Economists have an affinity for the concept of efficiency, but often this is quite a vague concept. In this article we attempt to explain a few different types of efficiency/inefficiencies and show the different situations in which the word “efficiency” should be used.
Before we start it is important to remember why inefficiencies are bad and why a healthy economy should strive to be efficient. Lionel Robbins defined economics as the study of the allocation of scarce resources. Therefore an economist’s job is to ensure that these scarce resources are used to their best potential, therefore waste should be minimised and this can be achieved through efficient use of materials. But, what exactly does efficiently using materials mean?
There are 4 main types of efficiency; allocative, productive, Pareto and x-efficiency.
Allocative efficiency, according to Harvey Leibenstein, is what economists mean when they refer to “efficiency”, he believes that there is an unhealthy disposition to focus on allocative efficiency to the detriment of the other types of efficiency. This type of efficiency is concerned with where resources go, and occurs when resources go to the production of goods that people most want. Technically speaking, allocative efficiency is achieved when P=MC. If in all industries every firm was operating allocatively efficiently then we would be in a Pareto efficient (see below) situation. Only perfectly competitive markets exhibit allocative efficiency, other firms which have some form of market power can set a price higher than marginal cost, but in contestable markets (i.e. freedom of entry/low cost to entry) new firms can enter the market if P>MC, hence P must equal MC.
Productive efficiency occurs when production occurs at the lowest point on the average cost curve. Graphically this point is where the marginal cost curve interests the average cost curve, therefore if AC=MC then the firm is productively efficient. An economy as a whole is said to be operating productively efficiently if it is on its production possibility frontier (PPF curve). This type of efficiency is important because if we aren’t operating productively then resources are being wasted. If a firm is operating along its average cost curve but above the minimum point (i.e. AC/=/MC) then it must be wasting resources, perhaps a clothes company is cutting too much cloth and therefore has to dispose of the waste. If economics is the study of scarce resources then we want to ensure that these scarce resources aren’t used unnecessarily, and would therefore wish to be operating productively efficiently. On a grander scale, if unemployment exists then an economy won’t be operating on its PPF curve and is therefore productively inefficient. This is considered bad because we have workers (and remember, to be called “unemployed” a person has to be actively seeking, and ready to participate, in employment) who want a job, but are unable to find one, who may also succumb to hysteresis effects.
Pareto efficiency occurs when one person cannot be made better off without making one person worse off. If we have a total of 10 goods in an economy and person 1 has 9 goods and person 2 has 1 good then we are in a situation of Pareto efficiency (even though this may not be equitable) because neither person can be made better off (given more resources) without another person being made worse off (having fewer resources). In another scenario imagine we still have a total of 10 goods but 8 goods go to Person 1, 1 good for Person 2 and then there is 1 good sitting idle in a factory. In this case we don’t have a Pareto efficient situation because that one idle good can be given to either person (it doesn’t matter to whom when considering Pareto efficiency) and make them better off without affecting the other person.
X-Inefficiency is the term, coined by Leibenstein, which refers to a situation where a firm operates above -not on – the average cost curve. This is due to “organisational slack” which can take the form of a variety of situations, for example:
-> Using inefficient production techniques, e.g. not setting out the factory so that machines are easily accessible
-> Paying too much for input goods due to a lack of motivation to source cheaper suppliers
-> Hiring too many workers/not encouraging workers to produce at their best. Perhaps due to a lack of motivation
The only firms which can operate x-inefficiently are monopolies. Leibeinstein believes that this occurs because managers face little competition and therefore don’t have the incentive, or are too lazy, to tighten costs.