Effects of allocative inefficiency on resource allocation and energy substitution in Pakistan's manufacturing

Empirical economists often ignore that firms may not minimise costs in the presence of allocative inefficiency. Assuming strict cost minimisation when actually cost is not minimum may produce biased parameter estimates and elasticities. We consider a method for estimating effects of allocative inefficiency on resource allocation and factor substitution and apply it to data from Pakistan's manufacturing. Results show strong evidence of allocative inefficiency leading to over-utilization of raw material and capital viz-a-viz energy and tabour, and increasing cost of production of firms by 1% per annum. Computed elasticities diverge from their true values in the presence of allocative inefficiency. (C) 2004 Elsevier B.V. All rights reserved.