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