X-inefficiency is known as the result of inputs not producing their maximum output as a consequence of an “X” factor. This translates into both cost minimisation and production maximisation failure and, hence, implies a loss of efficiency. This term was first introduced by Harvey Leibenstein in his “Allocative efficiency vs “X-efficiency”, 1966, since concepts such as organisation inefficiency or motivational inefficiency were not yet available. Therefore X-inefficiency makes reference to all non-allocative inefficiencies.

There are four main identified reasons that try to answer for X-inefficiencies:

• Relaxing maximisation behaviour: as the psychological Yerkes-Dodson Law postulates, individuals who are exposed to low pressure will not put much effort in their actions. As pressure builds up, maximising behaviours are reached until a point where too much pressure will again result in inefficiency. Other non-maximising decision making processes include habits, conventions, moral imperatives, etc.
• Incomplete contracts: employment contracts define workers economic compensation but other concerns such as the effort, the work load or specific tasks may remain undefined, which creates an incompleteness in contracts.
• Inertia: forces that are external to the company may exert pressure to make the firm become more competitive. Only with this external force efforts will increase.
• Discretion: it is assumed that workers will not show their “full potential” or maximize their efforts, and at the same time, that employers will not pay the maximum wages they could offer.

However empirical tests and models about X-inefficiency relevance have mixed results so no final transcendence can be assured. However, is interesting to realise the debate it has created, specially regarding incomplete contracts and managerial inefficiency, both also studied in the field of business management.

As a contribution to industrial organization, George Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939, which moved slightly away from neoclassical cost analysis.

This theory arises as many economist started to criticize the traditional U-shaped representation of a firm’s average costs. George Stigler used empirical data to question the traditional theory. His cost theory can be divided into the analysis of both the short-term and long-term average costs:

Average Costs in the short-term

According to classical economics, each plant ensured only a specific level of output could be produced in the short-run because of production inflexibility. However, Stigler introduced the notion that firms could adapt to changes in demand and be flexible even in the short-run. His main argument in favour of this idea is that whenever a firms built a plant they would have what is known as a reserve capacity.

The existence of this reserve capacity is justified by economic and technical reasons. From the former we include possible changes in the good’s demand due to cyclical reasons, favourable changes in consumers’ tastes or as a preventive method to avoid a production stop in case there is a breakdown or a repair. The latter can arise as there are some basic installations that are indivisible or as managers and workers are hired in excess to allow future expansions.

-before X₁  : marginal costs < decreasing average costs (increasing returns to scale)

-X₁ to  X₂: marginal costs = average costs (constant returns to scale, maximum efficiency)

-after X₂  :  marginal costs > average costs (both increase, therefore decreasing returns to scale)

It must be noted that this theory allows for maximum efficiency to exist for a while, which completely differs from the neoclassical view, which viewed maximum efficiency as a point of inflection, rather than a straight line.

Average Cost in the long-term

Taking into account production costs and managerial costs, Stigler argued that in the long-run average costs will decrease until a point where they cannot longer do so and from which they will become constant.

Production costs will decrease due to economies of scale until the optimum size is reached and then remain constant. Further average production cost reduction could come along with technological or skills increase. As for managerial cost, he considers, they will start to increase after a certain size is reached. However, managerial diseconomies of scale would be compensated by technical economies of scale, with a zero sum net effect and therefore would remain constant as a result.

George Joseph Stigler, 1911-1991, was an American economist and Professor at Brown University, Columbia and University of Chicago.  Furthermore, and regarding the University of Chicago, he stands out as one of the most prominent members of the School of Chicago. Stigler was awarded the Nobel Prize in Economic Sciences in 1982 for his researches regarding industrial structures, functioning of markets and causes and effects of public regulations.

From Stigler’s contribution to the microeconomic theory and industrial organization we can highlight his work of enhancement and adaptation of microeconomics in such a way, that it allows its use and analysis in a great range of real phenomena. In this field we find Stigler’s cost analysis theory, which changed the way we understand economies of scale. Amongst his top works we can find “The Economics of Information”, 1961 and “The Theory of Economic Regulation”, 1971.

Stigler also produced a great amount of work as a historian of the economic thought. His merit does not related to the amount he covered, but the depth and originality of his analysis, and how clarifying they were. We can highlight his first economic history book “Production and Distribution Theories” 1941, that studies the formative period of neoclassical economics.

Industrial Organization is the economic field that studies the strategic behaviour of firms, and their interaction to determine the structure of markets. Knowing their evolution helps to understand them. The traditional neoclassical theory made the relation between “industrial” and “manufacturing”, making the manufacturing market the main target of studies focusing in the technological result. It left aside aspects, such as organization, management and property. This perspective was criticized for using unrealistic assumptions and because it failed to explain a series of phenomena such as imperfect competition and asymmetric information amongst others.

