Assessing the efficiency of firms is a powerful means of evaluating performance of firms, and the performance of markets and whole economies. There are several types of efficiency, including allocative and productive efficiency, technical efficiency, ‘X’ efficiency, dynamic efficiency and social efficiency.
Allocative efficiency
Allocative efficiency occurs when consumers pay a market price that reflects the private marginal cost of production. The condition for allocative efficiency for a firm is to produce an output where marginal cost, MC, just equals price, P.
Productive efficiency
Productive efficiency occurs when a firm is combining resources in such a way as to produce a given output at the lowest possible average total cost. Costs will be minimised at the lowest point on a firm’s short run average total cost curve.
This also means that ATC = MC, because MC always cuts ATC at the lowest point on the ATC curve.
Technical efficiency
Technical efficiency relates to how much output can be obtained from a given input, such as a worker or a machine, or a specific combination of inputs. Maximum technical efficiency occurs when output is maximised from a given quantity of inputs.
The simplest way to differentiate productive and technical efficiency is to think of productive efficiency in terms of cost minimisation by adjusting the mix of inputs, whereas technical efficiency is output maximisation from a given mix of inputs.
To identify which output a firm would produce, and how efficient it is, we need to combine data on both costs and revenue.
We can assume that most real firms face a downward sloping demand (AR) curve, and MR falls at twice the rate.
Diagrammatically, productive efficiency occurs where ATC is at its lowest, and is equal to MC.
X efficiency is a concept that was originally applied to management efficiencies by Harvey Leibenstein in the 1960s. The concept can be applied specifically to situations where there is more or less motivation of management to maximise output, or not.
X efficiency occurs when the output of firms, from a given amount of input, is the greatest it can be. It is likely to arise when firms operate in highly competitive markets where managers are motivated to produce as much as possible.
When markets are less than perfectly competitive, as in the case of oligopolies and monopolies, there is likely to be a loss of ‘X’ efficiency, with output not being maximised due to a lack of managerial motivation.
Dynamic efficiency
The concept of dynamic efficiency is commonly associated with the Austrian Economist Joseph Schumpeter and means technological progressiveness and innovation.
Neo-classical economic theory suggests that when existing firms in an industry, the incumbents, are highly protected by barriers to entry they will tend to be inefficient. Schumpeter argued that this is not necessarily the case; indeed, firms that are highly protected are more likely to undertake risky innovation, and generate dynamic efficiency.
Firms can benefit from two types of innovation
- Process innovation occurs when new production techniques are applied to an existing product. For example, this is common in the production of motor vehicles with firms constantly looking to develop new methods and production processes.
- Product innovation occurs when firms generate new or improved products. For example, this is common in many consumer product markets, including electronics and communications.
Social efficiency exists when all the private and external costs and benefits are taken into account when producing an extra unit. Private firms only have an incentive consider external costs into account if they are forced to internalise them through taxation or through the purchase of permit to pollute.
Knowledge and efficiency
Information failure is a type of inefficiency that can affect markets and firms in certain circumstances. There are various types of information failure.
The principal-agent problem
The principal-agent problem is associated with large firms, where ownership and control are in the hands of different people.
The principal-agent problem can occur whenever owners of a firm appoint managers to make key decisions. The owners are the principals, and those appointed to run and manage the business are the agents. This separation causes asymmetric information, where the agents know more than the owners do, and this creates the need for owners to construct mechanisms to monitor and check the performance of agents. The problem develops because the owners and managers usually have different objectives, so the owners cannot trust the managers to act on their behalf, creating the need for constant checking. This leads to inefficiencies in terms of the need to employ checkers and complex monitoring systems.
The principal-agent problem is most often associated with larger firms, especially plcs, where ownership is by shareholders, but directors and managers make decisions.
The principal-agent problem can also occur in the public sector, where the government (as principals) appoint managers to undertake the day-to-day operations of publicly owned enterprises. Conflicts between agents and principals can frequently occur. For example, managers of the railway network may want to generate maximum revenue, whereas the government may want a safer railway system.
Solutions to the principal-agent problem
A firm can adopt a number of strategies to resolve the principal-agent problem, including:
- Allocating shares to managers of a firm, so that they understand the shareholders’ objectives, and are more likely to consider their view when making day-to-day decisions.
- Using incentives tied to profits, such as with performance-related pay.
Moral hazard
and adverse selection
There are several other notable implications of asymmetric information, including moral hazard and adverse selection.
Moral hazard occurs when people alter their normally careful behaviour in the belief that someone else will deal with the effects of their careless behaviour.
This occurs because either:
- They think ‘they can get away with it’. Asymmetric knowledge means the person predicts that they are not likely to be found out, such as a manager not bothering to keep costs to a minimum.
- Or because they think they are ‘insured’ against the damage and loss associated with the behaviour – ‘..if I get it wrong someone else will come to the rescue…’.
