Shadow Cost Research Articles

The Effect of Asymmetric Information and Transaction Costs on Asset Pricing: Theory and Test

This paper presents a capital asset pricing model in the presence of asymmetric information and transaction costs. The model is a generalized version of Merton's (1987) model and Black's (1974) model. Empirical tests show a negative relation between the expected rate of return and the shadow costs of incomplete information. The results in this paper have the potential to explain the home bias equity in a domestic and an international context.

Net Worth, Risk Taking and Investment

This paper analyzes how agency problems in financial contracting determine risk-taking and investment. In perfect capital markets a risk-neutral firm would invest until the expected marginal return equals the interest rate. However, as firms with little net-worth face agency cost in financial contracting the shadow cost of external funding are increased. It is often argued that this wedge forces firms to underinvest (the 'balance-sheet-effect'). However, this claim is premature. Firms with low net worth, hence high cost of external financing, might even overinvest. We establish a robust though more subtle balance sheet effect. Agency problems in financial contracting generate risk avoidance at the firm level even when all actors are risk neutral. This may explain why during major economic downturns firms and banks shun risks that could be accepted in better times.

Stochastic Estimation of Firm Inefficiency Using Distance Functions

Econometric estimation of allocative and technical efficiency has frequently been carried out using a shadow cost function and its associated share or demand equations. Since the problem is formulated in terms of shadow prices, the effect of allocative inefficiency on input usage must be computed indirectly from input share or demand equations. As an alternative approach, we derive and estimate an input shadow distance system comprising the dual shadow input distance function and the price equations derived from the shadow cost minimization problem. Estimated shadow quantities provide direct estimates of the effect of allocative inefficiency on input usage. One can also easily calculate firm- and time-varying technical inefficiency by decomposing the residuals. We also compute returns to scale and the cost savings obtained by eliminating both types of inefficiency. Our approach is illustrated using a panel of U.S. railroads. Both the cost function and the distance function are valid representations of multioutput technologies. The arguments of the cost function are output quantities and input prices, while the arguments of the distance function are input and output quantities. The input distance function measures the extent to which the firm is input efficient in producing a given set of outputs, while the cost function assumes cost minimization by a firm which is input efficient. The shadow cost function is a generalization of the cost function and depends on output quantities and shadow (internal to the firm) input prices rather than actual (market) input prices. Thus, the shadow cost function assumes shadow cost minimization but not actual cost minimization. This function has frequently been employed in fixed-effects estimation of allocative efficiency (AE) and technical efficiency (TE). An observed input vector is technically efficient if it is on the isoquant of the observed output vector. An input vector is allocatively efficient if the radial contraction of the input vector to the isoquant is cost minimizing. Identification of parameters that measure AE can be achieved by the estimation of a shadow cost system comprising the actual cost equation and the share or input demand equations, which are expressed in terms of shadow prices and output quantities. Shadow cost systems have been estimated by Atkinson and Halvorsen (1984), Sickles, Good, and Johnson (1986), Eakin and Kniesner (1988), Kumbhakar (1992), and Atkinson and Cornwell (1994), among others. Given panel data, the deviation of shadow from actual input prices can be measured by price-specific inefficiency parameters that may vary across firms and over time. However, the estimation of the effect of

Stochastic Estimation of Firm Inefficiency Using Distance Functions

Econometric estimation of allocative and technical efficiency has frequently been carried out using a shadow cost function and its associated share or demand equations. Since the problem is formulated in terms of shadow prices, the effect of allocative inefficiency on input usage must be computed indirectly from input share or demand equations. As an alternative approach, we derive and estimate an input shadow distance system comprising the dual shadow input distance function and the price equations derived from the shadow cost minimization problem. Estimated shadow quantities provide direct estimates of the effect of allocative inefficiency on input usage. One can also easily calculate firm‐ and time‐varying technical inefficiency by decomposing the residuals. We also compute returns to scale and the cost savings obtained by eliminating both types of inefficiency, Our approach is illustrated using a panel of U.S. railroads.

