Productivity and profitability decomposition: A parametric distance function approach

One of the main focus of productivity studies is measurement of partial and/or total factor productivity which is entirely based on the production technology. In firm level studies these productivity measures do not necessarily indicate firm performance judged in terms of their financial performance (for example, profit) and are not very intuitive. In this article we provide the link between physical productivity and profitability, and in doing so we decompose profit change in terms of changes in outputs, output and input prices, in addition to technical change (TC), returns to scale, and markup components. Thus, the decomposition takes into account both the characteristics of the technology and prices. The technology part of the decomposition technique is based on a primal representation of the multi-output technology – estimation of which does not depend on price data. The technique is illustrated using Norwegian dairy farms during the period 1993–2006. We find that TC and especially markups had positive effects on profit growth. However, these positive effects were to some degree offset by negative effects from scale, input and output prices. The positive markup component indicates the presence of non-competitive behavior in output markets, which is expected in a regulated industry such as Norwegian dairy farming.