X-inefficiency is the divergence of a

firm A company, abbreviated as co., is a legal entity representing an association of people, whether natural, legal or a mixture of both, with a specific objective. Company members share a common purpose and unite to achieve specific, declared go ...

’s observed behavior in practice, influenced by a lack of

competitive Competition is a rivalry where two or more parties strive for a common goal which cannot be shared: where one's gain is the other's loss (an example of which is a zero-sum game). Competition can arise between entities such as organisms, indivi ...

pressure, from efficient behavior assumed or implied by

economic theory Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyzes ...

. The concept of X-inefficiency was introduced by

Harvey Leibenstein Harvey Leibenstein (1922 – February 28, 1994) was a Ukrainian-born American economist. One of his most important contributions to economics was the concept of X-inefficiency and the critical minimum effort thesis in development economics. Conce ...

. X-Inefficiency is introduced in 1966 by the professor of Harvard University, Harvey Leibenstein's publication in the '' American Economic Review,'' named "Allocative efficiency vs. X efficiency". X-Inefficiency refer to the firm's production that fails to make full use of its resources, resulting reaches to the maximum possible level of

output Output may refer to: * The information produced by a computer, see Input/output * An output state of a system, see state (computer science) * Output (economics), the amount of goods and services produced ** Gross output in economics, the value o ...

given the existing resources and environment, namely the efficiency frontier. X-inefficiency pin out irrational actions performed by firms in the market.

Overview

The difference between the actual and minimum cost of production for a given output produces X-inefficiency. Companies will incur X-Inefficiency as a result of lack of motivation to control its costs, which brings the

average cost In economics, average cost or unit cost is equal to total cost (TC) divided by the number of units of a good produced (the output Q): AC=\frac. Average cost has strong implication to how firms will choose to price their commodities. Firms’ sale ...

of production exceeds costs actually required for production. For example, the company have a potential potential cost curve. However, due to the lack incentive to motivate on control costs, the company's actual cost curve is at a higher position compared to the potential cost curve. The phenomenon of X-inefficiency is in relation to the allocation of effort, especially the managerial effort. Mainstream

economic An economy is an area of the production, distribution and trade, as well as consumption of goods and services. In general, it is defined as a social domain that emphasize the practices, discourses, and material expressions associated with the ...

theory tends to assume that the management of firms act to maximize profit by minimizing the inputs used to produce a given level of output. Competition energizes firms to seek productive efficiency gains and produce at lowest unit costs or risk losing sales to more efficient rivals. With market forms other than perfect competition, such as

monopoly A monopoly (from Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situation where a speci ...

, productive inefficiency can persist, because the lack of competition makes it possible to use inefficient production techniques and still stay in business. In addition to monopoly, sociologists have identified a number of ways in which markets may be organizationally embedded, and thus may depart in behavior from economic theory. Organizational slack occurs when firms opt to employ more resources than are needed to produce a given level of output. Unused capacity results in X-inefficiency. Organizational slack can be explained by the principal-agent problem. In companies ownership and management are separate. Shareholders (the principal) elect directors (the agent) to act on their behalf and maximize shareholder value. Managers may take decisions that maximize their own and not shareholder objectives e.g. hiring extra staff to reduce manager workloads. This increases unit costs. X-inefficiency only looks at the outputs that are produced with given inputs. It doesn't take account of whether the inputs are the best ones to be using, or whether the outputs are the best ones to be producing. For example, a firm that employs brain surgeons to dig ditches might still be X-efficient, even though reallocating the brain surgeons to curing the sick would be more efficient for society overall. In this sense, X-inefficiency focuses on

productive efficiency In microeconomic theory, productive efficiency (or production efficiency) is a situation in which the economy or an economic system (e.g., bank, hospital, industry, country) operating within the constraints of current industrial technology canno ...

and minimising costs rather than

allocative efficiency Allocative efficiency is a state of the economy in which production is aligned with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the mar ...

and maximising welfare. For more extensive discussions, see Sickles and Zelenyuk (2019, p. 1-8, 469) and references therein.

Arguments about X-Inefficiency

Based on the assumption that the non-trade output of the firm is zero, Leibenstein argues that the X-inefficiency results from the lack of motivation of the resource owners to produce less than the maximum technical output of the trade goods. Leibenstein also argued that sometimes firms are not maximising their profits because there may be a certain level of efficiency, considering the human element which introduced by Leibenstein

Causes to X-Inefficiency

Through the study on two monopoly companies IBM and Xerox about X-inefficiency, Emily Nowlan stated four possible causes of X-inefficiency which led companies to decline. First, the company did not predict market trends before making decision and implementing actions. Second, the mismanagement of innovation and the waste of opportunities. Companies' negative behaviors when facing regulatory barriers are also the cause of X-inefficiency. Ultimately, wasting resources looking for new markets will also induce X-inefficiency and lead to the decline of companies.

Examples

Monopoly

is a

price maker In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service by manipulating either the supply or demand of the product or service to increase economic profit. In other words, market powe ...

in that its choice of output level affects the price paid by consumers. Consequently, a monopoly tends to price at a point where price is greater than long-run average costs. X-inefficiency, however tends to increase average costs causing further divergence from the economically efficient outcome. The sources of X-inefficiency have been ascribed to things such as overinvestment and empire building by managers, lack of motivation stemming from a lack of competition, and pressure by

labor unions A trade union (labor union in American English), often simply referred to as a union, is an organization of workers intent on "maintaining or improving the conditions of their employment", ch. I such as attaining better wages and benefits (su ...

to pay above-market wages. Suggested by Bergsman, The sum of X-inefficiency and monopoly returns is much larger than costs of mis-allocation. In reality, industries with strong monopoly capacity will be more restricted by legal regulations. These regulations can impose competitive pressure on companies and prevent the industry turning into a true monopoly. Meanwhile, these artificial pressure of regulations can induce competitive pressure to companies, thus improving X-inefficiency.

References