X-Efficiency Theory by Leibenstein

X-inefficiency is the difference between efficient behaviour of firms assumed or implied by economic theory and their observed behaviour 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

The degree of efficiency maintained by individuals and firms under conditions of imperfect competition. According to the neoclassical theory of economics, under perfect competition individuals and firms must maximize efficiency in order to succeed and make a profit; those who do not will fail and be forced to exit the market. However, x-efficiency theory asserts that under conditions of less-than-perfect competition, inefficiency may persist.

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.

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.

Leibenstein regards entrepreneurship as a creative response to X-efficiency. Other people’s lack of effort and the consequent inefficiency of the organizations that employ them, create opportunities for entrepreneurs. Entrepreneurial activities pose a competitive threat to inefficient organizations.

Leibenstein identifies two main roles for entrepreneurs. The first role is the ‘input completion’ involves making available inputs which improve efficiency of existing production methods or facilitates the introduction of new ones. It is normally effected by intermediation in factor markets, in particular the markets for venture capital and management skills. The role of entrepreneur is to improve the flow of information in these markets.

The second role ‘gap filling’ is closely related to arbitrage function emphasized by Kirzner. Leibenstein provides a very vivid description of gap filling, visualizing the economy as a net made up of nodes and pathways.

The nodes represent industries or households that receive inputs (or consumer goods) along the pathway and send outputs (final goods and inputs for the other commodities) to the other nodes. The perfect competition model would be represented by a net that is complete: one that has pathways that are well marked and well defined, one that has well-marked and well-defined nodes, and one in which each element (that is firm or household) of each node deals with every other node along the pathways on equal terms for the same commodity.

The concept of X-efficiency was introduced by Harvey Leibenstein a noted economist in1966 in his article titled “Allocative efficiency vs. X-efficiency”. This is also referred to as X-inefficiency. In general X-inefficiency refers to the difference between the optimal efficient behaviour of business in theory and the observed behaviour is practice which occurs owing to different factors.

X-efficiency refers to the effectiveness with which a given set of inputs are used to produce outputs. If a particular firm is producing the maximum output it can, given the resources it employs with the best available technology, it is said to be technical-efficient. X-inefficiency occurs when technical-efficiency is not achieved. Whenever an input is not used effectively the difference between the actual output and the maximum output attributable to that input is a measure of the degree of X-efficiency.

Harvey Leibenstein had mentioned that for allocative efficiency the whole economy was considered whereas in case of X-efficiency just specific companies and industries are to be considered.

X-efficiency arises either because the firm’s resources are used in the wrong way or because they are wasted, that is, not used at all.

The entrepreneur has been entrusted two roles; first the role of a gap filler and second an input completer. The production function usually has certain deficiencies. These deficiencies and gap arise because all the factors of production function cannot be marketed. The entrepreneur has been entrusted the job to fill the gaps in the market. The second role of the entrepreneur is input completion. The entrepreneur has to mobilize all the available inputs in order to improve the efficiency of existing production methods.

Leibenstein advocated two types of entrepreneurship. First type is the ‘Routine entrepreneurship’ which involves the important functions of management of business. Second type is that of the ‘New entrepreneurship’ which involves innovative entrepreneurship.

Criticisms:

The Leibenstein’s theory has been often compared with the neoclassical views.

The theory has many novel contributions but has been criticized on following counts:

1. The exact influence which the X-efficiency has on output of an organisation cannot be determined.
2. The theory is less predictable as compared to normal theories.