In this paper, we model the relationship between technical efficiency measures and internal trade, debt guarantee and mortgage to better understand the role of internal business transactions to the technical efficiency of Korean firms. Difference in technical efficiency due to firm characteristics such as its size, its inclusion as part of the 30 largest business groups, and the type of opening to public of the firm is examined. Furthermore, this study also investigates input-output data such as gross output, labor input, capital input, intermediate input, and internal transaction data among affiliates or more specifically internal trade, debt guarantee and mortgage for the period 1992 to 1998 for 1,640 firms included in the business groups.

The stochastic frontier production function applied in this study have parameter estimates for labor, intermediate input, capital input and time trend that are not only statistically significant but reliable in their economic interpretation. The decomposition of variance of error terms shows that 65 percent of variance may be assumed as constituting the random part, while the remainder may be linked to technical inefficiency. This suggests that the stochastic production function as specified in this study is correctly chosen and specified.

The coefficients of 6 variables used to explain the technical inefficiency are also tested and found to be statistically significant. The role of internal sales and purchases among affiliates on the technical inefficiency of firms that are included in a business group is negative, which implies that the transaction cost hypothesis is appropriate to explain the business behavior of Korean firms that belong to business groups. Debt guarantees and mortgage from affiliates also contributed to the increase of technical efficiency by way of providing easy bank loans. However providing mortgage to affiliates tends to lower technical efficiency. Further research is needed to explain the differences in the effects of the provision of debt guarantees and mortgage to affiliates.

This study also examines the relationship between technical efficiency and type of firm. Firms included in the 30 largest business group have enjoyed higher technical efficiency by way of internal transactions. However the type of opening to public and size of firm do not affect the technical efficiency of the firm engaged in internal transactions. The effect of an increase of technical efficiency from internal transactions in the 30 largest business groups do not adversely affect other firms included in the smaller business groups.