Big and beautiful? On non‐parametrically measuring scale economies in non‐convex technologies

Knowledge on the scale economies drives the incentives of regulators, governments and individual utilities to scale‐up or scale‐down the scale of operations. This paper considers the returns to scale (RTS) in non‐convex frontier models. In particular, we evaluate RTS assumptions in a Free Disposal Hull model, which accounts for uncertainty and heterogeneity in the sample. Additionally, we provide a three‐step framework to empirically analyze the existence and extent of RTS in real world applications. In a first step, the presence of scale (and scope) economies is verified. Secondly, RTS for individual observations are examined while in a third step we derive the optimal scale for a sector as a whole. The framework is applied to the Portuguese drinking water sector where we find the optimal scale to be situated around 7–10 million m³.