Most empirical studies of productivity to date have considered only marketed or desirable outputs and have neglected changes in the production of pollutant outputs. This neglect of negative externalities is also evident in studies that have attempted to assess the impact of environmental regulation on productivity growth. This study employs parametric input distance functions that incorporate both desirable and undesirable outputs to provide a more complete representation of the production technology from which environmentally adjusted productivity and efficiency measures can be generated. This framework can also be used to generate information on the shadow prices of pollutant outputs or pollution abatement costs to producers that are useful inputs for environmental policy making. The method was applied to data from the Canadian pulp and paper industry for the period from 1959 to 1994. Four desirable outputs, two water pollutant outputs (BOD and TSS) and seven inputs were identified in the estimation of the input distance function.

Our results indicate that productivity measures that ignore pollutant outputs substantially underestimate the performance of the industry. Our environmentally-adjusted approach indicates that the total factor productivity of the industry has been growing at the rate of 1.00% per year over the period from 1959 to 1994, considerably higher than the 0.19% per year estimate obtained without considering pollutant outputs. Our shadow price estimates, however, indicate that the cost to producers of pollution control has been rising. The main conclusion of this study is that productivity improvement, from the social viewpoint, has been stronger despite increased cost of pollution abatement.