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Solving the Endogeneity Problem in Empirical Cost Functions: An Application to US Banks

Abstract Empirical cost functions tend to ignore that firm differences in output levels depend on differences in cost levels and hence suffer from an endogeneity problem. We argue that traditional solutions for the endogeneity problem are insufficient for solving the problem and propose a structural approach to solve the problem. We apply both the traditional and the alternative models to panel data on large banks and found that a hybrid version yields results that are fully compatible with economic theory, whereas the traditional model provides theoretically incorrect in-sample predictions of scale elasticities.