International Applied Economics and Management Letters 1(1): 19-23 (2008)

The Technical Efficiency of Food Industry in Malaysia: An Application of Stochastic Frontier Model
Alias Radam, Mohd Rusli Yacob and Saidatul Asima Kamarulzaman Shah
Faculty of Economics adn Management, Universiti Putra Malaysia, Serdang, Selangor

Abstract: This study attempts to measure the status of technical efficiency of food industry in Malaysia using the stochastic frontier model. In an economic where recourses are scarce and opportunities for a new technology are lacking, efficiency studies will be able to show the possibility of raising productivity by improving the industrys efficiency. The estimated extent of inefficiency can help firms to decide whether to improve efficiency or to develop or adopt new technologies in order to raise the productivity. The computed technical efficiency indices show that the sampled of food industry under study were highly technical inefficient, with an average efficiency ratio of 0.688. Therefore, the results indicated that there is a great potential exists for food industry to further increase the value added using the available input and technology. Keywords: Technical efficiency, stochastic frontier model, food indistry

InTroducTIon Prior to the 1985-87 recessions, food and agricultural policies were aimed at increasing the production of export commodities such as cocoa and oil palm. After the recession, the government realised the need to focus on the production of final food products to diversify the economy. Through incentives provided for food processors under the Industrial Master Plan (MIDA, 1985), the government expected the food manufacturing sector to flourish and thus make more food available in the local market. The incentives given were meant for encouraging more investments in new machinery or technology in the sector. By employing the investment promotion strategy in food production, the government anticipated an increase in domestic food production and, hence a reduction in the dependence on imported food items. These anticipated changes, however, have yet to be materialised. In examining the food sector as a whole, understanding the sectors performance and measuring its productivity is important because of the fact that productivity growth is an important source of overall economic growth and welfare improvement of both consumers and producers. Productivity improvement will lead to lower products prices and higher consumer welfare. Measurement of productivity and efficiency in the agricultural production and food processing sectors in developed countries has been the focus of numerous studies (e.g., Morrison, 1999; Gopinath and Roe, 1997; Ball et al., 1997; Huffinan and Evenson, 1992; Chavas and Cox, 1994; Pardey et al., 1997; and Capalbo and Antle, 1988), with

most studies emphasizing on the production agriculture. The concept of technical efficiency is based on input and output relationships. Technical efficiency arises when actual or observed output from a given input mix is more than the maximum possible. Beside that, technical inefficiency also arises when actual or observed output from a given input mix is less than the maximum possible. A locative inefficiency arises when the input mix is not consistent with cost minimization. Empirical measurement of technical efficiency typically involves the specification and estimation of a frontier production function. In this paper, we used the stochastic frontier production function proposed by Battese and Coeli (1992), which followed the models, developed by Aigner et al. (1977). Data of 1952 food manufacturing firms in Malaysia for the year 2004 were used in this study. The advantages of using the stochastic production frontier model are that, disturbance term representing noise, measurement of error, and exogenous shock beyond the control of production unit in were introduced in addition to the efficiency component. The maximum likelihood estimation procedure was employed to obtain parameter estimates. In this study, a translog stochastic frontier production function is estimated using survey data of the food in the manufacturing firms in Malaysia. The rest of the paper is organized as follows: Section 2 describes the methodology involved in obtaining the total factor productivity measurements and its decomposition into technical efficiency change and technological change. Section 3 presents the empirical results, followed by a discussion and conclusion section.

