X-inefficiency

X-inefficiency is the difference between efficient behavior of firms assumed or implied by economic theory and their observed behavior in practice. It occurs when technical-efficiency is not being achieved due to a lack of competitive pressure. The concepts of x-inefficiency were introduced by Harvey Leibenstein.

Economic theory assumes that the management of firms act to maximize economic profits -- which is accomplished by adjusting the inputs used or the output produced. In perfect competition, the free entry and exit of firms tends toward firms producing at the point where price equals long run average costs and long run average costs are minimized. Thus firms earn zero economic profits and consumers pay a price equal to the marginal cost of producing the good. This result defines economic efficiency or, more precisely, allocative economic efficiency.

Empirical research suggests, however, that a number of firms do not produce at the point where long run average costs are minimized^{[citation needed]}. Some of this can be explained away by the mechanics of imperfect competition; what cannot be explained by traditional economics is described as X-inefficiency.

With market forms other than perfect competition, such as monopoly, it may be possible for x-inefficiency to 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.

X-inefficiency is not the only type of inefficiency in economics. 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, which is referred to as allocative efficiency. 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.

Examples

Monopoly 

A monopoly is a price maker 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 the X-inefficiency have been ascribed things such as overinvestment and empire building by managers, lack of motivation stemming from a lack of competition, and pressure by labor unions to pay above-market wages.

X-inefficiency can also occur when monopolies or even oligopolies produce higher than the minimum average cost^{[citation needed]}.

The USPS is a classic example of X-inefficiency. While USPS must compete with private firms in package and urgent delivery services, its monopoly status in the areas where it does not face competition, such as nonurgent deliveries, seems to have made the USPS inefficient. Postage prices offer evidence of this inefficiency. While most goods tend to get cheaper in inflation-adjusted terms over time, the price of a first-class stamp rose by twice the rate of inflation from 1970 to 2010. - Matthew Mitchell, The Pathology of Privilege: The Economic Consequences of Government Favoritism

See also

• Inefficiency
• Government failure
• Pareto efficiency
• Production, costs, and pricing
• Tax choice