Incorporating risk into the analysis of production

This paper evaluates alternative strategies for incorporating risk into the analysis of production and argues that accounting for the effects on production of financial structure and endogenous risk, motivated by the objective of value maximization, is essential to recovering firms' technologies, measuring their efficiencies, and detecting such risk-related phenomena as the effects of better diversification on scale economies and the agency costs of different mixes of debt and equity. This paper also demonstrates how the Most Preferred Production System of Hughes et al. [1996] incorporates endogenous risk and the firm's financial structure and, in doing so, is able to control for differences in risk among banks in measuring their profit efficiency and to uncover scale economies in U.S. commercial banking that elude studies based on standard cost and profit functions.Presidential Address presented at the Forty-Sixth International Atlantic Economic Conference, Boston, Massachusetts, October 8–11, 1998. The author is grateful to William Lang, Loretta Mester, Choon-Geol Moon, and Michael Pagano for their helpful discussions and comments on an earlier draft.