Theory and Application of Directional Distance Functions

Author(s): ROLF FÄRE and SHAWNA GROSSKOPF

Source: Journal of Productivity Analysis, Vol. 13, No. 2 (March 2000), pp. 93-103
Published by: Springer
Stable URL: https://www.jstor.org/stable/41770008
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 ■MB Journal of Productivity Analysis, 13, 93-103 (2000)
© 2000 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.

Theory and Application of Directional Distance

Functions

ROLFFÄRE rolf.fare@orst.edu
Department of Economics and Departm

SHAWNA GROSSKOPF shawna.grosskopf@orst.edu

Department of Economics, Oregon State University, Corvallis, OR 973

Abstract

In 1957 Farceli demonstrated how cost inefficiency could be decomposed into two mu-
tually exclusive and exhaustive components: technical and allocative inefficiency. This
result is a consequence of the fact that - as shown by Shephard - the cost function and
the input distance function (the reciprocal of Farcell's technical efficiency measure) are
'dual' to each other. Similarly, the revenue function and the output distance function are
dual providing the basis for the decomposition of revenue inefficiency into technical and
allocative components (see for example, Färe, Grosskopf and Lovell (1994)). Here we
extend those results to include the directional distance function and its dual, the profit
function. This provides the basis for defining and decomposing profit efficiency. As we
show, the output and input distance functions (reciprocals of Farceli efficiency measures)
are special cases of the directional distance function. We also show how to use the di-
rectional distance function as a tool for measuring capacity utilization using DEA type
techniques.

Keywords: directional distance function, profit efficiency, Farrell efficiency

1. Introduction

The directional (technology) distance function2 has recently been shown to be an importan
tool in production theory, yielding the more familiar Shephard type output and input distanc
functions (also familiar as radial measures of technical efficiency) as special cases. Th
duality between this distance function and the profit function was exploited by Chamber
Chung and Fare (1998) and Färe, Grosskopf and Weber (1999) in the theoretical develop
ment and empirical application of profit efficiency and its decomposition into allocative and
technical efficiency, respectively. Here, too the Farrell decompositions of overall cost an
revenue efficiency into allocative and technical efficiency can be shown to be special case
of the corresponding profit efficiency decomposition.
Again exploiting the profit-directional distance function duality, Fare and Grosskop
(1998) proved that additive separability of the profit function can be expressed as a particula
condition on the distance function. This is the analog of linear homogeneity exhibited by th

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 94 FÄRE AND GROSSKOPF

traditional distance functions (al

distance function has also proved
of undesirable outputs and measu
example Chung, Fare, and Grossk
These papers exploit the fact tha
expansion of desirable outputs an
In this paper we start by giving
and its relationship to the profit
directional distance function, nam
techniques.

2. Distance Functions and Their Duals

We begin by reviewing some of the properties of the directional (technology) distan

function. We then provide a proof of how the translation property of the directional dis
tance function evolves into homogeneity when the directional vector is chosen to yield on
of its special cases - the output distance function. We also show the basic dual relatio
between the directional distance function and the profit function. From this we deri
the Mahler (output) inequality which is the foundation for efficiency measurement and it
decomposition into allocative and technical components in the spirit of Farrell (1957).
We denote the technology by T , and think of it as describing the transformation of input
vectors x = (jti, . . . , jt#) e into output vectors y = (yi, ... , jm) £ 9^+ » i.e.»

T = {(x, y): X can produce y}. (1)

In terms of properties satisfied by the technolog

set and that inputs and outputs are freely disposa
as

for (jt, y) e T, x' > X, yr < y, imply ( x , /) G T. (2)

Imposing free disposability of outputs implies that there is no output congestion. The
advantage of the assumption of free disposability is that duality between the distance an
profit function can be proved using only nonnegative input and output prices. Convexity an
closedness of the technology are assumed in order for the duality between the direction
distance function and the profit function to hold.
Following Chambers, Chung and Fare (1998), let g = (-gx , gy) be a 'directional' vector,
then the directional distance function defined on the technology T is

ĎT(x, y; -gx, gy) = sup{/3: {x - ß gx, y + ßgy) e T}. (3

This distance function simultaneously seeks to expand output and contract input. This
illustrated in Figure 1. In the figure, g = (-gx,gy) is the directional vector in which the
input-output vector ( x , y) is projected onto the boundary of T at (x - DTgx, y + DTgy
where ĎT = ĎT(x, y, -gx, gy).

