Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

X-Efficiency

What it is:

X-efficiency describes a company's inability to get the maximum output for its inputs due to a lack of competitive pressure.

How it works (Example):

Economist Harvey Leibenstein, a Harvard professor who studied the psychological aspects of economics, first used the term. His theory was that when companies aren't very competitive, their workers don't behave as efficiently. For example, let's say that companies A, B, and C together own about 90% of the market for widgets. They are large companies that compete fiercely on price and service. Company D is a tiny company that is also trying to sell widgets, but it is not doing so profitably.

Despite the fact that the market for widgets is competitive, Company D isn't much of a competitor and the employees know that. According to the theory, the employees don't work as hard at Company D because of this. They know that being more efficient won't make a difference. That is, their x-efficiency falls.

Similarly, let's assume that Company A is the only manufacturer of widgets in the market. It has a monopoly. This scenario, under the theory, leads to the same situation that Company D was in: Because employees know that nothing foreseeable will change the company's market share, they become less productive.

Why it Matters:

Leibenstein's concept of x-efficiency conflicts with traditional neoclassical economics because it suggests that companies and people don't always maximize utility. That is, they don't always make the most efficient choices.

One side effect of reductions in x-efficiency, one should note, is that it is usually predicated on a lack of competitive ability. Accordingly, when a company with lower x-efficiency is less focused on undercutting and taking out competitors, it might deploy more of its capital in other areas (R&D or higher wages, for example), that could improve its health in the long-term. It is also important to note that x-efficiency doesn't evaluate whether a company's inputs are the best inputs for the outputs it is seeking to produce.

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