Profit Inefficiency of Japanese Securities Firms

We develop a new indicator of profit inefficiency, which is based on decision-makers choosing the amount to spend on each input and the amount to earn on each output, rather than choosing physical quantities of inputs and outputs. The method is suitable for situations when prices and quantities are not directly observable, when markets are non-competitive, or when qualitative differences exist for inputs and outputs between firms. The indicator of profit inefficiency equals normalized lost profits arising from technical inefficiency and allocative inefficiency. We offer an empirical example of our method using firms in the Japanese securities industry during the period 1989–2005. We find profit inefficiency rises from 1989 to 1993, declines during the 1994–2001 period, and then increases during the years 2002–2005. Allocative inefficiency tends to be a greater source of profit inefficiency than technical inefficiency. Lost profits as a percent of assets range from 0% to 15% and are highest in 2002–2005.