This paper proposes a simultaneous stochastic frontier model that consists of a cost frontier and an output price frontier that relates a firm’s output price (P) to its marginal cost (MC). The gap between P and MC reflects a firm’s degree of market power, and the Lerner index (LI) is equal to the ratio of the gap to P. The salient feature of our model permits LI to be internally determined by the simultaneous equations model, which avoids obtaining negative estimates of the index. The joint probability density function of the composed errors can be derived in the context of copula methods. Our model is applied to study the competitive conditions of Taiwan’s banking industry. Findings show that: (1) the quiet life hypothesis is rejected; (2) the relationship between financial innovation, measured by the technology gap ratio of Huang et al. (2014), and our LI is U-shaped, which is robust over different specifications; and (3) the nexus between innovation and competition is inverted-U shape and consistent with Aghion et al. (2005) and Bos et al. (2013).
Quarterly Review of Economics and Finance, Vol.67, pp.362-375