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Fortnightly Magazine - January 1 1996

output measure; and an alternative that uses net generation as the output measure. Each ratio variable has been standardized to the unit interval for easier comparison. Perhaps the most striking feature of the plot that uses net generation as output is the relative position of San Diego Gas & Electric (SDG&E), which now appears a significant distance from the frontier.

The Center for Regulatory Studies is currently engaged in an extensive analysis of electric utility efficiency issues, applying stochastic frontier methods. Our results should shed considerable light on the types of questions raised but left unanswered by Taylor and Thompson.

Matthew J. Morey, Director

L. Dean Hiebert, Associate Director

Center for Regulatory Studies

Normal, IL

The authors respond:

We welcome the analysis by Morey & Hiebert (M&H). But their arguments led us to imagine the mood in Detroit's boardrooms in the 1970s: "We don't need to worry about those Japanese cars." Today we know how that turned out.

First, M&H claim better results from stochastic measurements (em e.g., statistical regression (em than from DEA Best Practice. Experts have long debated the merits and demerits of these alternative techniques. The recent monographs edited by Fried et al. (The Measurement of Productive Efficiency, Techniques and Applications, New York: Oxford Univ. Press, 1993) and Charnes et al.(Data Envelopment Analysis, Theory, Methodology and Applications, Boston: Kluwer Acad. Pub., 1994) include bibliographies of well over 500 publications. We doubt that utility managers have time to address this debate, but several key points warrant examination.

First, decisions based on the "average" can lead to mediocrity. Figure 2 depicts four hypothetical firms (A, B, C, & D) using two factors (em labor and capital. A, B, & C determine the Best Practice frontier; D lags behind with excessive labor and capital use. If A, unaware of its position, used the average as the norm (em reducing labor costs, but failing to increase capital outlays (em it could lose its Best Practice status and see its costs rise. If D pursued the average, its situation would improve, but remain mediocre.

Stochastic frontier methods provide an average, as do virtually all statistical methods, particularly regression techniques. DEA Best Practice, in contrast, reveals the best-in-class performers. No known statistical technique provides such revelations.

Second, M&H claim better input-output identification. Measurement experts have long argued about the best variable representations. We sought to use definitions in accordance with both FERC reports and financial statement accounting practices. FERC Form 1 accounts solely for utility activities. This point is important because some utilities today engage in nonutility business, such as cable TV. And quibbling about cash as capital ignores that it forms a basic requirement of continuity. Similarly, some firms are reportedly outsourcing much of their labor under a part-time classification.

Third, M&H measure output by electricity units, but that focus ignores the real world. As the data shows, some utilities produce more than one output (em namely, gas and electricity. Not accounting for the gas part of the business may significantly underestimate total output and bias, and could flaw the efficiency estimates. Gas revenues