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 DIRECTIONAL DISTANCE FUNCTIONS 95

Figure 1. The directional distance function.

It is important to observe that the directional dis

zation of the technology. Formally this is expresse

ĎT(x, y, -gx, gy) > 0 if and only if (x, y) e T. (4)

Among the other properties of the directional distance function, we focus on one, namely
the translation property.4 This property corresponds to the homogeneity of degree +1 of
outputs in the output distance function, as we show below.
We begin by defining the Shephard (1970) output distance function as

D0(x,y) = mf{9: (x ,y/6)eT}. (5)

As noted above, this function is homogene

Do(x,0y) = eDo(x,y). (6)

Moreover the directional and the o

DT(x9y;0,y) = a/Do(x,y))-l. (7)

I.e., if the directional vector g is taken to b

described by (7). We include a summary of th

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 96 FARE AND GROSSKOPF

Table 1. Three distance functions.

Directional Distance Fn Dj(x, y;

Output Distance Fn D0(x , y) = inf{0: (a:, y/6) e T }
Input Distance Fn A (J< x) = sup{À: ( x/k , j) e T }

Relationships Among the Distance Functions

ĎT(x , y; 0, y) = ('/D0(x, y)) - 1, for (gy, gx) = (0, y)

Ďr(x,y;x,0) = (1 - 1/D¿(y,x)), for (gy,gx) = (x,0)

and their relationships in Table 1. Included is the Shephard input distance function (which
is reciprocal to the Farrell measure of input technical efficiency, or the Debreu coefficient
of resource utilization).
To show that the homogeneity condition (6) is a consequence of the translation property,
let us first define the latter. We say the distance function DT satisfies the translation property
if for a > - 1,

ĎT(x - agx,y + agy ; - gx,gy ) = ĎT(x,y, - gx,gy ) - a. (8)

Now take -gx = 0 and gy = y, then by (8)

E>t(x, y +ay; 0, y) = ĎT{x, y ' 0,y) - a

and

(1+g)¿r(*, (1 + a)yi 0, y) = (1 + a) Drix, (1 + o)y; 0, (1 + a)y)

(1+a)

This last equality holds since the distance function DT has the property DT(x, y
Xgy) = (l/X)ĎT(x, y; -gx, gy), see Chambers, Chung and Färe (1998).
Now apply (7) twice, then

(1 + a)(l /D0(x, (1 + a)y) - 1) = ^ -I- a

and

D0(x, Oy) = 6D0(x, y ),

where (l+a) = 0>O proving our statement. This new result establishes the re
between the homogeneity and translation properties.
Our next task is to establish the dual relationship between the directional distance f
and the profit function. Denote input prices by w = (w' , . . . , w^) g and outp
by p - (/?i,..., pm) € 9Î+ , then the profit function is defined as

n(p, w) = sup{/ry - wx : (x, y) € T], (9)

(*,y)

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 DIRECTIONAL DISTANCE FUNCTIONS 97

This means that U(p,w) is greater than or equal to t

vector, i.e.,

n (p,w) > py - wx for all (jc , y) e T.

Thus since (x - ĎT(x , y; -gx, gy)gx , y + ĎT(x , y

n(/?, w) > /?(j + ¿>r(x, ~gx, gy)gy ) - - D

or

n(/7, w) > py - wx + ĎT(x, y; -gx, gy)(pgy + wgx). (10)

The inequality in (10) shows the relationship between the profit function U(p,w) and the
directional distance function Dt(x, y; -gx, gy). This we call the Luenberger inequality
which is in essence an additive Mahler inequality, which eventually will be used to derive our
definition and decomposition of profit efficiency. From (10) the following duality theorem
can be derived.

Tl(p, w) = max I py - wx + ĎT(x, y; -gx, gy)(pgy + wgx) | .

