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I. INTRODUCTION Institutions of higher education comprise knowledge creation (research) and knowledge dissemination (teaching). Thus, the university's mission is to deliver quality undergraduate and graduate education and to expand the frontier of academic research. Numerous studies (Verry and Layard 1975; Cohn, Rhine, and Santos 1989; deGroot McMahon, and Volkin 1991; Nelson and Hevert 1992; Lloyd, Morgan, and Williams 1993; Dundar and Lewis 1995; Koshal and Koshal 1995, 1999) have investigated, as in the case of firms, the multiple-product cost function of producing the vector of outputs on undergraduate and graduate education and research. The cost structure of higher education is studied via the scale economies and the scope economies of the cost function. However, these measures of scale and scope economies may be elusive if the quality dimension of colleges and universities is not considered. Without taking into account the quality variation, in the short-run, a university can reduce the average cost of operation by lowering the quality. Universities with more congested educational facilities are substituting facility utilization for capital; universities with a higher student/faculty ratio and less research engagement are substituting quality of education for quantity of undergraduate and graduate enrollment. The consequence is an upward bias in estimating the economies of scale and scope. This conclusion is consistent with the early studies of Nelson and Hevert (1992) which showed that failure to control for class size in cost function may result in specification bias, and an economy of scale is evident if class size is allowed to expand. Quality of higher education is multidimensional. Quality in instruction, faculty research, and the quality of educational environment are all significant factors determining the long-run university cost structure and the crucial determinants of the scale and scope economies of higher education. How and to what extent quality affects a university's operating cost depends on the goal and orientation of the institutions. Higher quality increases the university's cost of operation. But, in a large research-oriented university, a disproportional share of the budget often benefits the graduate, not the undergraduate program. It is unrealistic to assume that quality affects only the average cost and that the marginal costs of various educational programs are independent of quality. Quality is unlikely to be simply a neutral cost-shifting factor. The purpose of this paper is to propose a university cost function and a semiparametric-estimating technique that treats quality as a nonneutral cost-shifting factor, which directly affects the marginal cost of outputs in undergraduate and graduate education. More precisely, the marginal costs of outputs are specified as a nonparametric smooth function of quality. A semiparametric specification of university cost is applied to 56 comprehensive and science/technology universities in Taiwan over the period 2000-2003. II. SEMIPARAMETRIC COST FUNCTION AND ESTIMATION TECHNIQUE Following the conventional multiproduct cost specification for higher education (Cohn, Rhine, and Santos 1989; deGroot, McMahon, and Volkin 1991; Lloyd, Morgan, and Williams 1993; Dundar and Lewis 1995; Koshal and Koshal 1995, 1999), the total cost (C) is specified as a quadratic function of outputs, undergraduate and graduate enrollments. However, the quadratic cost function is modified by allowing for the coefficients to be functions of quality in the following form: (1) C = [[beta].sub.0](Q) + [k.summation over i=1] [[beta].sub.i](Q)[Y.sub.i] + (1/2) X [k.summation over i=1], [k.summation over j=1], [[beta].sub.ij](Q)[Y.sub.i][Y.sub.j] + [m.summation over i=1], [[alpha].sub.i][Z.sub.i] + [epsilon] where C is the total cost of producing k educational outputs (Y), and [Z.sub.i] is the ith institutional characteristics. …

1. INTRODUCTION The financial plight and plunging quality of higher education has dominated the current debate about educational reforms in Taiwan. The debate has provided a forum on the issues of the economic behavior of institutions of higher education, including the amalgamation of institutions, in the search for economies of scale, the conglomeration of undergraduate and graduate programs, in the search for economies of scope, and the enormous quality disparity between private the public institutions. The paper aims to illuminate the debate by providing an empirical study on the scale and scope economies by estimating a multi-product university cost structure in Taiwan. The number of colleges and universities in Taiwan has increased rapidly in the last two decades. As of 2003, there were 139 colleges and universities compared with only 26 institutions in 1980. During the same period, the number of college student enrollments increased fivefold, and real educational expenditure per student more than tripled. (1) The variation in unit instructional costs among colleges and universities is substantial. For small institutions, the per-student instruction cost is on average 71% higher than in larger institutions. while public, research-oriented institutions' unit instructional costs are more than twice that of private institutions. (2) The cost differences may be due to the difference in orientation and goals between undergraduate teaching and graduate research. If the larger institutions have lower unit costs. it might be because there are economies of scale and scope. Many empirical studies in the United States and in other developed countries have uncovered factors that account for costs in higher education. However, there are no empirical studies investigating the existence or magnitude of economies of scale and scope or the impact of the dual role of higher education in teaching and in research on the university cost structure in Taiwan. Over the last several decades, the universities in Taiwan have essentially been administered at the discretion of the government. The Ministry of Education oversaw every step of university operations, both in public and in private universities, ranging from student admission and enrollment, faculty hiring and promotion, curriculum design and instruction, to budgeting decisions and administrative appointments. In recent years, the government has gradually lessened its rigid control and allowed universities more administrative and financial independence. This policy change has exerted undue pressure on administrators and policy makers to emphasize productivity, efficiency, and cost-effective management. In this paper, we explore university cost structure by estimating a stochastic frontier cost function. Particular attention is given to the estimation of cost efficiency and to the effect of quality-adjusted outputs on economies of scale and scope. While most empirical studies of higher education production in other countries show some evidence of scale and scope economies, (3) we demonstrate in this paper that they are elusive because the studies have failed to account for quality variation among colleges and universities, in particular, the endogeneity of congestion in facility utilization. In the short run, a university can reduce the average cost of enrollment by tolerating more congested living and learning environments in dormitory rooms and in recreational space, in classrooms and in libraries, etc. Since the congestion factor is endogenous, this leads to a reduced average cost, and it may give a myopic administrator an incentive to engage, at least in the short run, in a policy of overutilizing the university's fixed capital resource. Congestion thus has an implicit long-run cost in higher education production. While many empirical studies have linked the student-faculty ratio and faculty research activity to the quality of university's under-graduate and graduate education, these studies generally ignored how the congestion is linked to the estimation of university cost structure, in particular to scale and scope economies. …