is the difference between efficient behavior of firms assumed or implied by economic theory and their observed behavior in practice.
Economic theory assumes that the management of firms act to maximize owners' wealth by minimizing risk and maximizing economic profits -- which is accomplished by simultaneously maximizing revenues and minimizing costs, usually through the adjustment of output. In perfect competition, the free entry and exit of firms tends toward firms producing at the point where price equals long run average costs and long run average costs are minimized. Thus firms earn zero economic profits and consumers pay a price equal to the marginal cost of producing the good. This result defines economic efficiency or, more precisely, allocative economic efficiency.
Empirical research suggests, however, that a number of firms do not produce at the point where long run average costs are minimized. Some of this can be explained away by the mechanics of imperfect competition; what cannot be explained by traditional economics is described as X-inefficiency.
: A monopoly
is a price maker
in that its choice of output level affects the price paid by consumers. Consequently, a monopoly tends to price at a point where price is greater than long-run average costs. X-inefficiency
, however tends to increase average costs causing further divergence from the economically efficient outcome. The sources of the X-inefficiency
have been ascribed things such as overinvestment
and empire building
by managers, lack of motivation stemming from a lack of competition, and pressure by labor unions
to pay above-market wages.
X-inefficiency can also occur when monopolies or even oligoplies produce higher than the minimum average cost .
- Harvey Leibenstein, "Allocative Efficiency and X-Efficiency," The American Economic Review, 56 (1966), pp. 392-415.