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Home > Corporate Governance Checklists > Understanding Economic Efficiency Theory

Corporate Governance Checklists

Understanding Economic Efficiency Theory


Checklist Description

This checklist examines the basics of economic efficiency theory, and considers ways in which companies can apply some elements of the theory to work more efficiently in practice.

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Definition

Conventional economic efficiency theory states that companies should structure their output to achieve the lowest possible cost per unit produced. Given the combination of fixed and variable costs typical in business, low levels of output are inefficient because fixed costs are shared out across a relatively small number of units. At the other extreme, although above-optimal production can, in theory, generate economies of scale, in practice this apparent benefit is often more than offset by additional costs related to the overstressing of existing systems. In the short term, the point of maximum operational efficiency is achieved at the level of output at which all available economies of scale are taken advantage of, yet short of the level at which the diseconomies of overstraining existing systems come into play. Over the longer term, however, the optimal level of productive efficiency can be raised by increasing the capacity of existing systems.

The second element of conventional economic efficiency theory relates to the way existing resources are allocated. The logic is that high levels of competition among producers should prevent them from making excessive profits by raising their selling prices to an unreasonable level above their marginal costs. At the company level, maximum allocative efficiency is achieved when the firm produces the optimal output level of a combination of goods or services to maximize the benefit to the company as a whole. The theory takes account of the fact that company resources are finite and can be used only once, with the result that using a quantity of a material for one purpose involves an opportunity cost—that is, it denies the company the chance to use the same material for another purpose. Allocative efficiency is achieved only when no other pattern of utilization of resources can deliver a better overall result in terms of the welfare of all interested parties. This point of maximum allocative efficiency, at which improvements in one aspect of usage can only be achieved at the expense of losses elsewhere, is sometimes referred to as the Pareto optimal allocation of resources.

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Advantages

  • The theory provides a basic framework to help understand the various factors that are associated with existing operating costs.

  • An understanding of the main principles of the theory could provide scope for managers to find ways of making some elements of their business work more efficiently.

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Disadvantages

  • The theory encourages managers to take a “static” view of their business, with no regard to the possibilities offered by innovation. The rapid pace of technological development over recent years has highlighted this shortcoming in classic economic efficiency theory.

  • The focus on the lowest possible cost can give an overly simplistic representation of the way businesses operate, although the theory retains value in some low-technology, noninnovative manufacturing applications.

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Action Checklist

  • Analyze your company’s cost structure, determining which costs are fixed and which are largely variable; in practice most costs tend to be semivariable in nature.

  • Consider the levels of production that are likely to begin to put serious strain on existing infrastructure to the point that diseconomies of scale begin to appear. It may be that lessons can be learned from the way systems performed during past periods of temporary high demand.

  • Study how finite resources are being put to work at present. Excessive downtime of resources, including human resources, should be investigated in an effort to bolster allocative efficiency.

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Dos and Don’ts

Do

  • Make use of the theory to gain a greater understanding of various cost and resource utilization patterns within companies. However, remember that an excessive focus on miniscule cost improvements could distract management from changing industry trends, potentially allowing competitors to capitalize on exciting new opportunities.

  • Consider whether present resource allocation has more to do with past needs and in-house politics than present or future requirements. Remember that, as the business environment evolves, company resource allocation decisions should reflect changing demands on the business.

Don’t

  • Don’t use economic efficiency theory in isolation. Remember that taking a static view of your business is unlikely to be the best preparation for change.

  • Don’t ignore human factors when seeking greater efficiency. Demoralizing staff in the pursuit of insignificant cost savings could generate unforeseen human resource costs.

  • Don’t lose sight of wider opportunities to make a quantum leap in efficiency, rather than the small incremental improvements that are typically achieved using economic efficiency theory. Innovation, particularly related to technology, can deliver substantial efficiency benefits.

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Further reading

Books:

  • Quinzii, Martine, and Sujaya Parthasarathy (trans). Increasing Returns and Efficiency. New York: Oxford University Press, 1993.
  • Ravenscraft, David J., and Frederic M. Scherer. Mergers, Sell-Offs, and Economic Efficiency. Washington, DC: Brookings Institution, 1987.
  • Zerbe, Richard O., Jr. Economic Efficiency in Law and Economics. Cheltenham, UK: Edward Elgar Publishing, 2001.

Article:

  • Ng, Yew-Kwang. “Increasing returns and economic organization: Introduction.” Journal of Economic Behavior & Organization 55:2 (October 2004): 129–136. Online at: dx.doi.org/10.1016/j.jebo.2004.05.001

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