COST-FUNCTIONS AND NONLINEAR PRICES - ESTIMATING A TECHNOLOGY WITH QUALITY-DIFFERENTIATED INPUTS

The paper is concerned with developing a production theory for the cas e when some inputs have nonlinear prices because the price depends on endogenous quality. This involves extending the notion of a cost funct ion to the case where nonlinear prices are parameters of costs. After developing the appropriate theory, we apply our results to the case of coal-fired electric power generation where fuel quality depends on su lfur and ash impurities. Environmental regulations induce a negative v alue on sulfur whereas ash impurities degrade performance and thus red uce production possibilities. A number of empirical results emerge, in cluding significant rates of technological change that are sulfur and ash saving though capital using. This change may explain in part the r ecent drop in the price of sulfur allowances in the United States.