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Chapter 3: Production and Cost Function Analysis *

In the discussion in Chapter 2, we assumed that we had only data on marketlevel prices and quantities, together with cost and demand shifters. In this case, we were forced to make inferences about costs from the market outcomes together with an equilibrium assumption on the model. We saw how the equilibrium assumption can influence the resulting estimates of cost. Inside of learning about costs via equilibrium assumptions, we might be better off collecting data on the underlying cost and production process. The resulting data could be used together with a model of production or costminimization to estimate the production parameters without any reference to overall market equilibrium, or else the production and market equilibrium assumptions could be combined in one analysis. The careful treatment of cost and production functions brings up a range of classic economic and policy questions, including the issue of returns to scale (which is bound up with many questions of public regulation and/or ownership of firms) and with questions about firm-level productivity and how productivity is affected by policy. There are two related literatures. One focuses on estimation of the production function and is greatly concerned with simultaneity and with correct