(*,;y)>:0 I J

- , , 'U(p,w)-(py-wx)]
(W,P)> 0 I pgy + WgX J
DT(x,y' , -gx,gy) , = max '

The first expression above shows how the profit function is defined in terms of the direc-
tional distance function Dt(x, y ; - gx, gy) and the second part shows how to recover the
directional distance function from the profit function. In contrast, the output distance func-
tion is dual to the revenue function and the input distance function is dual to the cost function.
As a handy reference, we summarize the relevant Luenberger and Mahler inequalities and
dualities in Table 2.
Returning to the inequality in (10), we can see how it may be used to provide a definition
of profit efficiency. (10) may be rewritten as

n(p,w)-(py-wx) -
Pgy + wgx

and we may close the inequality by adding an allocative inefficiency term AE, i.e.,

Tl(p,w)-(py-wx) -
Pgy + u>gx

Chambers, Chung and Färe (1998) refer to the left hand side of (13) as the Nerlovian profit
efficiency measure. The directional distance function provides a measure of technical
efficiency and A E measures the residual inefficiency due to failure to choose the profit
maximizing input-output bundle given relative prices.5 We note that profit efficiency is the
ratio of the difference between maximal and observed profit normalized by the value of
the direction vector. This normalization implies that the measure is independent of unit of

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 98 FÄRE AND GROSSKOPF

Table 2. Distance functions: Inequali

Three Inequalities

Profit T'(p , if) > py - wx + ĎT(

Revenue R(x , /?) > py/D0(x , j)
Cost C(j, if)) < wx/Diiy , x)
Three Dualities

Profit n(/7, w) = sup(jc v)>0 {/ry - wx + Ôr(x, y; -g*, gv)(pgv + wg*)}

Dr (X. y; -fc. g,) = sup(u,ip)ï0 j )

Revenue R(x, p) = supv { D^y) }
D0(x, J) = suP;,{^}
Cost C (y, w) = inf^ { }

measurement. It also h
is negative or zero. Not
value of the output dir
note that profit efficie
vector chosen. In prac
of the observation, i.e.
symmetry with the tra
observed input or outp
It is important to obse
Nerlovian measure. He
decompostion can be de
First we need to define the revenue function

R(x , p) = sup{/?y: D0(x, y) < 1} (14)

y

and the corresponding overall Farrell output based measure of revenue efficiency may be
written

1 -/£, (15)
py D0(x,y)

where (1/D0(x, y)) is the output based measure of technical efficiency and
efficiency. In general, AE in (13) and AE in (15) will differ.
To show how (15) may be derived from our general profit and directional d
formulation, we follow Fare and Grosskopf (1997) and note that if the dire
is taken to be equal to g == (0, y), then (12) becomes

n (p, w) + wx > py/D0(x, y). (16)

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 DIRECTIONAL DISTANCE FUNCTIONS 99

Table 3. Decompositions of efficiency.

Profit " = Djix, y; -g,. gy) + AE

Revenue R(x, p)/py = AE/D0(x , y)

Cost C(y, w)/wx = AE/Di(y,x)

Furthermore,

n (p, w) > R(j c, /?) - lüx for all (x, y) £ T, (17)

and if x* is the input vector that maximizes profit, (17) holds with equality
equals

R{x'p)>py/D0(x'y) (18)

which is the Mahler output inequa

expression with an allocative effic
based decomposition

^A = -^.ÂE (19)
py D0(x, y )

Thus we have shown that the Farrell output efficiency measures and decomposi
a special case of the Nerlovian profit efficiency and its decomposition. One may s
derive the Farrell input efficiency and decomposition from the Nerlovian profit effi
All three decompositions are summarized in Table 3.

