effect by extending (6) to
(7) Xi = eφ Ft ( K. ) = Aeφ∙ ψ ( Yrl )μ,
where E(φi) = E(ψt) = 0.
The second interpretation is to assume a (neo-classical) technology with one
output and several inputs, of which two are capital and materials, and output
constrained cost minimization. Let Xiit denote output, Yiit = (Yiit1 ,...,YiitG) the
vector of G inputs, and wti = (wti1 ,...,wtiG) the vector of input prices, common to
all firms - all treated as latent variables. We describe the technology by
(8) Xiit = eφiFt(Yiit ),
where Ft is a production function common to all firms, t reflecting that tech-
nological changes are allowed for. We interpret φi as a constant known to firm
i, but unobserved by the econometrician. The dual cost function can then be
written as Ciit = Gt(wti,e-φiXiit) [cf., e.g., Jorgenson (1986, section 5)], where
Ciit = PkG=1 wtik Yiit k. Using Shephard’s lemma, we can express firm i’s optimal
input of factor k in year t as
(9) Yiitk =gtk(wti,e-φiXiit),
where gk (∙) = ∂Gt(∙)/∂wi. Assuming that Ft represents a homothetic technology,
so that Gt can be separated as Gt(wti ,e-φiXiit)=Ht(wti)K(e-φiXiit), where the
functions Ht and K are monotonically increasing, (9) becomes
Yiitk =htk(wti)K(e-φiXiit),
with hk(∙) = ∂Ht(∙)/∂wi. If, in particular, (8) has a constant scale elasticity μ for
all firms and years, then K(e-φiXitt) = e~cφμi∣μ(X*t)1 /μ for all i,t and hence
(10) Y'lk = hk ( w, ) e--∙-'μ ( Xit )1 /μ.
Taking logs, we can then write both (7) and (9) in simplified notation as
(11) χit = c + αi+ γt + βξit,
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