Adverse selection
Adverse selection occurs as a result of asymmetric knowledge, as is well illustrated in the lemons problem. When parties to a transaction are ignorant of certain aspects of the transaction, such as the quality of the product they are buying, they are forced to make assumptions, often based on price. For example, a buyer may assume that goods are of poor quality if their price is low, and that goods are of high quality if their price is high.
In some markets, only low quality products will be sold, the so-called lemons problem. The lemons problem was first analysed by American economist George Akerlof in 1970. Akerlof explored the problem associated with pricing second hand cars in the USA, which he called a lemons market – a ‘lemon’ is a derogatory term for a poor-quality second-hand car. However, the lemon’s problem has wider implications in terms of understanding information failure in general.
For example, in terms of second hand cars, buyers may be suspicious of the motives of seller, and wonder whether the car is a ‘lemon’. If an individual buys a new car for £30,000 and tries to sell on the second-hand market shortly after, they may be forced to accept a much lower price, given that buyers will be suspicious of the sellers motive. Potential buyers, not having all the facts, are likely to assume the worst and expect the car to have a problem – in other words, that it is a ‘lemon’. Therefore, given that second hand cars will generally attract a low price, only those sellers who actually do have poor-quality cars will use this market. After a short period, it can be predicted that all cars sold on the second hand car market will be lemons.
When applying this concept to other markets it can be suggested that, whenever there is information failure, there is the possibility that markets will become lemons markets. This means that the supply of good-quality products will fall and the supply of poor-quality will products rise.
The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the idea of efficiency. In everyday parlance, efficiency refers to lack of waste. An inefficient washing machine operates at high cost, while an efficient washing machine operates at lower cost, because it’s not wasting water or energy. An inefficient organization operates with long delays and high costs, while an efficient organization is focused, meets deadlines, and performs within budget.
The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency. Figure 1, below, illustrates these ideas using a production possibilities frontier between health care and education.
Figure 1. Productive and Allocative Efficiency.
Productive efficiency means that, given the available inputs and technology, it’s impossible to produce more of one good without decreasing the quantity of another good that’s produced. All choices along the PPF in Figure 1, such as points A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either health care increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it’s possible to produce more of one good, the other good, or some combination of both goods.
For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and health care on the vertical axis is also higher at point C than point R (H2 is greater than H1).
Any time a society is producing a combination of goods that falls along the PPF, it is achieving productive efficiency. When the combination of goods produced falls inside the PPF, then the society is productively inefficient.
Allocative efficiency means that the particular mix of goods a society produces represents the combination that society most desires. For example, often a society with a younger population has a preference for production of education, over production of health care. If the society is producing the quantity or level of education that the society demands, then the society is achieving allocative efficiency. Determining “what a society desires” can be a controversial question and is often discussed in political science, sociology, and philosophy classes, as well as in economics.
At the most basic level, allocative efficiency means that producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocative efficient choice for society as a whole. For example, in order to achieve allocative efficiency, a society with a young population will invest more in education. As the population ages, the society will shift resources toward health care because the older population requires more health care than education.
In the graph (Figure 1), above, a society with a younger population might achieve allocative efficiency at point D, while a society with an older population that required more health care might achieve allocative efficiency at point B.
Why Society Must Choose
Every economy faces two situations in which it may be able to expand the consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward, and society will be able to afford more of all goods.
However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. So, a society must choose between trade-offs in the present—as opposed to years down the road. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. But for both the government and the market economy, in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.
The PPF and Comparative Advantage
While every society must choose how much of each good it should produce, it doesn’t need to produce every single good it consumes. Often, how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curve of a country’s PPF gives us information about the trade-off between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills.
Suppose two countries, the U.S. and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climate, Brazil can produce a lot of sugar cane per acre but not much wheat. Conversely, the U.S. can produce a lot of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true; the U.S. has a lower opportunity cost of producing wheat than Brazil. This can be illustrated by the PPF of each country, shown in Figure 2, below.
Figure 2. Brazil and U.S. PPFs
When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. In our example, Brazil has a comparative advantage in sugar cane, and the U.S. has a comparative advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If, however, it devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount, at point B. By moving from point A to point B, Brazil would give up a relatively small quantity in wheat production to obtain a large production in sugar cane. The opposite is true for the U.S. If the U.S. moved from point A to B and produced only sugar cane, this would result in a large opportunity cost in terms of foregone wheat production.
The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat is generally higher in Brazil. In the module on International Trade you will learn that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage and trade part of that production for goods in which they don’t have comparative advantage in. With trade, goods are produced where the opportunity cost is lowest, so total production increases, benefiting both trading parties.
Self Check: The Production Possibilities Frontier
Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.
You’ll have more success on the Self Check if you’ve completed the two Readings in this section.
Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.