X is for X-efficiency

August 14th, 2014 at 11:00 am by David Farrar

The  struggles to find an economic term starting with X:

It would have been a stretch for us to relate X-rays or Xylophones to . Lucky for the ABCs of economic literacy, Harvey Liebenstein prefixed the word inefficiency with a big X when proposing the concept of X-efficiency in the 1960s. It is the only economic concept in MIT’s Dictionary of Modern listed under X.

X-inefficiency arises when firms fail to achieve the maximum possible level of output from given inputs. It contrasts with allocative inefficiency, which is the failure to produce the optimal mix of outputs, even if each output is produced at least cost.

X-inefficiency represents a forgone opportunity to increase profits, wages or both. A text-book monopolist would not fail to maximise profits but, in practice, some firms might.

The New Palgrave Dictionary of Economics cites, as evidence for the existence of X-inefficiency, a study in 1981 of a Ford plant in Germany that was producing 50 percent more automobiles with 22 percent less labour than an identically-designed plant in the UK. (Presumably German workers were getting paid commensurately more, reflecting their greater productivity.)

Differences in labour market laws, entrenched labour market practices, cultural attitudes to work, performance and pay may make it hard for even a profit-maximising owner to raise the productivity of the UK plant to the German level. But if wages are sufficiently lower in the UK, a profit-maximising owner might be able to make enough profit out of the UK plant to justify not closing it and shifting all production to Germany.

Managerial slack is a related source of X-inefficiency. Employee managers are likely less motivated than owner-managers to maximise profits. Owners may be unable to fully overcome this problem. Diffuse ownership may be one reason why owners might fail in this manner.

Laws that make it unduly difficult to hire or fire managers or workers or to target incentives at top-performers (performance pay) may contribute to X-inefficiency. For example, anti-takeover laws may protect under-performing management teams.

Performance measures across firms and countries, such as the Ford factory one above, can help identify egregious cases of X-inefficiency, but eliminating its causes may be too hard if they are entrenched.

The theory is controversial because if people prefer not to work as hard and as productively as they could, and consider the lower wage to be a price worth paying, they are actually optimising. Their lower productivity is efficient.

Two to go.

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3 Responses to “X is for X-efficiency”

  1. unaha-closp (1,158 comments) says:

    Two examples of maximising X-inefficiency in a NZ context are:

    National creating an Auckland Super City.

    National conferring a lifetime monopoly to Sky City Casino.

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  2. hj (6,871 comments) says:

    Currently there is a debate about FDI in farmland. It is argued that a foreign buyer who has more capital than a local buys a farm and frees up capital; the economic efficiency argument is used to justify it. I can see how it might work in a global economy but not in NZ’s case as it assumes that that capital will find something better for the economy than farming. Better for the economy being tradeables?

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  3. Miritu (29 comments) says:

    “not in NZ’s case as it assumes that that capital will find something better for the economy than farming”
    The assumption is correct. Provided the market is free and open, capital will ultimately find its best use in the search for best economic returns.

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