PRODUCTION EFFICIENCY - INTERPRETATION
We have seen how economic efficiency (or inefficiency) of production activities can be
evaluated empirically. The question then is: what is the economic significance to find that a
particular firm is inefficient?
1. Technical inefficiencies
By definition, a firm that is technically efficient uses the best available technology.
Alternatively, a firm that is found to be technically inefficient does not make use of the best
available technology.
1.1. Causes of observed technical inefficiencies
What can cause a departure from technical efficiency?
1.1.1. Measurement problems
A firm may be found to be technically inefficient because of measurement problems.
First, the inputs and output may be subject to measurement errors. Second, some inputs may
have been omitted in the measurement of the production frontier (e.g. rainfall, soil quality, etc.).
In either case, the estimated production frontier would be biased and the results possibly
unreliable. This stresses the need to rely on good data providing an accurate description of the
factors influencing the underlying production process. This also emphasizes the importance of
obtaining good measurements of inputs used in the production process, reflecting both their
quantity and their quality. The issue of controlling for quality in the estimation of a production
frontier is especially crucial if inputs exhibit significant quality differences across observations
(e.g. quality of fertilizer, equipment, labor, managerial ability, ...). For example, managerial
ability is positively influenced by the education and experience of the manager (e.g. as they affect
his/her ability to process and use relevant technological information). However, a precise
measurement of "management quality" remains difficult. This suggests that
 all the factors of production should be accounted for and measured accurately in any
efficiency analysis.
 an attempt should be made to account for quality differences across observations in
the analysis of production efficiency.
 estimated technical inefficiencies can be interpreted as the effects of managerial
ability and other factors not accounted for in the analysis.
1.1.2. Technical change
A firm may be found to be technically inefficient because of technical change. First, firms
in an industry do not adopt a new technology all at the same time. This is the process of diffusion
of a new technology. At any point of a diffusion cycle for an improved technology, early
adopters will appear to be technically more efficient than late adopters. In this context, efficiency
analysis can help identify the early adopters. To the extent that the managerial characteristics of
the early adopters are transferable, this can help design extension programs intended to speed up
the diffusion process, increase the adoption rates among late adopters and improve productivity
in the industry.
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Second, technical change may be associated with observed technical inefficiencies if
technology is embodied in an asset that is fixed in the short run. The corresponding technology
has been called a "putty-clay" technology, i.e. a technology that is unrestricted in choice up to the
point where an investment is made ("putty"), but that is fixed (at least in the short run) after the
investment is made ("clay"). In this situation, the technology used by a firm is the technology
available at the time of the investment (e.g. building a plant). In the presence of technical change
embodied in capital, this implies that the level of technical efficiency of a firm will depend on the
vintage of its capital: firms with recent (older) vintage will tend to appear technically more (less)
efficient. Note that this argument can be applied to firms as well as industries (e.g. the case of
manufacturing in Germany or Japan versus Great Britain after 1945).
1.2. Welfare implications of technical inefficiencies
In the absence of externalities, any firm that is technically inefficient does not generate a
Pareto optimal allocation of resources. For example, with any TEI < 1, we have seen that (1 TEI) can be interpreted as the proportional reduction in production cost that can be achieved by
the firm becoming technically efficient (through a proportional reduction in all inputs). As long
as the marginal utility of money is positive, this reduction in production cost would always be
associated with a welfare improvement for the firm. To the extent that this change can be made
without affecting the welfare of any one else, this would identify a Pareto improving move. In
other words, any institution or policy that helps eliminating technical inefficiencies in an industry
can contribute to improving the efficiency of resource allocation. This can take the form of
education and training programs intended to improve managerial ability, or of extension
programs designed to speed up the adoption of improved technologies...
2. Allocative inefficiencies
Allocative efficiency is defined in terms of cost minimizing and/or revenue maximizing
behavior. Thus, for a firm, allocative inefficiency means that input choices are not made so as to
minimize the cost of production, and/or that output choices are not made so as to maximize
revenue.
