Estimating Supply Response in the Presence of Technical Inefficiency Using the Profit Function: An Application to Ethiopian Agriculture

Studies of supply response using the profit function have typically maintained the neo-classical assumption of efficiency. Using farm-level data from Northern Ethiopia, this study examines the impact of technical inefficiency on the response of small holder farmers. Two systems of output supply and input demand functions are estimated and compared: one the standard model in which technical efficiency is assumed and another in which technical inefficiency is explicitly incorporated into the profit function. While the results from non-nested hypotheses tests are inconclusive, the model with technical inefficiency is preferred to the other model for theoretical consistency. Incorporation of inefficiency has generally increased the magnitudes and the statistical significance of own price elasticities, substantially so in the case of teff and fertilizer. The results indicate that farmers in Ethiopia do respond positively and significantly to price incentives. The results also underscore the need to improve farmer’s access to better quality land, farm inputs and credit, and public investment in roads and irrigation.