Cost Structure Analysis Under Disequilibrium : Price, Scale, Efficiency and Capacity Utilization Effects with an Application to the G-5 Banking Industries

This study proposes a "Flexible Cost Model" (FCM) for settings in which firms may be unable or unwilling to optimally manage their cost structures. FCM, which nests a wide range of more restrictive models, allows for a flexible specification not only of the technology but also of firm-level heterogeneity in technical and allocative efficiency levels. The proposed methodology is implemented on a G-5 banking dataset in the period 1989-1996, in the expectation that banks might not have adjusted their factor mix rapidly enough to keep up with the continued dramatic decline in the relative price of information technology. Considerable and heterogeneous levels of allocative inefficiency are found in the dataset, and the restrictions implied by the neo-classical model and by other more restrictive models are rejected. Significant scale economies are found for large banks, and scale diseconomies for small banks. G-5 banks, especially Continental European and small banks, are generally found to increasingly suffer from excess labor. For large banks, the 1996 results point to 14-24% excess labor in the United States, in the United Kingdom and in Japan, and 38-47% in France and Germany, with corresponding cost surcharges of 1-5% and 10-17%. The impact of labor market rigidities on French and German banks is estimated to be considerable. For large banks, these rigidities are estimated to "protect" in 1996 26-37% of banking jobs; they induce excess costs that represent an annual $32,000-37,000 per "protected" job and amount to an implicit "rigidity tax" in the 32-34% range--a range comparable to that of explicit corporate tax rates. Despite data limitations, the evidence suggests that the relative uncompetitiveness of the current cost position of French and German banks is entirely due to high labor prices and labor market rigidities