20

Alias Radam, Mohd Rusli Yacob and Saidatul Asima Kamarulzaman Shah

ProducTIVITY And EFFIcIEncY MEASurEMEnT Although a variety of methods are used to measure production frontier, each of these methods has advantages and disadvantages and there is no obvious the superior approach among these methods (Aly et al., 1987). The choice of estimation method may have a significant influence on the calculated technical efficiency of farms in a given sample (Kalaitzandonakes et. al, 1992; Bravo-Ureta and Rieger, 1990; Neff et al., 1993; Dawson, 1985 and Ekanayake and Jayasuria, 1987). Insensitivity of these differences would lead to errant policies an inappropriate identification of farms most in need of extension (Neff et al., 1993). In view of the above, in this study, we have selected the most common method used in estimating frontier function that is, the stochastic parametric frontier. The maximum likelihood estimation procedure was employed to obtain parameter estimates. Farrells work directly measures the technical efficiency by means of linear programming techniques that simultaneously estimate the production frontier. The estimation of the deterministic frontier production function by Farrell, which provides the upper bound of output levels at all combination of inputs, was followed by the works of Aigner and Chu (1968), Timmer (1971), Arfiat (1972). Richmond (1974) and Schmidt (1986) first use mathematical programming techniques, both parametric and nonparametric, and then the econometric approach to measure technical efficiency. Measuring technical efficiency of firms by estimating frontier models is the latest econometric method developed. The stochastic frontier production function (SFPF) was independently proposed by Aigner et al. (1977). This function differs from the traditional (average) production function in that its residuals have two components: one to account for technical inefficiency and the other to permit random event that affects production. Many authors have altered and generalized the original specification of the SFPF. Forsund et al. (1980), Schmidt (1986), Bauer (1990) and Battese (1992), provide excellent surveys of the literature on frontier analysis. The stochastic frontier production function developed by Aigner et al. (1977), and Meeusen and van den Broeck (1977) was based on an econometric specification of a production frontier. A stochastic frontier production function as proposed by Battese and Coelli (1992) can be defined as: Yi = f (Xi, ) e
i

Yi is output vector for the ith firm, Xi is vectors of inputs, is a vector of parameter and i is an error term. In this model, a production frontier defines output as a function of a given set of inputs, together with technical inefficiency effects. The stochastic frontier is also known as composed error model, because it postulates that the error term i is composed of two independent error components. i = vi + ui (2)

Where vi ~ N(0,v2) represent any stochastic factors beyond the firms control affecting the ability to produce on the frontier such as luck and weather, where a symmetric component normally distributed. It can also account for measurement of error in Y i or minor omitted variables. The asymmetric component, in this case distributed as a half-normal, ui ~ |N (0,u2)|, ui 0, can be interpreted as pure technical inefficiency. This component has also been interpreted as an unobservable or latent variable, and in most cases representing managerial ability. The parameters of v and u can be estimated by maximizing the log-likelihood function as shown follows:

(3) where; i = Y f((Xi ; ) v 2 2 = u + u

= F = The standard normal distribution function N = Number of observation Given the assumption on the distribution of v and u, Jondrow et al. (1982) showed that the conditional mean of u given is equal to (4) where f and F the standard normal density and distribution function evaluated at . Measures of technical efficiency (TEi) for each firm can be calculated as;

(1)

International Applied Economics and Management Letters Vol. 1, 19-23

The Technical Efficiency of Food Industry in Malaysia: An Application of Stochastic Frontier Model

21

TEi = exp(-E[ui|i]) so that 0 TEi 1

(5)

The translog stochastic frontier production function in logarithm form is as follows;

Table 1: Empirical Estimates of Frontier Production Function

t-ratio 21.0653a 7.77968a 1.0400 -0.3781 1.0532 15.3838a 8.1966a 4.2257a -4.5887a -7.7694a

ln Yi = ln 0 + 1 ln Li + 2 ln Ci + 3 ln W + 4 ln E + 3 ln L.lnL + 2 ln C.lnC + 3 ln E.lnE + 1 ln L.lnC + 2 ln L.lnE + 3 ln C.lnE + i (6) where Y represent value of added (RM) per year. Independent variables are C (capital, RM), L (numbers of labor), and E (energy, RM). The advantage of using the stochastic production frontier model is the introduction of a disturbance term representing noise, measurement error and exogenous shock beyond the control of production unit in addition to the efficiency component. EMPIrIcAL rESuLTS The Maximum Likelihood Estimated (MLEs) of the - parameter for the stochastic model and parameter for the efficiency model and their asymptotic t-statistic are reported for the Tranlog stochastic production frontier in Table 1. The significant of the parameter to 0.8187 showed that there exists sufficient evidence to suggest that technical inefficiencies are present in the data. As shown in Table 1, the estimates of the errors variances 2u and 2v are 0.23129 and 0.345511 respectively. Therefore, it can be easily seen that the variance of one-side error 2u is smaller than the variance of random error 2v. Thus, the value of deficients less than one, implies that only a small part of the residual variation in value added is associated with the variation in technical inefficiency rather than with measurement error which is associated with uncontrollable factors related to the production process. This situation can be interpreted that variations in actual production between firms do not arise mainly from differences in industry practice rather than from random variability. Following the Battese and Cora (1977), we can also estimate the total variation in output from frontier that is attributable to technical efficiency using the parameter , where equal . After calculating using this formula, the is 0.3046. This means, 30.46 percent of the discrepancies between

