth-
esis that public capital facilitates the production of private-sector output by
lowering technical inefficiency.
These results provide an explanation for the statistical significance of
public infrastructure in estimated average production functions, which as-
sume no technical inefficiency. If private-sector technical inefficiency is as-
sumed to be zero when in fact it exists, then the stochastic structure of the
production function is misspecified. In the case, then, in which technical
inefficiency is omitted from the model but is negatively correlated with pub-
lic capital, the latter will be positively related to output if it is included as an
explanatory variable in an estimated average production function.

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 Public Infrastructure and Private Productivity

Further evidence in support of the model proposed here, and against

the standard approach, is provided by estimating a production frontier which
includes the public-capital variable. Such an estimating equation incorpo-
rates aggregate technical inefficiency, but otherwise follows previous litera-
ture by specifying public capital explicitly as an input_ Maximum likelihood
estimates are reported in column (2) of Table 3 and reveal that the estimated
coefficient on public capital is not significantly different from zero. This
result contrasts with the finding of Mullen, Williams, and Moomaw (1996)
that public capital increases both technical efficiency and output in U.S.
manufacturing.
This finding, coupled with the estimate of the statistically significant
effect of public capital on technical inefficiency reported in Table 4, leads
us to the following conclusions. Estimates of a positive, direct effect of public
capital on (average) private-sector productivity reported in previous studies
may have been obtained from a stochastically misspecified model. When the
possibility of aggregate technical inefficiency in production is incorporated
through the specification and estimation of a stochastic-frontier model, the
estimated coefficient on public capital is no longer significantly different
from zero. Instead, public capital is found to affect private productivity only
indirectly, by reducing technical inefficiency in an aggregate production
frontier which omits public capital as a direct input.

3. Conclusion
The stochastic-frontier approach to modeling aggregate production
was employed in this paper to test the hypothesis that public infrastructure
reduces technical inefficiency in the private economy. Most previous em-
pirical studies of the effect of public capital on aggregate real private output
have reported estimates of average production functions. A number of those
studies concluded that public capital increases real private output but in the
context of a model in which public capital is included as a conventional input
in the production function, along with private capital and labor. With the
exception of Mullen, Williams, and Moomaw (1996), however, none of these
studies considered the potential role for public capital in reducing the tech-
nical inefficiency of private-sector production. Consequently, the stochastic
structure of these earlier models may well have been misspecified, thereby
calling into question the conclusions based on their estimates.
To determine whether public capital reduces aggregate technical in-
efficiency in the private sector, we employed a specification test originally
proposed by Schmidt (1986). A stochastic production frontier was estimated
in first-differenced form, and the one-sided residuals were regressed against
the change in the ratio of public capital to labor. The empirical results are

573
C. D. DeLorme, Jr., H. G. Thompson, Jr. and R. S. Warren, Jr.

consistent with the view that public capital reduces private-sector technical
inefficiency, but does not directly affect private output. A policy implication
of these results is that additions to the public-capital stock cannot be used
countercyclically to replace periodic shortfalls in private-capital accumula-
tion or reductions in employment. Instead, infrastructure investment can
contribute to a steady-state policy of reducing the technical inefficiency of
private-sector production.
The results reported in this paper are, of course, conditional on the
particular specifications of technology and technical inefficiency that were
employed. A constant-returns-to-scale, Cobb-Douglas production function
was specified in order to provide comparability with the preponderance of
past empirical studies of public capital as a productive input. A more flexible
representation of technology (the translog) has been used by Mullen, Wil-
liams, and Moomaw (1996) in previous research on this topic. However,
Moroney (1992) showed that, with aggregate U.S. time-series data (of the
sort used in this paper), the translog function generates severe multicol-
linearity and is conclusively rejected in favor of a constant-returns-to-scale,
Cobb-Douglas representation of technology. Finally, technical inefficiency
was modeled by a random disturbance that has a half-normal distribution.
Other stochastic specifications of inefficiency (like the exponential distribu-
tion) are feasible, and it may be worthwhile to examine the sensitivity of
these results to alternative parameterizations.

Received: February 1997

Final version: September 1998

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