X-efficiency refers to a firm’s inability to receive optimal outputs for its inputs because of a lack of pressure from competition. These can include such things as manufacturing efficiency and employee productivity. In an extremely competitive market, companies are forced to be as efficient as possible to secure hefty profits and enjoy ongoing success. X-efficiency does not hold true in imperfect competitive circumstances, including duopoly or monopoly. Harvey Leibenstein, an economics professor at Harvard University, coined the term after he closely studied the psychological aspects of the economy.
How Does X-Efficiency Work?
Leibenstein’s theory states that when firms aren’t extremely competitive, their staff doesn’t efficiently perform. For instance, let’s say that firms A, B, and C together comprise 90% of the market for thingamabobs. They are bigger companies that fiercely compete on service and price. Firm D is a startup that is also trying to sell thingamabobs. However, it isn’t doing so profitably.
Despite the high demand for thingamabobs, Firm D isn’t much of a competitor and its employees know that. According to Leibenstein’s theory, Firm D’s staff won’t work as hard as they should because they know being more productive won’t make a difference. Thus, their x-efficiency drops.
Now let’s assume that Firm A is the only manufacturer of thingamabobs in the market. This company has a monopoly. Under the theory, this leads to the same challenges faced by Firm D: Since the employees know that nothing will change in the company’s market share for the foreseeable future, they become less efficient.
Why Does It Matter?
Leibenstein’s x-efficiency theory suggests that people and firms don’t always maximize utility. In other words, they don’t always make more efficient decisions.
Drops in x-efficiency are typically based on a lack of competitive ability. When a firm with lower x-efficiency is less focused on taking out its competition, it may use more of its capital in other areas, such as higher wages, that could boost its long-term health.