During the 1930s, a new perspective started to take shape, especially from ideas coming from the Harvard school, and theory began to focus in the behaviour of agents in the industry and in the structure of both firms and industry. In his book “The Theory of Monopolistic Competition”, 1933, Edward H. Chamberlin wrote about imperfect competition and found that many markets were differentiated, thus turning markets into unique. There were many works and papers produced on how markets were arranged in terms of the concentration of suppliers, describing how some markets were dominated by a relatively small number of firms.

In his book “Industrial Organization”, 1959, Joe S. Bain Jr. provided the Structure, Conduct and Performance paradigm (SCP), which is used as an analytical framework, to make relations amongst market structure, market conduct and market performance. The market structure will determine its conduct and thereby its performance.

As implications of all this, regarding economic policies, Harvard School recognizes market power as being dangerous, and establishes a relation between, the concentration ratio, and the harmful effects on social welfare. The dynamic behaviour of buyers and sellers have an effect on the markets, making it harder to predict and establish fixed market structures. Difficulties arise when trying to explain the paradigm and this is due to data shortage, and the multiple definitions and extension of markets.

The Chicago school criticized the “empiricism without theory” of the SCP paradigm, and so returned to the Neoclassical pricing theory, having a more benign view of the market’s results, and having a theoretical (rather than empirical) approach. They start from the framework of perfect competition, and consider interventionism as being the source of monopolies. From Chicago’s point of view, the market’s efficiency guarantees the achievement of social welfare, and therefore firms are encouraged to seek efficiency in their production and distribution. As to the implications regarding economic policies, government intervention is considered undesirable, as the market’s forces should be left to act, and the cost of the intervention is believed to be higher than the social benefit, producing a deadweight loss.

The Austrian school also contributed to the development of the Industrial Organization theory, breaking with the Neoclassical approach. From the same school we can distinguish two main views: von Mises and his disciples’ view and Schumpeter‘s.

Mises describes the structure of the market as a dynamic process of exploration of new methods and opportunities to improve the use of resources, and thus competition is beneficial, as it encourages efficiency and innovations. Therefore, markets have to be free, and it dismays government intervention, although some regulation is praised when innovation is promoted.

From Schumpeter’s point of view, technical progress comes from a process of creative destruction, in which innovations make prior technology out-dated and originate from the innovative entrepreneur. Monopolies have a positive consideration, as they carry out the function of promoting innovation and investments, and government intervention should guarantee both of these.

Contestable markets came up as an alternative approach to the problems concerning market power. These ideas were first introduced by William J. Baumol in his “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982. In contestable markets there are no entry or exit barriers, no sunk costs and firms have access to the same level of technology. All this makes the number of firms irrelevant, as many will access it and then leave, following different strategies. This view has important limitations: for instance, its starting assumptions are quite restrictive; the definition of cost is not fully suitable; and that, in the real world, a market with such characteristics, is unconceivable.

Between the 1970s and 1980s, a series of theoretical models formulated using game theory in a framework of imperfect competition, made obsolete previous models, such as the SCP paradigm. As a result, there is more emphasis in imperfect information, in firms’ behaviour and, also, in mathematical tools used to calculate social or optimal equilibrium and market equilibrium. In general, there is a shift towards analysing the internal structure of firms, and different views of the firm arose.

Ronald H. Coase, described businesses as being a series of contracts amongst its workers, and explains that it is more beneficial to form firms, since there are a number of transaction costs that can be reduced or even eliminated.

When a business grows in size, there will normally be a distinction between managers and owners. Olivier E. Williamson took notice of the internal boundaries that firms have, and distinguished between decision-making, management and business ownership. The agency theory describes and explains the issues that arise between business managers and owners, as their respective objectives differ.

George Stigler’s contributions to industrial organization must also be mentioned, even though they were more focused on the economical aspect of the theory, rather than opening a debate on how firms interact with each other. Stigler stressed the importance of economies of scale, since it would make a big difference when concentration in the market and firms’ size increased. Furthermore, Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939 (see Stigler’s cost analysis theory), which moved slightly away from neoclassical cost analysis. When considering the size of firms, economies of scope are also a possibility, as Baumol pointed out in his co-authored book “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982.

To conclude, it is necessary to clarify that, nowadays, the industrial organization theory accepts multiple perspectives. This theory has not only grown within its field, but also in others, such as applied microeconomics and business management, and, as we have seen during the last years, the boundaries of business and markets have become less clear, and many new definitions and shapes are appearing. This explains the flexibility and the relevance of the industrial organization theory.