What is X-Efficiency?

The efficiency businesses retain in the face of imperfect competition is called X-efficiency. In this sense, efficiency refers to a business’s ability to maximize outputs from inputs, such as worker productivity and production efficiency. Companies must operate efficiently in a highly competitive market to guarantee solid profitability and long-term survival. This is untrue in instances of imperfect competition, such as monopolies or duopolies.

Knowing About X-Efficiency

X-efficiency indicates that enterprises are acting irrationally in the market. The tenet of traditional neoclassical economics was that businesses acted rationally, maximizing output at the lowest feasible cost—even without efficient markets. Harvey Leibenstein, a Harvard economist and professor, challenged the notion that businesses are always rational. He called this oddity “X” for unknown or x-efficiency. Businesses are more tolerant of operational inefficiencies when there isn’t any actual competition. The x-efficiency concept is used to calculate how much more efficient a company might be in a more competitive setting.

Harvey Leibenstein (1922–1994), a professor at Harvard University, was born in the Ukraine. Aside from x-efficiency and its many applications to property rights, entrepreneurs, economic development, and bureaucracy, his main contribution was the critical minimum effort theory, which sought to break the cycle of poverty in developing nations.

Regression analysis is often used to model a data point chosen to represent an industry to determine x-efficiency. To get a single data point for a company, a bank may be evaluated by dividing its expenditures by its total assets. Regression analysis would then be used to compare the data points for each bank to determine which is the most efficient and where the bulk of the data points fall. This study may be performed across borders for a single sector to observe the regional and jurisdictional variances, or it can be done for a particular nation to see how efficient various industries are.

The X-Efficiency’s Past

In a 1966 study titled “Allocative Efficiency vs. ‘X-Efficiency,'” published in The American Economic Review, Leibenstein introduced the idea of x-efficiency. When a business’s marginal costs match its price, it operates at allocative efficiency, which may happen in highly competitive industries. Economists believed enterprises were efficient until 1966, when allocative efficiency conditions applied. Leibenstein established the concept of the “human element,” which states that variables related to labor or management prevent manufacturing from maximizing output or achieving the lowest feasible costs.

“Microeconomic theory focuses on allocative efficiency to the exclusion of other types of efficiencies that are much more significant in many instances,” Leibenstein said in the paper’s summary section. Furthermore, one of the critical components of the growth process is an increase in “non-allocative efficiency.” Leibenstein ultimately concluded that the theory of the business is not dependent on cost-minimization but rather on the effect of x-efficiency on unit costs, which in turn “depends on the degree of competitive pressure as well as other motivational factors.”

In the event of an extreme market structure—a monopoly—Leibenstein noted reduced labor input. As stated differently, worker and management motivation to optimize output and engage in competition is reduced in the absence of competition. On the other hand, workers put in more significant effort when they faced intense competition. Leibenstein contended that maximizing x-efficiency instead of allocative efficiency benefits a company and its money-making methods.

When the theory of x-efficiency was first proposed, it caused controversy since it went against the widely accepted hypothesis of economic theory—that behavior should be maximized in utility. In essence, utility is the gain or enjoyment that results from a behavior—like using a product, for example.

In a market where the company is already profitable and faces little competition, X-efficiency helps to explain why companies might need more motivation to maximize profits.

Before Leibenstein, businesses were thought to consistently and rationally maximize profits without intense competition. The concept of X-efficiency proposes that companies could function at different levels of efficiency. Businesses that lack competition or motivation may be more prone to X-inefficiency, which is the decision to forego profit maximization due to a lack of incentive to attain maximum utility. The notion of x-efficiency, according to some economists, is just the observation of workers’ utility-maximizing trade-off between effort and leisure. There is conflicting empirical support for the x-efficiency theory.

Comparing X-Efficiency and X-Inefficiency

The economic concepts of x-efficiency and x-inefficiency are the same. The X-efficiency of a company indicates its proximity to the ideal efficiency level in a particular market. A company may, for instance, be 0.85 x-efficient, which suggests that it is working at 85% of its maximum efficiency. This would be regarded as extremely high in a market with substantial government controls and state-owned businesses. The exact measurement, known as X-inefficiency, is used to highlight the discrepancy between actual and potential efficiency. If a state-owned business operates at only 35% of its maximum efficiency, it can have an x-efficiency ratio of 0.35 in the same market as the previous company. In this instance, even though x-efficiency is still being measured, the firm may be referred to as x-inefficient to highlight the significant discrepancy.

Conclusion

• The efficiency level businesses maintain when there is imperfect competition, like in a monopoly, is known as x-efficiency.
• Harvey Leibenstein, an economist, challenged the notion that businesses are always rational and labeled this anomaly “X” for unknown or x-efficiency.
• Leibenstein brought in the human factor, stating that there could be different levels of efficiency and that businesses occasionally only maximized profits.