ORIGINAL ARTICLE Productivity and profitability decomposition: A parametric distance function approach SUBAL C. KUMBHAKAR 1 & GUDBRAND LIEN 2,3 1 Economics Department, State University of New York, Binghamton, USA, 2 Faculty of Economics and Organisation Science, Lillehammer University College, Lillehammer, and 3 Norwegian Agricultural Economics Research Institute, Oslo, Norway Abstract 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. Keywords: Profit, total factor productivity growth, duality, input distance function, Norwegian dairy farming. Introduction Given that resources are scare, no matter whether one looks at the economy as whole or individual produ- cers in a specific sector of the economy, there is always a need for a better understanding of how well resources are used and what the sources of produc- tivity and profitability changes are. In a micro study of producers such understandings can identify units that are better than others in terms of certain measures of productive performance, either physical or financial or both. Knowledge of their performance and its components are useful for policy purposes. For example, if the objective is to promote growth and profitability (and therefore survival) of the producers, the knowledge of why some producers are better than others might be useful in setting targets as well as helping those that are underperformers. One common measure of performance is physical measures such as partial or total factor productivity (TFP) which is quite popular for country studies. In a country study, one often associates TFP growth with economic wellness (an indicator of the coun- try’s richness). In a micro study this analogy might not be true because the objective of the producers might be to maximize profit, but high profits are not always associated with high productivity and vice versa. Alternatively, maximization of productivity growth might not maximize profit. Because profit maximization is viewed as the goal of most produ- cers, we measure performance in terms of profit and decompose profitability (change in profit) into components such as output growth, output and input price changes, technical change (TC), returns to scale (RTS), and markups. We also relate profit- ability with TFP growth which is widely used in the literature, even for micro studies using panel data. There are several approaches to measuring pro- ductivity change 1 (Diewert, 1992a), including both Correspondence: Subal C. Kumbhakar, Economics Department, State University of New York, Binghamton, NY 13902, USA. Tel: 607 777 4762, Fax: 607 777 2782. E-mail: kkar@binghamton.edu Food Economics  Acta Agricult Scand C, 2009; 6: 143155 ISSN 1650-7541 print/ISSN 1651-288X online # 2009 Taylor & Francis DOI: 10.1080/16507541.2010.481898 Downloaded By: [Lien, Gudbrand] At: 19:57 21 May 2010