X Inefficiency occurs when a firm lacks the incentive to control costs. This causes the average cost of production to be higher than necessary. When there is this lack of incentives, the firm will not be technically efficient.
In theory, the firm could have an average cost curve at “Potential AC” but due to organisational slack, it’s actual average costs are higher. The difference between actual and potential costs is the x-inefficiency.
X Efficiency would occur be when competitive pressures cause firms to combine the optimum combination of factors of production and produce on the lowest possible average cost curve.
Causes of X Inefficiency
1. Monopoly Power. A monopoly faces little or no competition. Therefore, it might be easy for the monopolist to make supernormal profits. Therefore, in the absence of competitive pressures, they may not try very hard to control costs.
2. State Control. A nationalised firm owned by the government may face little or no incentive to try and make a profit. Therefore, it has less incentive to try and cut costs.
3. Principal-agent problem. Shareholders may wish to maximise profits and minimise costs. But, managers and workers may pursue other objectives – keeping costs low enough to protect their job but then allowing costs to rise as it makes work more enjoyable.
4. Lack of motivation. Workers and managers may simply lack the necessary motivation to work hard. For example, if there are poor industrial relations, workers may purposefully take extra long breaks and not try hard.
Examples of X Inefficiency
- Employing workers who aren’t necessary for the productive process. For example, a state-owned firm may be more concerned about the political implications of making people redundant than getting rid of surplus workers.
- Lack of Management Control. If a firm doesn’t have supervision of workers, then productivity may fall as workers ‘take it easy’
- Not finding the cheapest suppliers. Out of inertia, a firm may continue to source raw materials from a high-cost supplier rather than look for cheaper raw materials.
Theory of X Inefficiency
X Inefficiency was first mentioned in:
Leibenstein, Harvey (1966), “Allocative Efficiency vs. X-Efficiency”, American Economic Review 56 (3): 392–415