1 2 3 Log likelihood function

7.9086a 38.7155a

0.7592 0.34511 0.23129 0.58746 0.48093

v u
Note: aSignificant at 1 percent level

observed output and frontier output are due to technical inefficiency. In other word, the shortfall of obser ved output and the frontier output is primarily due to factors which are within the control of the firms. The estimated technical efficiency indices using Jondrow et al. (1982) are presented in Table 2. The level of efficiency has a width range. The minimum estimated efficiency is 19.19 percent while the maximum is 87.34 percent and the mean level of technical efficiency is 68.80 percent. According to Grabowski et al. (1990), a firm is considered technical inefficient even if the firm registered a technical efficiency index of 82 percent. By this standard, therefore, the number of firms considered efficient technically is only 39.3 percent of the total firms in the sample under study. Separating the composed error term of stochastic frontier model provides the level of technical inefficiency for a sample of food manufacturing industry in Malaysia. The analysis shows that, on average, there is 33 percent technical inefficiency in the sample firms. This means that actual firm output is 33 percent less than maximal output which can be achieved from the existing level of inputs.

International Applied Economics and Management Letters Vol. 1, 19-23

22

Alias Radam, Mohd Rusli Yacob and Saidatul Asima Kamarulzaman Shah

Table 2: Food Manufacturing Industry Specific Technical Efficiencies in the Stochastic Production Frontier Efficiency Level (%) 10 19.99 20 29.99 30 39.99 40 40.99 50 59.99 60 69.99 70 79.99 80 89.99 90 99.99 Total Minimum Maximum Mean Std. Deviation Frequency 0 1 7 10 24 175 843 782 110 1952 19.19 89.34 68.80 8.24 Percent 0.00 0.05 0.36 0.51 1.23 8.97 43.19 40.06 5.64 100.00

the government should continue to increase its support for public investment in infrastructure and technology such as road, research and extension. rEFErEncES
Aigner, D.J. and S.F. Chu. 1968. On Estimating the Industry Production Function. American Economic Review, 58: 826-839. Aigner, D.J., Lovell, C.A.K. and P. Schmidt. 1977. Formulation and Estimation of Stochastic Production Function Models. Journal of Econometrics, 6: 21-37. Aly, H.Y., K. Balbase, R. Grabowski and S. Kraft. 1987. The Technical Efficiency of Illiois Grain farms: An Application of Ray-homothetic Production Function. Southern Journal of Agricultural Economics, 19: 69-78. Arfiat, S.N. 1972. Efficiency Estimation of Production Function. International Economic Reciew, 13: 568-598. Ball, E. V., B. Jean-Christophe, R. Nehring, and A. Somwaru. 1997. Agricultural Productivity Revisited. American Journal. of Agriculture Econonomics, 79 (November): 1045-1063. Battese, G.E and G. Corra. 1977. Estimation of a Production Function Frontier Model: With Application to the Pastrol Zone of Eastern Australia. Australian Journal Agricultural Economics, 21: 169-179. Battese, G.E. 1992. Frontier Production Function and the Technical Efficiency: A Sur vey of Empirical Application in Agricultural Economics. Agricultural Economics, 7: 185-208 Battese, G.E. and T.J. Coelli. 1992. Frontier Production Functions, Technical Efficiency and Panel Data: with Application to Paddy Farmers in India. Journal of Productivity Analysis, 3: 153-169. Bauer, P.W. 1990. Recent Development in Econometric Estimation of Frontier. Journal of Econometrics, 46: 39-56 Bravo-Ureta, B.E. and L. Rieger. 1990. Alternative Production Frontier Methodologies and Dair y Farm Efficiencies. Journal of Agricultural Economics, 41: 215-226. Capalbo, S. and J.M. Antle. (Eds.) 1988. Agricultural Productivity: Measurement and Explanation, Resources for the Future, Washington DC.