Deregulation, Ownership, and Productivity Growth in the Banking Industry: Evidence from India

This paper analyzes the relationship between deregulation and total factor productivity (TFP) growth in the Indian banking industry using a generalized shadow cost function approach. TFP growth is decomposed into a technological change, a scale, and a miscellaneous component. A disaggregated panel data analysis, using the population of public and private banks over 1985-96 that covers both pre-and post-deregulation periods, indicates that a significant decline in regulatory distortions and the anticipated increase in TFP growth have not yet materialized following deregulation. While private sector banks have improved their performance mainly due to the freedom to expand output, public sector banks have not responded well to the deregulation measures.

Inventory Cost Rate Functions with Nonlinear Shortage Costs

This article considers five cost-rate models for inventory control, each summarizing the expected holding and shortage costs per period as a function of the inventory position. All models have linear holding costs and shortage cost coefficients of dimension [$/unit/period], [$/unit], and [$/period]. The latter two coeficients may be the shadow costs of a fill-rate and a ready-rate service constraint, respectively. One of the cost-rate models is a new suggestion, intended to facilitate modeling of periodic-review inventory systems. If-and-only-if conditions on the demand process are presented for which the cost rate is quasi-convex in the inventory position. The typical sufficient condition requires that the cumulative demand distribution be logconcave, a condition that is met by most demand distributions commonly used in the inventory literature. The results simplify optimization and extend the known optimality of (S, s) and (nQ, r) policies to cost structures common in applications and to the presence of typical service constraints. As a prerequisite for the study, a series of new monotonicity results are derived for compound renewal processes.

The effect of the normalisation of the shadow price vector on the cost function estimation

The shadow cost model can be estimated by adopting two different normalizations of the input price distortions. However, the normalization suggested by Balk [Econ. Lett. 55 (1997) 45] produces estimates not invariant to the choice of the shadow input price chosen as numeraire in order to obtain linear homogeneity of the cost function.

Privatizations in Developing Countries and the Government's Budget Constraint

In this paper, we study the impact of government's budget constraint on the optimal industrial policy in industries with increasing returns to scale. We show that privatization is preferred to regulation for intermediate values of the shadow cost of public funds (i.e., the Lagrange multiplier of the government's budget constraint). However, the advantage of privatization is likely to disappear once the product market allows the entry of more than one firm.

An Empirical Analysis of Medicare-Eligible Veterans' Demand for Outpatient Health Care Services

Using data from the 1992 US National Survey of Veterans, we analyze Medicare-eligible veterans' use of VA and non-VA outpatient health care services. We apply a utility consistent, combined multinomial choice and count data model to identify factors that affect these veterans' outpatient health care usage and facility choices, with special reference to the effect of out-of-pocket cost, distance to the medical facility, and supplemental private medical insurance coverage. Our first stage count data regression shows that the out-of-pocket cost index calculated from the second stage multinomial choice model is significant in determining the Medicare-eligible veterans' demand of outpatient health care services. The calculated cost index elasticity of outpatient visits is about -0.65. In the second stage, we specify a multinomial choice model to study veterans' allocation of outpatient visits between VA and non-VA health care facilities, and we find that veterans' out-of-pocket cost and the distance to the health care facility have significantly negative effects on the probability of choosing the alternative. A number of other factors including family income, insurance status, means of transportation, home ownership, race, employment, health, disability status and diagnostic conditions were also found to be important at various stages of the decision making. We find no evidence of adverse selection in the market for supplemental private health insurance. The model is used to simulate the impact of alternative copayment policies on the demand for VA outpatient health care services. National Survey of Veterans, Health Care Demand, Two Stage Count Data Model, Nested Logit, Copayments, Shadow Cost, Consumer Surplus, CBOCs

