Examining the determinants of efficiency using a latent class stochastic frontier model

Abstract

In this study, we combine the latent class stochastic frontier model with the complex time decay model to form a single-stage approach that accounts for unobserved technological differences to estimate efficiency and the determinants of efficiency. In this way, we contribute to the literature by estimating “pure” efficiency and determinants of productive units based on the class structure. An application of this proposed model is presented using data on the Ghanaian banking system. Our results show that inefficiency effects on the productive unit are specific to the class structure of the productive unit and therefore assuming a common technology for all productive units as is in the popular Battese and Coelli model used extensively in the literature may be misleading. The study therefore provides useful empirical evidence on the importance of accounting for unobserved technological differences across produc- tive units. A policy based on the identified classes of the productive unit enables a more accurate and effectual measures to address efficiency challenges within the banking industry, thereby promoting financial sector development and economic growth.