Unobserved heterogeneity in stochastic cost frontier models: an application to Swiss nursing homes

This paper applies a number of stochastic cost frontier models to a panel data set and compares their ability to distinguish unobserved heterogeneity from inefficiency variation among firms. The main focus is on Greene's 2005 panel data model that incorporates firm-specific effects in a stochastic frontier framework. In cases where the unobserved heterogeneity is correlated with explanatory variables, while the random effects estimators can be biased the fixed effects model may overestimate inefficiency. In line with Mundlak, a simple method is proposed to include such correlations in random effects specification. The sample includes 36 Swiss nursing homes operating from 1993 to 2001. The results suggest that the proposed specification can avoid the inconsistency problem while keeping the inefficiency estimates unaffected.