“X-Efficiency,” M. Perelman (2011)

Do people still read Leibenstein’s fascinating 1966 article “Allocative Efficiency vs. X-Efficiency”? They certainly did at one time: Perelman notes that in the 1970s, this article was the third-most cited paper in all of the social sciences! Leibenstein essentially made two points. First, as Harberger had previously shown, distortions like monopoly simply as a matter of mathematics can’t have large welfare impacts. Take monopoly. for instance. The deadweight loss is simply the change in price times the change in quantity supplied times .5 times the percentage of the economy run by monopolist firms. Under reasonable looking demand curves, those deadweight triangles are rarely going to be even ten percent of the total social welfare created in a given industry. If, say, twenty percent of the final goods economy is run by monopolists, then, we only get a two percent change in welfare (and this can be extended to intermediate goods with little empirical change in the final result). Why, then, worry about monopoly?

The reason to worry is Leibenstein’s second point: firms in the same industry often have enormous differences in productivity, and there is tons of empirical evidence that firms do a better job of minimizing costs when under the selection pressures of competition (Schmitz’ 2005 JPE on iron ore producers provides a fantastic demonstration of this). Hence, “X-inefficiency”, which Perelman notes is named after Tolstoy’s “X-factor” in the performance of armies from War and Peace, and not just just allocative efficiency may be important. Draw a simple supply-demand graph and you will immediately see that big “X-inefficiency rectangles” can swamp little Harberger deadweight loss triangles in their welfare implications. So far, so good. These claims, however, turned out to be incredibly controversial.

The problem is that just claiming waste is really a broad attack on a fundamental premise of economics, profit maximization. Stigler, in his well-named X-istence of X-efficiency (gated pdf), argues that we need to be really careful here. Essentially, he is suggesting that information differences, principal-agent contracting problems, and many other factors can explain dispersion in costs, and that we ought focus on those factors before blaming some nebulous concept called waste. And of course he’s correct. But this immediately suggests a shift from traditional price theory to a mechanism design based view of competition, where manager and worker incentives interact with market structure to produce outcomes. I would suggest that this project is still incomplete, that the firm is still too much of a black box in our basic models, and that this leads to a lot of misleading intuition.

For instance, most economists will agree that perfectly price discriminating monopolists have the same welfare impact as perfect competition. But this intuition is solely based on black box firms without any investigation of how those two market structures affect the incentive for managers to collect costly information of efficiency improvements, on the optimal labor contracts under the two scenarios, etc. “Laziness” of workers is an equilibrium outcome of worker contracts, management monitoring, and worker disutility of effort. Just calling that “waste” as Leibenstein does is not terribly effective analysis. It strikes me, though, that Leibenstein is correct when he implicitly suggests that selection in the marketplace is more primitive than profit maximization: I don’t need to know much about how manager and worker incentives work to understand that more competition means inefficient firms are more likely to go out of business. Even in perfect competition, we need to be careful about assuming that selection automatically selects away bad firms: it is not at all obvious that the efficient firms can expand efficiently to steal business from the less efficient, as Chad Syverson has rigorously discussed.

So I’m with Perelman. Yes, Leibenstein’s evidence for X-inefficiency was weak, and yes, he conflates many constraints with pure waste. But on the basic points – that minimized costs depend on the interaction of incentives with market structure instead of simply on technology, and that heterogeneity in measured firm productivity is critical to economic analysis – Leibenstein is far more convincing that his critics. And while Syverson, Bloom, Griffith, van Reenen and many others are opening up the firm empirically to investigate the issues Leibenstein raised, there is still great scope for us theorists to more carefully integrate price theory and mechanism problems.

Final article in JEP 2011 (RePEc IDEAS). As always, a big thumbs up to the JEP for making all of their articles ungated and free to read.

Advertisements

10 thoughts on ““X-Efficiency,” M. Perelman (2011)

  1. Martin Mann says:

    Fyi, your link to the Schmitz paper 2005 JPE on iron ore producers trips a warning in Chrome that the site is not safe & that one should not proceed to connect.

  2. Anonymous says:

    Yes, remove the “s” in “https” since the certificate they use is for a different domain. Their mistake. Still, you wouldn’t want people to believe that the Minneapolis Fed is dangerous. 🙂

    • afinetheorem says:

      Fixed it. Thanks for the heads up, guys. And Minnesota has Kacherlakota in charge now – it’s a new day over there!

  3. Darcy Allen says:

    Great blog. Really enjoying the conversational style. I also appreciate your ability to merge both old and new scholars, it gives a great context.

  4. Eric L says:

    “For instance, most economists will agree that perfectly price discriminating monopolists have the same welfare impact as perfect competition.”

    Wait, seriously? That seems like the kind of obviously wrong conclusion that only an economist could believe… Sure, a perfectly discriminating monopolist would sell the same goods to the same people as a competitive market, but they would cost many people more money, which would result in them being unable to purchase other goods and services that they would have been able to get if the monopolist were replaced by a competitive market.

    The mistakes here are ones that economists love to make in other contexts. They assume you can make general statements about the macroeconomy by looking at individual markets in isolation; here for example the assumption that a monopoly can only constrain people’s ability to acquire the particular good the monopoly sells. And they prefer to pretend budget constraints don’t exist, believing that if they simply treat people as being constrained by their willingness to pay that is a reasonable approximation for budget constraints.

    • afinetheorem says:

      Eric,

      You are interested in economics, so you should study these welfare results in more detail – they are not controversial. Obviously the consumers of the good are worse off, but the sellers of the good (and anyone extracting rent from that seller) are better off and “have more money in their pocket”. Even in you are imagining that sellers and those extracting rent from sellers have lower propensity to consume, this only matters (in old-school Keynesian models) when we are very specific macroeconomic environments.

