Abstract
In this paper we propose a new latent class/mixture model (LCM) to determine whether firms behave like profit maximizers or just cost minimizers when there is no additional sample separation information. Since some firms might be maximizing profit while others might minimize cost, the LCM with behavioral heterogeneity can be quite useful. Estimation of the LCM amounts to mixing a cost minimization and a profit maximization model. Using the U.S. airlines data we find that after deregulation about 15% of the airlines are found to be consistent with profit maximizing behavior.
Highlights
Cost minimization and profit maximization behavioral assumptions are most widely used in microeconomic theory to analyze firm behavior
In this paper we address this problem via a latent class modeling approach in which some producers minimize cost while others maximize profit, and probabilities of being in these groups are made functions of covariates
The model helps us to determine which firms behave like profit maximizers and what differentiates them from firms that failed to maximize profit
Summary
Cost minimization and profit maximization behavioral assumptions are most widely used in microeconomic theory to analyze firm behavior. In practice researchers do not know whether every firm in the sample maximizes profit or minimizes cost. In this paper we address this problem via a latent class modeling approach in which some producers minimize cost while others maximize profit, and probabilities of being in these groups are made functions of covariates. This approach does not require researchers to know which firms maximize profit. The empirical findings suggest that very few units maximize profit
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