Estimating Production Functions with Heterogeneous Firms

We present a new approach to the estimation of production functions that allows for richer patterns of firm heterogeneity than can be accommodated under the proxy variable methods of Olley and Pakes (1996) and Levinsohn and Petrin (2003). In particular, we show that the economics of the firms static input choice contains the necessary identifying information to control for the endogeneity problem in the production function. From an econometric point of view, our estimation proceeds in a single GMM step, and thus standard asymptotic standard errors are available. We consider the identification and estimation of models with heterogeneity in both input and output prices, as well as heterogeneity in factor specific productivity. Our empirical results show that we control for more of the endogeneity problem than the proxy variable approach, resulting in estimates of labor productivity nearly half as small.