Abstract

This article is focused on modeling and analysing the cost structure of water supply companies. A cross-sectional data set was collected with respect to water firms in rural areas of East and West Germany. The empirical data is analysed by applying a symmetric generalized McFadden (SGM) functional form. This flexible functional form allows for testing the concavity required by microeconomic theory as well as the global imposition of such concavity restrictions without any loss of flexibility. The original specification of the SGM cost function is modified to incorporate fixed factors of water production and supply, e.g. groundwater intake and the number of connections supplied. The estimated flexible and global curvature correct cost function is then used to derive scale elasticities as well as the optimal firm size. The results show that no water supplier in the sample produces at constant retums to scale. The optimal firm size was found to be on average about three times higher than the existing one. These findings deliver evidence for the hypothesis that the legally set supplying areas - oriented towards public administrative criteria as well as local characteristics of water resources - are economically inefficient. Hence structural inefficiency in the rural water sector is confirmed to be policy-induced.