Determination of Production Technologies

To determine whether an industry exhibits constant returns to scale, whether the production fUnction is homothetic, or whether inputs are separabl~ a common approach is to specify a cost function, estimate its parameters using data such as prices and quantities of inputs, and then test the parametric restrictions corresponding to constant returns, a homothetic technology, or separability. Statistically, such inferences are valid if the true cost fUnction is a me~er of the parametric class considered, otherwise the inference is biased. That is, the true rejection probability is not necessarily adequately approximated by the nominal size of the statistical test. The use of fixed parameter flexible functional forms such as the Translog, the generalized Leontief, or the Box-Cox will not alleviate this problem. The Fourier flexible form differs fundamentally from other flexible forms in that it has a variable number of parameters and a known bound, depending on the number of parameters, on the error, as measured by the Sobolov norm, of approximation to an arbitrary cost function. Thus it is possible to construct statistical tests for constant returns, a homothetic technology, or separability which are asymptotically unbiased by letting the num~er of parameters of the Fourier flexible form depend on sample size. That is, the true rejection probability converges to the nominal size of the test as sample size tends to infinity. The rate of convergence depends on the smoothness of the true cost function; the more times is differentiable the true cost function, the faster the convergence. The method is illustrated using the data on aggregate US manufacturing of Berndt and Wood (1975, 1979) and Berndt and Khaled(1979).