Do mergers and "critical mass" really make a difference? The answer, it seems, is yes.

To become more competitive, U.S. electric utilities have embarked on a quest in recent years to improve operational efficiency and factor productivity. The question is: Are utilities making progress? And, which companies have gained a competitive edge? Which have not?

Industry analysts have long argued that given the structure of the markets they serve and their cost-based, rate-setting procedures, electric utilities tend toward monopolistic behavior. Consequently, they are prone to wasteful applications of resources, especially overcapitalization. Without proper incentives, the argument went, utility managers have little motivation to cut costs or improve efficiency. As Hicks has argued, they would be more likely to exploit their market power by not bothering to approach maximum efficiency. "The best of monopoly profits," Hicks suggests, "is a quiet life."

These arguments, however, are waning quickly as the bang and clatter of competition disturbs the utility manager's "quiet life." Prompted by the discipline imposed by competitive markets and the demands of incentive regulation, utilities are paying increasing attention to the economic fundamentals of electricity production and delivery.

An examination of efficiency improvements at U.S. utilities, as measured by megawatt-hours per employee, reveals a modest increase (0.5 percent per year) between 1990 and 1995, mostly after 1993. This has led to moderately lower average system rates (see Figure 1). Variable expenses have declined in nearly all categories of operation and maintenance, fuel and labor. Price stability in the oil markets and better procurement practices also have helped control fuel input costs. In fact, labor productivity has shown steady annual improvements of more than 6 percent per annum, increasing from 4,670 MWh per employee (1990) to 6,420 MWh per employee (1995).

We have estimated the operational efficiencies for 94 U.S. electric utilities from 1990 to 1995 using conventional statistical techniques. As might be expected, the patterns that emerge appear to show some link between operational performance and geographic location. Also, to lend credence to the current "merger mania," we found that size of operation (and the fact of the merger itself) does appear to act as a significant determinant of overall efficiency.

Measures and Models

One measure of operational efficiency is productivity (em the ratio of outputs to inputs. Productivity among firms can vary due to several factors, however, such as

differences in production technologies, environments in which production takes place and efficiencies of the production processes. A firm is efficient if it cannot increase its output without adding more inputs; or, conversely, if it cannot decrease the quantity of its inputs without reducing its output.

Productive efficiency has two components: technical and allocative. The technical component marks the ability to produce as much output as possible with available inputs, or using as little input as possible to produce the same level of output. The allocative component tracks the ability to combine inputs and outputs in optimal proportions under prevailing prices. In other words, it is the flexibility to adjust the mix of inputs as their prices change. Here, we measure overall operational efficiency