X-inefficiency

A basic assumption of the neoclassical model of production is that production is carried out in a technically efficient manner.(1) Leibenstein (1966) challenges this assumption. First, he argues that the empirical evidence suggests that producers typically do not achieve technical efficiency and he called this technical inefficiency, `X-inefficiency'.(2) Secondly, he argues, in terms of a theoretical explanation for this inefficiency, that there are four major reasons for X-inefficiency:

1. Labour contracts are incomplete. Such contracts do not and can not completely specify what is to be done by employees. The hiring of labour involves the hiring of time on the job but the intensity of effort is variable, that is, there are, in addition to incompleteness, moral hazard problems to contend with.(3)
   
2. Not all of the factors of production needed to achieve technical efficiency are markable and thus some of these factors may not be available to a producer. In particular, significant problems can arise when there are market imperfections in the market for management, meaning the quality of managers is hard to assess ex ante, that is, there are adverse section problems in the market for managers.
3. The production function is not completely specified nor completely known by the producer. Prior experience and ability to experiment are factors affecting the producer's knowledge of the production process. But if the producer does not fully understand the production function, it will struggle to achieve fully efficient production.
4. If there are strategic interactions between producers and uncertainty about competitors' reaction to a move by any given producer, then tacit collusion and imitation between producers can result and this could prevent producers from achieving fully efficient production. Put simply, competition matters for efficiency.

In later work, Leibenstein (1975, 1976), the theory of X-inefficiency has been expanded. It is noted that organisations are collections of individuals, each of whom has their own self-interest and whose efforts on behalf of the organisation are variable. Leibenstein emphasises the variability of effort by the individual rather than the mutuality of individuals' interests within the organisation. Individuals will pursue their own interests, which may (or may not) contribute to the interests of the organisation in its entirety. But there are constraints placed on the individual's actions by the organisation.

"The 'tightness' of these constraints depends upon the nature of the job being done, the system of payments (e.g. payment by results, payment by time, etc.), and the type of organization. Two important factors in determining the tightness of the constraint are likely to be the strength of the competition in the markets where the firm operates, and its degree of success" (Sawyer 1975: 131).

It is worth noting that the idea of X-inefficiency is related to the concept of `slack' noted in the sections above. It arises in this context due to the pursuit of self-interest by individuals, variations in their effort and incomplete monitoring of individuals. In the behavioural theory, it arises because of the bargaining processes within the organisation while in the managerial models it is due to the pursuit of self-interest by managers. But the presence of slack, for whatever reason, suggests the non-minimisation of costs and thus the non-maximisation of profits.

Notes.

(1) This section is based on Sawyer (1975: section 8.4)

(2) A more formal model of X-inefficiency is given in Crew (1975: 110-5).

(3) Hawkins (1973: 50) explains that human beings are different from other factors of production in important ways.

``Machines have a potential output which can be achieved by pressing the right switches. Human beings by contrast can adjust the quality and pace of their work in line with their own preferences. By supervision, by punishments and incentives, human effort can be varied. There is no reason why a shop-floor worker, or manager, should have a utility function which coincides with that of the firm as a whole or of its shareholders. Employees may maybe compelled to produce a minimum output - or lose their job. There may also be a maximum output of which they are capable given all the right sticks and carrots. But between these levels they can choose to vary the amount of time they spend on various activities, the pace at which they work and the quality of the work they do. There is no single-valued relationship between the number of man-hours purchased and the quality or quantity of effort that is expended in production. As a result, it is unlikely that every employee's choices will be exercised in such a way as to give maximum output per unit of input. So X-inefficiency almost always exists".

Refs.

• Crew, Michael A. (1975). Theory of the Firm, London: Longman.
• Hawkins, C. J. (1973). Theory of the Firm, London: The Macmillian Press.
• Leibenstein, Harvey (1966). 'Allocative Efficiency vs. X-Efficiency', The American Economic Review, 56(3) June: 392-415.
• Leibenstein, Harvey (1975). 'Aspects of the X-Efficiency Theory of the Firm', Bell Journal of Economics, 6(2) Autumn 1975: 580-606.
• Leibenstein, Harvey (1976). Beyond Economic Man, Cambridge Mass.: Harvard University Press.
• Sawyer, Malcom C. (1979). Theories of the Firm, London: Weidenfeld and Nicolson.

Are rights always right?

The Winter 2020 issue (vol. 34, no. 1) of the Journal of Economic Perspectives contains an article that looks at The Consequences of Treating Electricity as a Right, by Robin Burgess, Michael Greenstone, Nicholas Ryan and Anant Sudarshan (pp. 145-69).

Abstract

This paper seeks to explain why billions of people in developing countries either have no access to electricity or lack a reliable supply. We present evidence that these shortfalls are a consequence of electricity being treated as a right and that this sets off a vicious four-step circle. In step 1, because a social norm has developed that all deserve power independent of payment, subsidies, theft, and nonpayment are widely tolerated. In step 2, electricity distribution companies lose money with each unit of electricity sold and in total lose large sums of money. In step 3, government-owned distribution companies ration supply to limit losses by restricting access and hours of supply. In step 4, power supply is no longer governed by market forces and the link between payment and supply is severed, thus reducing customers' incentives to pay. The equilibrium outcome is uneven and sporadic access that undermines growth.

Making something a "right" can have negative unintended consequences.

A very brief history of perfect competition

A brief chronology of the development of the idea of perfect competition. We start with Counot and end with Knight

A very brief history of perfect competition by Paul Walker on Scribd

Bernie Sanders and the disastrous rent control plan

Rent controls really are a bad idea.

There isn’t much disagreement among economists about what a national rent control policy would do to harm renters, housing prices, housing stock, and the incentive to build new housing. Nonetheless, Bernie Sanders persists. Ryan Bourne comments.