Measuring Competition in Banking: A Two-Product Model

Abstract

Bresnahan (1982) proposed an empirical test for the degree of competition, applicable when firms produce a single product and the industry demand is not separable in its exogenous variables; see also Lau (1982). His method estimates the degree of competition on the basis of firms' reactions to changes in the slope of the demand function: theory predicts a certain response on the part of the monopolist and no response for the competitive firm. Bresnahan's test was applied to the banking industry in Shaffer ( 1989, 1993 ). In these tests, banks are viewed as producing a single product (loans) using deposits as an input. If banks are viewed more realistically as producing multiple outputs, this test is no longer the most appropriate one. Application of this test would then require the indexation of products, which distorts the true supply relationship and probably leads to a loss of information. To obtain a proper test when firms produce two products, this paper extends Bresnahan's method to the case of two products, whose demand and marginal cost functions are interdependent. Banks produce mainly two products. For depositors, who accept a lower interest rate than the market rate, banks must provide free or undercharged services. These services can be approximated by payment transmission, which is by far the most important such service; cf. e.g. Brand and Duke (1982). For borrowers, banks produce signalling and monitoring services, which are best approximated by the real value of outstanding loans. The demand and cost functions for these two outputs may be interdependent; see e.g. Fama (1985). Since a large part of banks' resources are

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