2.1. Causes of allocative inefficiencies
Since allocative efficiency relates to production behavior, the associated inefficiencies
must necessarily be associated with the decision making process. For an entrepreneurial firm
where there is a single decision maker (the "manager"), the focus is on the ability of this decision
maker to minimize cost. This ability is often called managerial ability. Minimizing cost or
maximizing revenue requires information about both technology and market prices. In this
context, allocative inefficiencies must be associated with a lack of information and/or its
inappropriate use. In general, education and experience have a positive influence on managerial
ability: they tend to improve the ability of the decision maker to obtain and process information
about prices and technology. As a result, education and experience of the managers can
contribute to an improved allocative efficiency of production activities. To the extent that it
reflects the ability of producers to respond to market prices, allocative efficiency is a prerequisite
to a good functioning of market institutions and their resulting allocation.
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Note: In the case where there is more than one decision maker, then the organizational structure
of the firm can influence allocative inefficiencies. For example, the way the information about
prices and technology is used and transmitted within the firm can have a direct influence on the
input/output choice and thus on the cost of production and on revenue.
2.2. Welfare implications of allocative inefficiencies
Under competition, finding that a firm is not allocatively efficient implies that it is not
generating a Pareto optimal resource allocation. Indeed, with any AE < 1, we have seen that [(1 AE] can be interpreted as the proportional reduction in production cost that can be achieved by
the firm becoming allocatively efficient. As long as the marginal utility of money is positive, this
reduction in production cost would always be associated with a welfare improvement for the
firm. To the extent that this change can be made without affecting the welfare of any one else,
this would identify a Pareto improving move. In other words, any institution or policy that helps
eliminating allocative inefficiencies in an industry can contribute to improving the efficiency of
resource allocation. This can take the form of education and training programs intended to
improve managerial ability, or of programs that facilitate the access to information about prices
(e.g. price surveys, price outlook, etc.) and/or technology (e.g. experimental farms, technical
advisors, consulting services, etc.)...
3. Scale inefficiencies
Scale efficiency corresponds to situations where the firm chooses outputs so as to
minimize the ray-average cost of production (or just the average cost in the single output case),
or so as to maximize the ray-average revenue. This corresponds to a situation of industry longrun equilibrium, where the firm exhibits (locally) constant return to scale and zero profit.
3.1. Causes of scale inefficiencies
A particular firm can be found to be scale inefficient for at least two reasons.
3.1.1. Short run situations
First, "scale inefficiencies" might exist in short run situations. Indeed, if the entry-exit
process is not instantaneous, then a firm may be scale inefficient because there has not been
enough time for the industry to reach a long-run equilibrium. In this case, the firm may be either
in the region of increasing return to scale, or in the region of decreasing return to scale. If it is in
the region of increasing return to scale, it would be under pressure to exit the industry in the long
run. And, under free entry and exit, if it is in the region of decreasing return to scale, it would
face increased competition from new entrants that can choose to be scale efficient and produce at
a lower ray-average cost. In such a situation, just observing the ability for firms of different sizes
to survive over time can provide valuable information on scale efficiency in an industry. This is
called the survival method. Under stationary conditions, this method identifies an efficient scale
as a firm size for which the number of entries is larger than the number of exits. Alternatively,
an inefficient scale is identified as a firm size for which the number of exits exceeds the number
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of entries.
3.1.2. Lack of resource mobility
A firm might also be "scale inefficient" because resource mobility is less than perfect.
This can be due to entry barriers. This is often associated with asset fixity, with hysteresis, and
with the presence of sunk cost. Hysteresis is defined as the failure of an effect to reverse itself as
its underlying cause is reversed. And sunk cost is an investment cost that cannot be recovered in
the case of a later disinvestment.
