[BETA] Fortnightly

In a recent article ("The Efficient Utility: Labor, Capital, and Profit," Sept. 1, 1995), Taylor and Thompson attempt to measure the

economic efficiencies of 19 investor-owned utilities.

The authors use a method of efficiency measurement proposed by M.J. Farrell in a pioneering paper published nearly 40 years ago. Farrell's approach decomposes overall profit efficiency into two components: technical efficiency (the ability to produce a given physical output with a minimum quantity of inputs) and allocative efficiency (the choice of the optimal combination of inputs given the prices of the inputs).

Farrell's model belongs to a class known as "deterministic frontier models," which suffer from several critical deficiencies. First, any deviation from the frontier is attributed to the firm's inefficiency. In reality, some departures from the frontier are due to random exogenous factors (such as the weather). Second, these models are sensitive to extreme observations. If these extreme observations arise from measurement errors, estimates of the frontier will obviously be inaccurate.

We believe that a "stochastic" approach ameliorates these shortcomings by reflecting exogenous shocks that shift firms away from the efficient frontier.

In spite of its weaknesses, the deterministic frontier approach can yield important insights. Unfortunately, Taylor and Thompson's approach is flawed. First, the authors specify profit rather than physical production as the measure of the firm's "output" produced by labor and capital services. This specifi-cation confounds managerial

inefficiencies with the effects of differences in input prices, factors over which managers have limited control. Optimized profit is not directly a function of labor and capital. Rather, profit is indirectly achieved by (i) maximizing the output from a given combination of labor and capital inputs, and (ii) minimizing total costs, given input prices. Thus, deviations from a "profit frontier" include both technical inefficiency (waste) and allocative inefficiency (failure to minimize cost).

Second, we believe all variables in their analysis are inappropriately measured. The authors measure capital by the book value of total assets, which includes cash and investments in associated or subsidiary companies. We believe the appropriate proxy for the physical capital of the utility is the value of total utility plant. The labor variable appears to be measured by the total number of utility employees, with no adjustment for part-time workers, which could provide a distorted measure of labor hours used in production.

Third, the authors omit fuel as an input in the production process and make no adjustment for purchased power. Fuel efficiency is an important component of overall utility efficiency. Further, purchased power serves as an input in the production process of delivered power and its omission potentially distorts the evaluation of utility efficiency.

Finally, the authors make no attempt to distinguish short-run efficiency (capital stock is fixed) from long-run efficiency (capital stock can be varied). Observed technical inefficiency may be caused by poor management, but may also be due to the use of capital of older vintage. This distinction is important in the electric power industry, which is extremely capital-intensive and subject to lengthy adjustment lags.

Figure 1 compares the two frontiers: Taylor and Thompson's, with gross profits as the