Tests of allocative efficiency in regulated multi-product firms

In this paper a shadow normalized restricted profit function is used to test for allocative efficiency with respect to both inputs and outputs in regulated firms producing multiple outputs. The efficiency of input choices is tested by examining the relationship between marginal rates of technical substitution and input price ratios, while the efficiency of output pricing is tested by examining the relationship between the price and marginal cost of each output. Observation specific estimates of deviations from efficient behavior are obtained by specifying the shadow prices of outputs and variable inputs as functions of variables that are causally related to the sources of inefficiency.

The model is estimated with data for privately-owned electric utilities in the United States. The results indicate that the price of residential output is less than its marginal cost and the price of commercial-industrial output is greater than its marginal cost. Utilities subject to fuel adjustment clauses are found to use more than the cost-minimizing amount of fuel relative to labor.