What Is X-Efficiency?

X-efficiency refers to the degree of efficiency maintained by firms under conditions of imperfect competition. Efficiency in this context means a company getting the maximum outputs from its inputs, including employee productivity and manufacturing efficiency. In a highly competitive market, firms are forced to be as efficient as possible to ensure strong profits and continued existence. This is not true in situations of imperfect competition, such as with a monopoly or duopoly.

Understanding X-Efficiency

X-efficiency points to irrational actions in the market by firms. Traditional neoclassical economics made the assumption that companies operated in rational ways, meaning they maximized production at the lowest possible costs–even when the markets were not efficient. Harvey Leibenstein, a Harvard professor and economist, challenged the belief that firms were always rational and called this anomaly "X" for unknown–or x-efficiency. In the absence of real competition, companies are more tolerant of inefficiencies in their operations. The concept of x-efficiency is used to estimate how much more efficient a company would be in a more competitive environment.

Born in the Ukraine, Harvey Leibenstein (1922-1994) was a professor at Harvard University whose primary contribution—other than x-efficiency and its various applications to economic development, property rights, entrepreneurs, and bureaucracy—was the critical minimum effort theory that aimed to find a solution to breaking the poverty cycle in underdeveloped countries.

When calculating x-efficiency, a data point is usually selected to represent an industry and then it is modeled using regression-analysis. For example, a bank might be judged by total costs divided by total assets to get a single data point for a firm. Then, the data points for all the banks would be compared using regression analysis to identify the most x-efficient and where the majority fall. This analysis can be done for a specific country to find out how x-efficient certain sectors are or across borders for a particular sector to see the regional and jurisdictional variations.

History of X-Efficiency

Leibenstein proposed the concept of x-efficiency in a 1966 paper titled "Allocative Efficiency vs. 'X-Efficiency,'" which appeared in The American Economic Review. Allocative efficiency is when a company's marginal costs are equal to price and can occur when the competition is very high in that industry. Prior to 1966, economists believed that firms were efficient with the exception of circumstances of allocative efficiency. Leibenstein introduced the human element whereby factors could exist, attributable to management or workers, that don't maximize production or achieve the lowest possible costs in production.

In the summary section of the paper, Leibenstein asserted that "microeconomic theory focuses on allocative efficiency to the exclusion of other types of efficiencies that are much more significant in many instances. Furthermore, improvement in 'non-allocative efficiency' is an important aspect of the process of growth." Leibenstein concluded that the theory of the firm does not depend on cost-minimization; rather, unit costs are influenced by x-efficiency, which in turn, "depends on the degree of competitive pressure, as well as other motivational factors."

In the extreme market structure case–monopoly—Leibenstein observed less worker effort. In other words, with no competition, there is less worker and management desire to maximize production and compete. On the other hand, when competitive pressures were high, workers exerted more effort. Leibenstein argued that there is much more to gain for a firm and its profit-making ways by increasing x-efficiency instead of allocative efficiency.

The theory of x-efficiency was controversial when it was introduced because it conflicted with the assumption of utility-maximizing behavior, a well-accepted axiom in economic theory. Utility is essentially the benefit or satisfaction from a behavior, such as consuming a product.

Before Leibenstein, companies were believed to always maximize profits in a rational manner, unless there was extreme competition. X-efficiency posited that there could be varying levels of degrees of efficiency that companies might operate. Firms with little motivation or no competition could lead to X-inefficiency—meaning they choose not to maximize profits because there's little motivation to achieve maximum utility. However, some economists argue that the concept of x-efficiency is merely the observance of workers' utility-maximizing tradeoff between effort and leisure. Empirical evidence for the theory of x-efficiency is mixed.

X-Efficiency vs. X-Inefficiency

X-efficiency and x-inefficiency are the same economic concept. X-efficiency measures how close to optimal efficiency a firm is operating in a given market. For example, a firm may be 0.85 x-efficient, meaning it is operating at 85% of its optimal efficiency. This would be considered very high in a market with significant government controls and state-owned enterprises. X-inefficiency is the same measurement, but the focus is on the gap between current efficiency and potential. A state-owned enterprise in the same market as the previous company may have an x-efficiency ratio of 0.35, meaning it is operating at only 35% of its optimal efficiency. In this case, the firm may be referred to as x-inefficient to draw attention to the large gap, even though it is still x-efficiency that is being measured.