X-inefficiency is the difference between efficient behavior of firms assumed or implied by economic theory and their observed behavior in practice. It occurs when technical-efficiency is not being achieved due to a lack of competitive pressure. The concepts of x-inefficiency were introduced by Harvey Leibenstein
The degree of efficiency maintained by individuals and firms under conditions of imperfect competition. According to the neoclassical theory of economics, under perfect competition individuals and firms must maximize efficiency in order to succeed and make a profit; those who do not will fail and be forced to exit the market. However, x-efficiency theory asserts that under conditions of less-than-perfect competition, inefficiency may persist.
Economic theory assumes that the management of firms act to maximize economic profits—which is accomplished by adjusting the inputs used or the output produced. 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.
X-inefficiency is not the only type of inefficiency in economics. X-inefficiency only looks at the outputs that are produced with given inputs. It doesn’t take account of whether the inputs are the best ones to be using, or whether the outputs are the best ones to be producing, which is referred to as allocative efficiency. For example, a firm that employs brain surgeons to dig ditches might still be x-efficient, even though reallocating the brain surgeons to curing the sick would be more efficient for society overall.
Leibenstein regards entrepreneurship as a creative response to X-efficiency. Other people’s lack of effort and the consequent inefficiency of the organizations that employ them, create opportunities for entrepreneurs. Entrepreneurial activities pose a competitive threat to inefficient organizations.
Leibenstein identifies two main roles for entrepreneurs. The first role is the ‘input completion’ involves making available inputs which improve efficiency of existing production methods or facilitates the introduction of new ones. It is normally effected by intermediation in factor markets, in particular the markets for venture capital and management skills. The role of entrepreneur is to improve the flow of information in these markets.
The second role ‘gap filling’ is closely related to arbitrage function emphasized by Kirzner. Leibenstein provides a very vivid description of gap filling, visualizing the economy as a net made up of nodes and pathways.
The nodes represent industries or households that receive inputs (or consumer goods) along the pathway and send outputs (ﬁnal goods and inputs for the other commodities) to the other nodes. The perfect competition model would be represented by a net that is complete: one that has pathways that are well marked and well deﬁned, one that has well-marked and well-deﬁned nodes, and one in which each element (that is ﬁrm or household) of each node deals with every other node along the pathways on equal terms for the same commodity.