To illustrate the effects of sunk costs, consider the following profit maximization
problem:
Maxx,I [p y(x, I) – r x - (s+I+ + s-I-),
where y(I, x) is the production function,
x is a vector of variable inputs,
I  I+ + I- denotes investment,
I+  0 corresponds to investment,
I-  0 denotes disinvestment,
p is the price of the output y
r is a vector of input prices,
s+ is the price of I+,
s- is the price of I-.
Whenever the purchase price of an asset (s+) exceeds its selling price (s-), i.e. whenever s+
> s , part of the investment is sunk, the sunk cost per unit of investment being (s+ - s-). Sunk
costs can be associated with asset specificity, where a specialized asset (e.g. cars, equipment,
human capital, etc.) utilized in a particular situation does not have any good alternative use.
The first order conditions for an interior solution to the above profit maximization problem are
p y/x = r,
p y/I = s+ if I > 0, (e.g. corresponding to a high price p),
= s- if I < 0, (e.g. corresponding to a low price p),
= between s- and s+ if I = 0, corresponding to asset fixity (e.g. for some
intermediate price p).
This implies that fluctuations in the output price p would have no effect on investments
within the zone of asset fixity. In this situation, price signals would not be effective in guiding
resource allocation associated with investment activities. And this ineffectiveness would tend to
increase with sunk cost: the larger (s+ - s-), the larger the zone of asset fixity, and the less
effective price signals are likely to be.
Sunk costs can be associated with hysteresis. To see that, assume that a firm faces an
intermediate price p placing it within the asset fixity zone. At this point, the firm does not invest.
Now consider a large increase in price (generating a high price p) followed by a reduction in
price back to the same original intermediate price. With the price increase, the firm would
invest. However, it would fail to disinvest with the following price decline. This identifies the
existence of hysteresis in investment behavior as well as the presence of irreversibility in the
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effects of prices on production behavior. In that particular example, a price increase would tend
to affect production relatively more than an equivalent price decrease.
Finally, to the extent that investment (disinvestment) is necessarily associated with entry
(exit), sunk costs constitute entry barriers which tend to reduce resource mobility. Thus, under
sunk costs, an industry long run equilibrium may not correspond to the minimum of the average
cost of production. In other words, under sunk cost, some firms may be able to survive in the
long run without producing at the minimum average cost. In this case, the identification of an
"efficient scale" may not provide information on the prospect for long run firm survival or on the
long run structure of the industry.
3.2. Welfare implications of scale inefficiencies
If scale inefficiencies are associated with a short run situation and are expected to
disappear in the long run, then the only welfare issue is related to the nature of the adjustment
process from the short run to the long run. If this adjustment process were to be costless, the
implications would simply be that resource allocation needs some time to adjust. But if the
adjustment process is costly, then the nature of the adjustment costs becomes of interest. Then, it
becomes relevant to ask whether there exist institutions or policies that could reduce these
adjustment costs and possibly speed up the move toward a long run situation (e.g., retraining
program for the displaced labor).
If scale inefficiencies are associated with a lack of resource mobility, the welfare issue
then becomes whether it is possible to increase resource mobility. If resource mobility is reduced
because of the exercise of market power by some firm, anti-trust policies and their
implementation may be appropriate. If resource immobility is due to sunk costs, the question then
is whether these sunk costs could be reduced. An example of reduction in sunk costs is the
retraining of "specialized human capital." In general, any institution or policy that can reduce
sunk costs would contribute to greater resource mobility and a more effective functioning of
market institutions. However, there are situations where sunk costs are important and cannot be
reduced easily. Then, one may want to be cautious about relying exclusively on markets as a
means of allocating resources. In such a situation, non-market institutions such as vertical
coordination schemes (including contracts and vertical integration) or price stabilization
programs may be useful. Although they do not eliminate the sunk costs, they can help reduce the
chances that a particular firm will ever face the sunk cost of investment (when it wants to
disinvest following an initial investment).
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