Adjustment and unobserved heterogeneity in dynamic stochastic frontier models

Stochastic frontier models with autocorrelated inefficiency have been proposed in the past as a way of addressing the issue of temporal variation in firm‐level efficiency scores. They are justified using an underlying model of dynamic firm behavior. In this paper we argue that these models could have radically different implications for the expected long‐run efficiency scores in the presence of unobserved heterogeneity. The possibility of accounting for unobserved heterogeneity is explored. Random‐ and correlated random‐effects dynamic stochastic frontier models are proposed and applied to a panel of US electric utilities.