concLuSIon The purpose of this paper is to measure the efficiency of food manufacturing industr y in Malaysia using stochastic production frontier. The technical efficiency index computed shows that sample industry under study are highly technical inefficient, with an average efficiency ratio of 0.688. Therefore, our results indicate that great potential exists for the firms to further increase the output using the available inputs and technology. This means that without any additional costs, the technical efficiency can be increase substantially. The findings of the study emphases the need to further improve food industry efficiency at all levels of operations. Governments effort should be directed in education to produce skills workers; extension to enhance effective technology transfer and adoption; information and communication to improve marketing and trade, and supports in terms of infrastructure and finance to facilitate investments. These elements would be the driving forces to directly and indirectly improve the extent of food industry efficiency. The study also revealed that the technical inefficiency on individual firms varies greatly, from 19.19 to 89.34 percent. This is due to the fact that structure of the industry, characterized as disorganized with a few large firms at one end many small firms scattered at the other. Policy should be driven to consolidate the industry to achieve the economies of scale which consequently lead to more efficient industry. Other the hand, this implies that

International Applied Economics and Management Letters Vol. 1, 19-23

The Technical Efficiency of Food Industry in Malaysia: An Application of Stochastic Frontier Model

23

Chavas, J. P., and T.L. Cox. 1994. A Primal and Dual Approach to Nonparametric Productivity Analysis: The Case of U.S. Agriculture. Journal. of Productivity Analysis , 5: 359-373. Dawson, P.J. 1985. Measurement Technical Efficiency from Production Function: Some Further Estimates. Journal of Agricultural Economics, 36:31-40 Ekanayake, S.A.B. and S.K. Jayasuria. 1987. Measurement of Farm-Specific Technical Efficiency: A Comparison Methods. Journal of Agricultural Economics, 38:115122 Farell, M.J. 1957. The Measurement of Production Efficiency. Journal of the Royal Statistical Society, Series A, General. 120:253-290. Forsund, F.R. C.A.K. Lovell, and P. Schmidt. 1980. A Survey of Frontier Production Function and their Relationship of Efficiency Measurement. Journal of Econometrics, 13:5-25 Grabowski, R and C. Pasurka (1988). The Relative Technical Efficiency of Northern and Southern U.S. Farm in 1860. Sourthern Economic Journal. 54(3):598614. Gopinath, M. and T.L. Roe. 1997. Sources of Sectoral Growth in an Economy Wide Context: The Case of U.S. Agriculture. Journal. of Productivity Analysis, 8: 293-301. Huffinan, W. and R.E. Evenson. 1992. Contributions of Public and Private Science and Technology to U. S. Agricultural Productivity. American Journal of Agricultural Economics, 74: 751-756. Jondrow, J., C.A.K. Lovell, I.S. Materov, and P. Schmidt. 1982. On Estimation of Technical Inefficiency in the Stochastic Frontier Production Function Model. Journal of Econometrics 19(2/3), 233-238.

Kalaitzandonakes, N.G., S. Wu and J. Ma. 1992. The Relationship between Technical Efficiency and Farm Size revisted. Journal of Agricultural Economics, 40:427-442 Meeusen. W. and J. van den Broeck. 1977. Efficiency Estimation from Cobb-Douglas Production Functions with Composed Error. International Economic Review, 18: 435-444. Morrison-Paul, C. J. 1999. Scale effects and mark-ups in the US Food and Fibre Industries: Capital Investments and Import Penetration Impacts. Journal of Agricultural Economics., 50 (1): 64-82. Neff, D.L., P.Gracia, and C.H. Nelson. 1993. Technical Efficiency. A Comparison of Production Frontier Methods. Journal of Agricultural Economics, 44(3): pp. 479489. Pardey, P. G., B.J. Craig, and K.W. Deininger. 1994. A New Look at State-Level Productivity Growth in U.S. Agriculture. In W .B. Sundquist (ed. ), Evaluating Research and Productivity in an Era of Resource Scarcity. Staff Paper, Department of Applied Economics, University of Minnesota, St. Paul. Richmond, J. 1974. Estimating the Efficiency of Production. International Economic Review, 15:515521 Schmidt, P. 1986. Frontier Production Function. Econometric Review, 4:289-328. Timmer, C.P. 1971. On Measuring Technical Efficiency. Food Research Institute Studies, 9:99-171

International Applied Economics and Management Letters Vol. 1, 19-23