Three problems of measuring efficiency

After determining three problems of measuring efficiency’ they explained the reason of usage of frontiers. (MSY)

http://pages.stern.nyu.edu/~wgreene/FrontierModeling/SurveyPapers/Lovell-Fried-Schmidt.pdf (some passages from page 1-10)

By the efficiency of a producer we have in mind a comparison between observed and optimal values of its output and input. The exercise can involve comparing observed output to maximum potential output obtainable from the input, or comparing observed input to minimum potential input required to produce the output, or some combination of the two.

Even at this early stage three problems arise, and much of this Section is devoted to exploring ways each has been addressed. First, which outputs and inputs are to be included in the comparison? Second, how are multiple outputs and multiple inputs to be weighted in the comparison? And third, how is the technical or economic potential of the producer to be determined?

Knight proposed to redefine productivity as the ratio of useful output to input. Extending Knight’s redefinition to the ratio of useful output to useful input, and representing usefulness with weights incorporating market prices, generates a modern economic productivity index. As a practical matter, however, the first problem is not how to proceed when all outputs and all inputs are included, but rather how to proceed when not enough outputs and inputs are included.

What we have seen are simplified (if not simple) models of the firm in which measured performance differentials presumably reflect variation in the ability to deal with the complexities of the real world. Indeed performance measures based on simplified models of the firm are often useful, and sometimes necessary.

Even when all relevant outputs and inputs are included, there remains the formidable second problem of assigning weights to variables.

Alternatively, if market prices reflect monopoly or monopsony power, or cross-subsidy, or the determination of a regulator, do they still provide appropriate weights in a relative performance evaluation?

The third problem makes the first two seem easy. It is as difficult for the analyst to determine a producer’s potential as it is for the producer to achieve that potential.

In each of these cases we face the three problems mentioned at the outset of this section: what indicators to include, how to weight them, and how to define potential. The selection and weighting of indicators are controversial by our standards, although comparisons are appropriately made relative to best practice rather than to some ideal standard.

The same reasoning applies to the evaluation of business performance. We cannot know “true” potential, whatever the economic objective. But we do observe best practice and its change through time, and we also observe variation in performance among producers operating beneath best practice. This leads to the association of “efficient” performance with undominated performance, or operation on a best practice “frontier,” and of inefficient performance with dominated performance, or operation on the wrong side of a best practice frontier. Interest naturally focuses on the identification of best practice producers, and of benchmarking the performance of the rest against that of the best. Businesses themselves routinely benchmark their performance against that of their peers, and academic interest in benchmarking is widespread, although potential synergies between the approaches adopted by the two communities have yet to be fully exploited. Davies and Kochhar (2002) offer an interesting academic critique of business benchmarking

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