Pay, Technology and the Cost of Worker Absence

Conventional studies of absenteeism concentrate on labour supply. In this paper we analyse records of worker behaviour which enable us to investigate whether or not demand side effects exist. Using a compensating differentials model, we study how the shadow cost of absenteeism varies across firms which operate different technologies, (The shadow cost is the amount a firm would be prepared to pay to achieve a given small reduction in its absence rate.) It is to be expected that pay for a less reliable workforce would be less than for a more reliable one, and we confirm this expectation. More subtle is the rate at which remuneration should fall with increased unreliability. We claim that just-in-time technology implies that absence will be more expensive for firms adopting it. The loss of productivity when absence occurs will be greater for such firms than for others, and the wage premium for reliability should thus be higher for such firms. Using a matched employee/employer dataset from France, we are able to establish the existence of statistically significant differences of the kind predicted by the theory, and estimate the shadow cost of worker absence for firms operating different kinds of technology.

Investor Awareness and Market Segmentation: Evidence from S&P 500 Index Changes

Several studies have found that stock price changes resulting from firms added to the S&P 500 index can be best exp lained by a downward sloping demand curve. In this paper, we study price effects around both additions and deletions and find that the price effect of index changes is consistent with Merton's (1987) investor-awareness and market segmentation hypothesis. We find that the reduction in shadow cost of incomplete diversification that follows additions is correlated with abnormal returns accruing to the added stocks. We also find that the asymmetric price effects of additions and deletions that have not been explained by empirical studies thus far are consistent with market segmentation.

Stochastic estimation of firm technology, inefficiency, and productivity growth using shadow cost and distance functions

It is well-known that a firm's technology, allocative efficiency, technical efficiency, and productivity growth can be estimated using a shadow cost system, comprised of a shadow cost function and its share equations, whose arguments are outputs and shadow input prices (prices internal to the firm). We provide a dual characterization to estimate these measures using a shadow distance system. This system is comprised of a shadow distance function, expressed in terms of shadow input quantities and output quantities, plus the first-order conditions from the cost-minimization problem. An advantage of the distance system over the cost system is that we obtain direct estimates of input inefficiency with the former, but indirect estimates with the latter. We also show how to express cost function derivatives in terms of distance function derivatives, which allows calculation of returns to scale and price elasticities of demand from the estimated distance system. Using panel data on US electric utilities, we estimate both systems and find a strong similarity between their associated measures.

Measuring embodied technical change in the US local telephone industry

This study attempts to measure the rate of embodied technical change by using a short-run variable cost function that contains arguments for labour and capital quality. In this short-run variable cost model, the expansion of the amount of physical capital increases variable costs due to more maintenance outlays, and then it leads to improvements in capital quality. When a measure of competition is included as a proxy for organizational efficiency, improvements in labour and capital quality explain more than two-thirds of productivity growth. The degree of returns to scale and the shadow cost of capital input in the embodiment cost model are presented as well. The study is based on pooled time-series and cross-section data of eight US local exchange carriers.

Does International Harmonization of Environmental Policy Instruments Make Economic Sense

Harmonization of the instruments used in environmental policy has beenconsidered necessary to guarantee “fair” competition in internationalmarkets. We examine the economic costs of harmonizing paper recyclingstandards in countries where the urgency of the waste disposal problemsdiffer. Using data of seven European countries we estimate thetechnologically feasible input combinations of pulp and waste paper forpaper production. Short-term effects of two environmental policy measures,minimum content requirement and utilization rate target, are analyzed. Bytranslating the two administrative instruments into taxes and subsidies, weshow that the shadow costs of the harmonization vary considerably betweencountries. The difference in the domestic availability of waste may explainthe variation, and a modification of the policy measures to incorporate thisaspect is suggested.