      I have no idea why economics attracts so many cranks, where I’m defining crank as anyone who believes an entire field of people for a century are consistently making elementary mistakes. I would say certain portions of the media are largely responsible, but giving completely uninformed folks like Steve Keen the light of day.

      • Eric L says:

        Okay, I thought the claim of “same welfare impact” was meant to imply something stronger than that; now I’m pretty sure you just mean they preserve the welfare theorems, which don’t make very strong claims about welfare at all. But let me know if I’m understanding you correctly:

        A perfectly discriminating monopoly has the “same welfare impact” as perfect competition because, while it is worse for the consumers, it is better for the monopolist and possibly others like their suppliers. This is in no way a claim that the additional welfare gained by those who do better is equal to that lost by those who do worse (which I would expect “same welfare impact” to mean, but the welfare theorems do not suggest this.) Only that there is no possible economy where everyone, including the monopolists, is better off than in the case where there are perfectly discriminating monopolies.

        A non-price discriminating monopoly doesn’t have the “same welfare impact” as perfect competition because, while it is also better for the monopolist and worse for the consumers, and replacing the monopoly with perfect competition wouldn’t be a pareto improvement, if you did so while also exacting a tax on each person who benefited from the lower prices (but be sure not to tax them more than they benefit) and compensated everyone who benefited from higher prices you could make everyone better off. Of course if it weren’t hopelessly complicated to arrange such a deal the monopolist would offer that deal themselves. And I’m understating the complexity of the deal that would be necessary to make a pareto improvement over the monopoly pricing situation, because if there is any scarcity of resources, the increase in production by the monopoly will lead to something else being produced in smaller amounts, and someone who gets high utility from that good will be worse off unless they are compensated too. But while it’s not practically possible, the fact that the deal to improve on this situation for everyone can be imagined in theory and doesn’t require the economy to produce more than it’s capable of producing means we treat that economy as a possible economy, and therefore this economy with a non-price discriminating monopoly is not a pareto optimal economy and therefore can’t possibly be the best possible economy, unlike the perfect competition or perfectly price discriminating monopoly cases.

        Is that about right? If not, is there anything specific you recommend I study on these welfare results?

      • Eric L says:

        “I’m defining crank as anyone who believes an entire field of people for a century are consistently making elementary mistakes.”

        I should add, I don’t know how consistently such mistakes are made in economics and I’m sorry if you felt that I insulted your intelligence by accusing you of making a mistake you wouldn’t make. However, in my defense, it is not unheard of for economists to make this mistake. The Coase Theorem, for example, rests on this same mistake of believing you can ignore budget constraints if you treat people as just constrained by willingness to pay. And there are enough other problems with that theorem that at least when I was taught about it, this problem was not mentioned as one of them, so I don’t know how widely it is recognized as a mistake. It’s also a mistake in the common textbook explanation of volume discount pricing, though there I’m inclined to excuse it in that case as a justifiable simplification that makes it easier to explain a qualitatively correct theory. So these are the things that have led me to believe that this mistake may be common in economics, but I don’t know how pervasive this mistake is, I just know it is made in teaching undergraduate classes and isn’t called out as an assumption you have to watch out for and be aware of when it is or is not approximately true.

  5. Jim Rose says:

    Reblogged this on Utopia – you are standing in it! and commented:
    a good argument against x-inefficiency is De Alessi, L. “Property Rights, Transaction Costs, and X-Efficiency: An Essay in Economic Theory”. American Economic Review (March 1983).

    The puzzlingly large productivity differences across firms even in narrowly defined industries producing standard products lead to doubts about the efficiency of some firms, often the smaller firms in an industry. Some firms produce half as much output from the same measured inputs as rivals and still survive in competition (Syverson 2011).

    This diversity reflects inter-firm differences in managerial ability, organisational practices, choice of technology, the age of the business and its capital, location, workforce skills, intangible assets and changes in demand and productivity that are idiosyncratic to each individual firm (Stigler 1958, 1976, 1987; De Alessi 1983).

    Small and large firms can survive in direct competition because of different trade-offs they make between hierarchy, location, product ranges, production flexibility and pace of growth (Audretsch, Prince and Thurik 1998; Audretsch and Mahmood 1994; Stigler 1939, 1983, 1987; Jovanovic 1982; Chappell, Mayer and Shughart 1993; Das, Chappell and Shughart 1993).

    One reason that smaller firms are more flexible is they can hire more of the skills they need in the market to expand. Larger firms must invest more in recruitment and training before a new team member is fully productive.

  6. Jim Rose says:

    a good argument against x-inefficiency is De Alessi, L. “Property Rights, Transaction Costs, and X-Efficiency: An Essay in Economic Theory”. American Economic Review (March 1983).

    The puzzlingly large productivity differences across firms even in narrowly defined industries producing standard products lead to doubts about the efficiency of some firms, often the smaller firms in an industry. Some firms produce half as much output from the same measured inputs as rivals and still survive in competition (Syverson 2011).

    This diversity reflects inter-firm differences in managerial ability, organisational practices, choice of technology, the age of the business and its capital, location, workforce skills, intangible assets and changes in demand and productivity that are idiosyncratic to each individual firm (Stigler 1958, 1976, 1987; De Alessi 1983).

    Small and large firms can survive in direct competition because of different trade-offs they make between hierarchy, location, product ranges, production flexibility and pace of growth (Audretsch, Prince and Thurik 1998; Audretsch and Mahmood 1994; Stigler 1939, 1983, 1987; Jovanovic 1982; Chappell, Mayer and Shughart 1993; Das, Chappell and Shughart 1993).

    One reason that smaller firms are more flexible is they can hire more of the skills they need in the market to expand. Larger firms must invest more in recruitment and training before a new team member is fully productive.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: