The choice of functional form and estimation of banking inefficiency

Abstract

The effects of alternative functional forms on parametric estimation of a multi-product cost function are examined using a sample of rural US banks. Functional forms considered for possible choice are three versions of second-order Taylor-series expansions (or locally-flexible functional forms–translog, normalized quadratic, and generalized Leontief. The generalized quadratic Box–Cox transformation and the likelihood dominance criterion are used as vehicles for conducting nested and non-nested tests. Although all three forms are rejected by the nested test, the likelihood dominance criterion indicates that the translog is clearly preferred over the other two as the functional form of choice. Using either of the other functional forms would substantially alter conclusions about both scale elasticities and inefficiencies, including the impact of bank size on these measures.