Valuing Lease Contracts Under Incomplete Information: A Real-Options Approach

ABSTRACT This paper presents a unified framework for the pricing of leasing contracts in an option framework within incomplete information. Incomplete information is defined in the context of Merton's (1987) simple model of capital market equilibrium with incomplete information. Information costs are also used in Bellalah (1999, 2001, 2002) models for the pricing of derivative assets in the presence of shadow costs of incomplete information. The model is based on the main concepts behind interest rate models. It can be used to determine equilibrium lease rates for different types of leases such as forward leases, leases with options to renew or cancel, lease insurance contracts, adjustable rate leases, and leases with payments contingent on asset usage.

Mean-Variance Portfolio Allocation with a Value at Risk Constraint

In this paper, I first provide a unifying approach to Mean-Variance analysis and Value at Risk, which highlights their similarities and differences. Then I use it to explain how fund managers can take investment decisions within the well-known Mean-Variance allocation framework that satisfy the VaR restrictions imposed on them by regulators. I do so by introducing a new type of line to the usual mean - standard deviation diagram, called IsoVaR, which represents all the portfolios that share the same VaR for a fixed probability level. Finally, I analyse the shadow cost of a VaR constraint.

Optimal Portfolio Choice and the Valuation of Illiquid Securities

Traditional models of portfolio choice assume that investors can continuously trade unlimited amounts of securities. In reality, investors face liquidity constraints. I analyze a model where investors are restricted to trading strategies that are of bounded variation. An investor facing this type of illiquidity behaves very differently from an unconstrained investor. A liquidity-constrained investor endogenously acts as if facing borrowing and short-selling constraints, and one may take riskier positions than in liquid markets. I solve for the shadow cost of illiquidity and show that large price discounts can be sustained in a rational model. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

A reexamination of corporate risks under shadow costs of incomplete information

AbstractThe valuation of the firm and its assets has been done for a long time in the classic context of complete information. Several empirical tests of the main valuation methods reveal a divergence between theoretical prices and observed prices. These deviations might be explained by the standard assumptions of complete information. It is possible to introduce information uncertainty as done by Merton and by Bellalah in the reexamination of corporate risks in the presence of information costs. The concept of risk is useful in modelling the value of the firm and its business risk and in the definition of the required rates of return and the cost of capital of corporations. However, the main well‐known results ignore information uncertainty as defined by Merton. Using the main results from the study of Modigliani and Miller and the implications of Merton's model, we give expressions for the cost of capital and the value of the firm's equity and debt in the presence of information costs. We reexamine the relationships between interrelated risks in the same context. We introduce information costs in the computation of the cost of capital and in the pricing of equity in an option framework. When there are no information costs, the main relationships reduce to the classic results in the literature. Copyright © 2001 John Wiley & Sons, Ltd.

The decomposition of cost inefficiency into technical and allocative components with panel data of Italian dairy farms

This paper considers the decomposition of cost inefficiency into its technical and allocative components. First, the relevant literature is surveyed, showing that the shadow price approach has significant computational advantages over alternative procedures. To illustrate this approach, a shadow cost model is applied to a panel of dairy farms in Northern Italy, and cost inefficiency is decomposed into its technical and allocative components. The main results from this application are that the cost excess owing to inefficiency in the sample is on average 69 per cent, mainly as a result of technical inefficiency, and that allocative inefficiency relates to the under-utilisation of forage crops and of purchased feed with respect to hired labour.

Nitrogen efficiency of Dutch dairy farms: a shadow cost system approach

In this paper we analyse the cost efficiency and nitrogen efficiency of an unbalanced panel of Dutch dairy farms. Nitrogen efficiency is defined as the ratio of minimal to observed use of nitrogen (N-containing inputs), conditional on output and quasi-fixed inputs. Nitrogen efficiency is computed in a shadow cost system framework. Nitrogen-efficient production is found at the optimal mix of variable inputs, determined by the nitrogen content of these inputs. The optimal nitrogen content ratio is introduced using price distortion factors in the estimated cost function. The mean input-oriented technical efficiency is 84 per cent. The mean nitrogen efficiency is 56 per cent. The nitrogen surplus at the nitrogen-efficient point is less than half of the observed surplus, whereas production costs increase by only 3 per cent.