3. Capacity Measurement

Capacity has been measured using both an input based and an output based approach,
see Kirkley and Squires (1998) for a survey. Here we introduce a capacity measure that
combines these approaches by way of the directional distance function.
Our measure has its roots in Johansen (1968, p. 50), who defines plant capacity as '. . . the
maximum amount that can be produced per unit of time with the existing plant and equipment
provided that the availability of the variable factors is not restricted. ' To make this concrete,
let the input vector be partitioned into two subvectors x = (x/,xv), where Xf is the subvector
of fixed factors and xv is the subvector of variable factors. Define the production function
for M = 1 as

F(xf, xv) = F(x) = ma x{y: (x, y) e T}, (20)

and define capacity as

F(xf) = ma x{F(xf, xv): xv > 0} (21)

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 1 00 FÄRE AND GROSSKOPF

Then the Johansen capacity utilizatio

CU = F(xf, xv)/F(xf) = F(x)/F(xf). (22)

Due to the simple relationship between the output distance functio

function, namely

D0(x,y) = y/F(x ), (23)

capacity utilization (22) can be writ

CU = Ď0(xf,y)/D0(x,y). (24)
We take (24) as the multi-output measure of the Joh
where

D0(xf, y) = inf{6>: (xf,xv, y/0) eT,xv> 0}.

The Johansen approach as described in (22) and (24) is

does not account for the possibility that 'too much' of t
incorporate both expansion of outputs and contraction
we appeal to the directional distance function.
Recall that

Dt(x, y; -gx, gy ) = sup{/3: (x - ß gx, y + ßgy) € T}. (25)

Now using the partition of the input vector x into fixed inputs and variable inputs xv we
define the directional distance function when the variable inputs are unrestricted as follows

£>t(x/, y; -gxf,gy) = supfyS: (xf - ßgXf,xv, y + ßgy) e T, xv > 0}. (26)

Now our new capacity utilization measure is defined as

Prix, y ; -gx,gy) + 1 ^
ĎT(x/,y; -gXf,gy) + 1

This differs from the original Johansen measure in the

lows for expansion of output (as in Johansen' s definitio
contrast to his definition). Moreover, it follows from the r
of distance functions that if the directional vectors -g
then (27) simplifies to (24). Thus our measure is a genera
measure.

In order to show how this capacity utilization measure may be est

we show how the two component distance functions may be estima
techniques.

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DIRECTIONAL DISTANCE FUNCTIONS 101

We assume that there are k = 1 ..... À' observati

two distance functions that constitute (27) are es

ĎT(xk',yk''
P,Z
-gx,gy) = maxß
S.t.

53 Z*W"" - yvm + ßSym =

k= 1

^2 ZkXkn - Xk'n ~ ,n = l,...,N,

k= 1

zk> 0, k = l,...,K. (28)

and

Dt (Xf , /' ;-gxf,gy) = ß

s.t.

- yk'm+ ßgym,m = ',..

k= 1

Y^zk*kf > Xk>f-ßgXf

k= 1

Zk> 0, * = 1,...,Ä' (29)

where the are the intensity variables

difference between the two models in
included in the constraint set, while i
We note again that the directional vec
earlier, in practice, we generally choo
which is in the spirit of the origina
where the 'direction' of the scaling is
One could also imagine optimizing ove
example).

4. Conclusions

The duality between the Shephard input (output) distance function and the associated
(revenue) function have proven to be fruitful theoretical and empirical tools, providin
basis for the Farrell decompositions of input and output based efficiency mesurement. U
recently, similar duality between the profit function and distance functions proved el
Unlike the revenue and cost functions, the profit function has an additive structure.
suggests that the Shephard type distance functions, which are multiplicative, were no

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 1 02 FÄRE AND GROSSKOPF

appropriate dual model of techn

taneous (and additive) adjustment
from work on the demand side by
technology distance function - w
recently published papers. Here w
the directional distance function an
Shephard input and output distan
be special cases of the directional
respectively. We also show that th
is the analog of homogeneity of
generalized model of capacity and

Notes

1 . We are grateful to William Cooper for organizing this special session for the Athens productivity and efficiency
workshop.
2. Or shortage function as it was called by its originator, Luenberger (1992, 1995).

3. For a proof see Chambers et al (1998).

4. For other properties see Chambers et al (1998).
5. We note that if relative prices are positive our measure of allocative efficiency will capture inefficiency due to
'slacks' if estimated using activity analysis as in DEA. We would argue that the 'fiat spots' that arise in such
estimation may be thought of as arising due to lack of sufficient observations.

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