Measuring the effect of management on production: a two-tier stochastic frontier approach

We revisit the production frontier of a firm, and we examine the effects that the firm's management has on output. In order to estimate these effects using a cross-sectional sample while avoiding the costly requirement of obtaining data on management as a production factor, we develop a two-tier stochastic frontier model where management is treated as a latent variable. The model is consistent with the microeconomic theory of the firm, and it can estimate the effect of management on the output of a firm in monetary terms from different angles, separately from inefficiency. The approach can thus contribute to the cost-benefit analysis related to the management system of a company, and it can facilitate research related to management pay and be used in studies of the determinants of management performance. We also present an empirical application, where we find that the estimates from our latent-variable model align with the results obtained when we use the World Management Survey scores that provide a measure of management.