Market structure and market definition: the case of small market banks and thrifts

This paper introduces a simple method to test between two general approaches to defining bank and thrift product markets. I estimate two models that endogenize market structure using data on banks and thrifts from 1,884 rural markets for the year 2000. The first model assumes that banks and thrifts are in "independent product markets," i.e., that bank profitability depends only on competition from other banks and that thrift profitability depends only on competition from other thrifts. An alternative model is then estimated assuming that banks and thrifts are "perfect strategic substitutes," i.e., that a bank's equilibrium profitability falls equally with the presence of another bank or an additional thrift (and vice-versa). A transformation of the likelihood for the "independent markets" model allows me to test it against the "perfect strategic substitutes" model using Vuong's (1989) non-nested likelihood ratio test. The hypothesis that banks and thrifts compete in independent product markets is soundly rejected against the hypothesis that banks and thrifts are perfect strategic substitutes.