What is it about?
Economists use several techniques to establish whether an industry operates under economies of scale, which has important implications for regulation. The measurement of economies of scale is however flawed by the so-called endogeneity problem; do firms have lower costs per unit because they are big or are these firms bigger than others because they have lower costs per unit? This paper establishes the existence of the enedogeneity problem and proposes and tests a solution to that problem.
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Why is it important?
Understanding the cost structure of an industry is of crucial importance for regulators. Mergers are often justified using the argument of economies of scale (bigger firms have lower costs). Mismeasurement of scale economies will then lead to incorrect decissions on mergers and hence to consderable welfare losses.
Perspectives
The misuse of the concept of economies of scale (mainly by managers) is one of my pet peeves. Managers can gain considerably from an increase in the scale of operations (their wage and status depend on it) and hence have a strong incentive to exaggerate economies of scale. In this light, one would expect researchers to be more critical towards the concept, rather than accept a bias as obvious as the endogeneity problem in cost functions.
Dr Mark G Lijesen
Vrije Universiteit Amsterdam
Read the Original
This page is a summary of: Solving the Endogeneity Problem in Empirical Cost Functions: An Application to US Banks, Advances in Economic Analysis & Policy, January 2013, De Gruyter,
DOI: 10.1515/bejeap-2012-0070.
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