Economic efficiency

 

Author Definition

 

Definition

Economic efficiency is a measure of how well a market or the firms within it are performing. There are various different aspects of efficiency. Production efficiency (also referred to as technical efficiency) occurs when a firm produces a given output at the lowest unit cost of production given the technology employed. A related concept is x-inefficiency which measures cost incurred by a firm in excess of that which would be incurred in a competitive market. An example would be the ‘gold plating’ of the CEO’s office suite. The cost differential reflects the firm’s ability to ignore at least to some degree market pressures, that is, its market power.

Allocative efficiency refers to how well resources are allocated between productive activities in order to best satisfy consumer preferences. Firms will be allocatively efficient when consumers willing to pay a price at least equal to the marginal cost of producing the product obtain supply.

Together, production and allocative efficiency are static measures as they are assessed at a point in time and so assume that key variables such as technology are given.

Transaction costs, as the name implies, are costs that arise when making a sale that are additional to the cost of production. They include the cost of monitoring, controlling, and managing transactions. Decisions about whether to source inputs from the market or to self-supply are at least in part a reflection of these costs – high transaction costs provide an incentive to self supply. Arguably, ensuring that the organizational structure of a business minimises these costs is a form of efficiency. However, despite recognition of the significance of transaction costs, this is not a unanimously accepted view.

Dynamic efficiency is an assessment of how quickly and completely firms adjust to change, whether on the demand side, such as a change in consumer preferences, or on the supply side, such as the adoption of new cost-saving technology. Consequently, it is closely related to R&D and innovation. Dynamic efficiency may also be increased by the introduction of better work practices. This will have the effect of lowering the long run average cost curve but additional costs associated with this may increase costs in the short run, representing a tension between short run and long run gains.

 

Commentary

Central to competition policy and law is the acceptance that in competitive markets inefficient firms will not survive. They will incur higher costs than their rivals and so will be priced out of the market or they may not be supplying product of a quality or variety that consumers want. The exit of these firms enables resources to be reallocated to other firms that will better serve the market. Given this, only conduct that excludes or deters firms that are at least equally as efficient as the firm engaged in the conduct is likely to contravene competition law. However, an entrant into a market may be production inefficient even though once it becomes established it may be more efficient than incumbent firms because, for example, it has a better product or better technology. Conduct that caused the exit of that firm or even curtailed its ability to compete effectively could damage the competitive process

Markets that are not very competitive tend to be relatively inefficient. The lack of competition means that producers are able to restrict output and charge a price above the economic cost of production (which includes return to capital). If the unit cost of production decreases as output increases, this will be production inefficient. Additionally, a monopolist is likely to be x-inefficient. In addition, the higher prices mean that consumers lose some of the benefit of transacting in the market, that is, consumer surplus decreases. This is transferred to producers as economic rents/monopoly profits. In response to the higher prices some consumers will switch to other products which are cheaper but less preferred. The increased demand for these products causes those businesses to expand production. The result is that resources move from producing the products that consumers preferred to those that they prefer less – resources are inefficiently allocated. However, if a monopolist can perfectly price discriminate, charging each consumer their marginal willingness to pay, all consumers wiling to pay the marginal cost of supply will obtain supply and this outcome is allocatively efficient.

Dynamic efficiency is the engine of economic growth and is driven by innovation. Innovation may benefit consumers by making new products available that better meet consumer preferences, by making existing products safer, and by providing more variety for consumers. Consumers benefit from innovations that provide them with better products, although they may do so at a higher price (the higher price of new medical treatments). This identifies a tension between static efficiency which focuses on price and dynamic efficiency. In addition, the cost saving associated with technological improvements may not be passed on to consumers but it does represent an increase in total welfare. The tension here illustrates the debate concerning the measure of welfare against which the efficiency producing conduct is assessed.

Innovative distribution models, such as platform businesses, while clearly providing significant benefits for consumers, have raised concerns about increased market concentration with the dominance of mega-platforms such as Google and Facebook. The efficiencies available by the development of ecosystems around the original platform may raise barriers to entry, especially for suppliers of only part of the platform’s offering.

It is often said that competition policy promotes competition not for the sake of competition but because competition drives markets to be efficient and efficient markets increase economic welfare. However, if there are significant market failures this may not be the outcome. Indeed, conduct designed to overcome market failure and increase efficiency, such as the imposition of vertical restraints, may lessen competition. This creates another potential tension between competition policy and law and policies designed to increase efficiency and stimulate growth.

Under the influence of the Chicago School of economic thought, in the United States, antitrust authorities have tended to focus on promoting efficiency even if it has ani-competitive effects. Claims of efficiency benefits are used to justify conduct that is anti-competitive. Other jurisdictions are less permissive, generally balancing any pro-competitive effects from increased efficiency against associated anti-competitive effects. The detrimental effect on competition is offset by the saving in resources which increases total welfare.

 

Bibliography

Symposium: Recognizing Bert Foer, his AAI Founding and Presidency, Antitrust Bulletin 60 (2), June 2015.

Symposium: The Role of Efficiencies in Antitrust Law (Part II), Antitrust Bulletin 60 (3), September 2015.

OECD, The Role of Efficiency Claims in Antitrust Proceedings, Best Practice Roundtables, 2012

This article is being reviewed by the Editors of the Dictionary.

Author

Quotation

Rhonda L. Smith, Economic efficiency, Global Dictionary of Competition Law, Concurrences, Art. N° 86016

Visites 2157

Publisher Concurrences

Date 1 January 1900

Number of pages 500

 

Institution Definition

The sources of efficiency examined in economic welfare analysis are static (allocative, productive) or dynamic. The underlying rationale for mergers can be the possibility of achieving efficiency gains. Thus, most merger assessments will discuss productive and/or dynamic efficiency. Practices examined as abuse of a dominant position, while potentially exclusionary, may also have such efficiency benefits (for example, tying or bundling practices). The tension underlying competition policy is effectively between allocative vs. productive efficiency and static vs. dynamic efficiency. The welfare standard in use in a specific competition regime also affects whether certain types of efficiency gains are more easily accepted in practice. Rivalry and competitive markets result in pricing closely linked to underlying costs (allocative efficiency), to the benefit of consumer welfare. Thus, the intervention by competition authorities is to ensure that allocative efficiency is achieved and that firms do not earn excessive returns through exclusionary practices or mergers that hamper rivalry. Still, some mergers may yield lower-cost or higher-quality outputs (productive or dynamic efficiency), to the benefit of total welfare. One of the difficulties in competition assessment is to weigh consumer and producer welfare in a balanced way, so that efficiency benefits can be accepted when they increase producer welfare. A situation where there is a single (or few) buyer(s) and seller(s) of a given product in a market. The level of concentration in the sale of purchase of the product results in a mutual inter-dependence between the seller(s) and buyer(s). Under certain circumstances the buyer(s) can exercise countervailing power to constrain the market power of a single or few large sellers in the market and result in greater output and lower prices than would prevail under monopoly or oligopoly. This would particularly be the case when: the "upstream" supply of the product is elastic, i.e. fairly responsive to price changes and not subject to production bottlenecks; the buyers can substantially influence downwards the prices of monopolistic sellers because of the size of their purchases; and the buyers themselves are faced with price competition in the "downstream" markets (see vertical integration for discussion of terms upstream-downstream). Such a situation is particularly likely in the case of purchase of an intermediate product. However, if the supply of the product upstream is restricted and there is no effective competition downstream, the bilateral monopoly/oligopoly may result in joint profit maximization between sellers-buyers to the detriment of consumers. © OECD

 
A B C D E F G H I J L M N O P R S T U V