What Is X-Efficiency?

X-efficiency is the degree of efficiency maintained by firms under conditions of imperfect competition. An example of imperfect competition is a monopoly. According to the neoclassical theory of economics, under perfect competition, companies must maximize efficiency to succeed and make a profit; those who do not will fail and be forced to exit the market.

In other words, the widely held belief was that companies were always rational, meaning they maximized production at the lowest possible costs–even when the markets were not efficient. Economist Harvey Leibenstein challenged the belief that firms were always rational and called this anomaly "X" for unknown–or X-efficiency.

Understanding 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, caused by management or workers, that don't maximize production or achieve the lowest possible costs in production.

Key Takeaways

  • X-efficiency is the degree of efficiency maintained by firms under conditions of imperfect competition such as the case of a monopoly.
  • Economist Harvey Leibenstein challenged the belief that firms were always rational and called this anomaly "X" for unknown–or X-efficiency.
  • Leibenstein introduced the human element, arguing that there could be degrees of efficiency, meaning that–at times–firms didn't always maximize profits.

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."

X-Efficiency and X-Inefficiency

In the extreme market structure case–monopoly—he observed less worker effort. In other words, with no competition, there's less desire to maximize production and compete. This inability by management and workers to maximize profits is called X-inefficiency.

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. Leibenstein introduced the concept of X-efficiency or 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 helps to explain why companies might have little motivation to maximize profits in a market where the company is already profitable and faces little threat from competitors.

Harvey Leibenstein in Brief

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.