PRODUCTION FUNCTION ESTIMATION WITH UNOBSERVED INPUT PRICE DISPERSION

Paul L. E. Grieco, Shengyu Li, Hongsong Zhang
2016 International Economic Review  
We propose a method to consistently estimate production functions in the presence of input price dispersion when intermediate input quantities are not observed. The traditional approach to dealing with unobserved input quantities-using deflated expenditure as a proxy-requires strong assumptions for consistency. Instead, we control for heterogeneous input prices by exploiting the first order conditions of the firm's profit maximization problem. Our approach applies to a wide class of production
more » ... unctions and can be extended to accommodate a variety of heterogeneous intermediate input types. A Monte Carlo study illustrates that the omitted price bias is significant in the traditional approach, while our method consistently recovers the production function parameters. We apply our method to a firm-level data set from Colombian manufacturing industries. The empirical results are consistent with the prediction that the use of expenditure as a proxy for quantities biases the elasticity of substitution downward. Moreover, using our preferred method, we provide evidence of significant input price dispersion and even wider productivity dispersion than is estimated using proxy methods.
doi:10.1111/iere.12172 fatcat:7bmsl67vx5bwroovqwy5e7bprq