Industrial Efficiency:

Concepts and Measurements

Lecture 2
Book Reference: R.R. Barthwal
Discussion Topics
• This chapter is concerned with the
• Understanding of the term industrial efficiency
• Measurement of industrial efficiency
• Its implications for the business firm and society at large
Concept of Industrial Efficiency
• The core of any economic activity, whether it is production or
consumption, is to strive for maximum possible efficiency. Since our
objective is to study the economic behaviors of firms and industries,
here we will term it as “Industrial Efficiency or Economic Efficiency”
and try to explain it using their point of views.
• Industrial efficiency has many dimensions
• Productive efficiency
• Business or economic efficiency
Productive Efficiency:
• Productive efficiency has been defined by Farrell' in terms of two
main components:
1. Technical Efficiency
2. Factor price Efficiency
1. Technical Efficiency
Technical efficiency refers to doing a job in the cheapest way possible.
That is, production of a given level of output from the lowest
combination of inputs. Here lowest combination of inputs refer to
lesser cost of production.

2. Factor Price Efficiency

It measures the skill in choosing the best combination of inputs by taking into account
their relative prices. This plays a very important role in case of input substitution in the
process of production.
Technical Efficiency
• Technical efficiency may mean any of the following:
• We can say that a machine or appliance or organization is technically efficient if it is
adequate to the demands made on it, or it lives up to the claims made for it.
(reliability and quickness)
• The technical efficiency may be assessed on the basis of some quantitative standard
of performance.
• Technical efficiency may mean doing a job in the cheapest possible way, that is,
production of a given level of output from the lowest possible combination of inputs.
• Second and third concepts are linked together but there may be conflict
between the first and the third one.
• Technical efficiency is a prerequisite for economic efficiency. If there is
inefficiency in this regard, it is bound to create economic inefficiency in due
course.
• II’ is an isoquant which shows the most efficient
(minimum combination of factors) combinations
of the two factors 𝑋1 and 𝑋2 used to produce a
given level of output of a commodity.
• In reality, a firm may deviate from II’ curve causing
inefficiency in factor uses.
• Let, P be the actual situation where the firm uses
OD and OC quantities of two factors 𝑋1 and 𝑋2 to
produce that specific level of output.
• The technical efficiency of the firm at P in relation
𝑂𝑄
to II’ can be measured by the ratio
𝑂𝑃
(usually technical efficiency is measured as the ratio
between the minimum input and the observed
input under the assumption of fixed output)
• AB is the iso-cost line in the diagram indicating
the combinations of the two factors that can
be purchased from a given amount of money
given its factor prices.
• The factor price efficiency of the firm (in
relation to II’) is thus measured by the ratio
𝑂𝑄1
because any combination of the two
𝑂𝑄
factors will not be possible beyond AB when
total resources and factor prices are fixed.
Also considering the fixed output.
𝑂𝑄 𝑂𝑄1 𝑂𝑄1
• So, productive efficiency = x =
𝑂𝑃 𝑂𝑄 𝑂𝑃
• The nearer this ratio moves towards unity, the
higher will be the productive efficiency. So, at
point R the productive efficiency is maximum
where the isoquant is tangent to the iso-cost
line!
Productive Efficiency
• The desirability of the productive efficiency cannot be questioned.
However, it may be difficult to achieve it since
• the planning and forethoughts of managers responsible for production may
not be perfect,
• the coordination of the complex operations may be difficult and inadequate,
and
• the knowledge of the ‘best’ in the current practices as well as of factor prices
may not be precise.
All these are essential requirements for achievement of the productive
efficiency.
Economic Efficiency
• The propositions on which the broader concept of “Economic
Efficiency” depends are:
1. Resources (men, machines, materials, money and time) at the
disposal of the firms are scarce.
2. The resources can be put on alternative uses.
Contd.
Given the scarcity of resources and their alternative uses, it is quite
natural for a rational firm to get the best out of them. Based on this
fact, we may define the concept of Economic Efficiency as follows:
“An industrial system is economically efficient if it is technically efficient
and succeeds in rationing out its scarce resources and the scarce
products of this resources in the most desirable way”.
 Determinants of Economic Efficiency
• For the sake of simplicity we put the determinants into two categories:
1. Internal Forces/ Factors:
In the first category we may include all those activities which define the
managerial function of a firm. For economic efficiency a firm must have
- efficient planning and regulation of the operations
- willingness to accept changes in the policies regarding the conduct of the
business including technological innovations
- smooth flow of work insuring proper supervision
- adequate facilities for work including fair pay etc.
Contd.
• It is the task of the management to ensure these jobs. They are
responsible for making proper policies and to execute them.
• If there is inefficiency on their part, the entire operations will be
inefficient and so ultimately there will be low economic efficiency
• The managerial or broadly organizational slackness is also called
'internal inefficiency' or 'X-inefficiency' in Leibenstein's terminology.
It’s an amalgamation of all internal forces causing economic
inefficiency in business.
 Determinants of Economic Efficiency
2. External Forces/ Factors:
• The second category of forces that affects the economic
efficiency includes
• the organizational or structural conditions prevailing in the
industry to which the firm belong
• short-term fluctuations in the market for both input and output
of the firm
• trade union activities and government policies or regulations, etc.
• Market structure exerts considerable influence on the
economic efficiency (e.g. performance) of a firm
Measurement of Efficiency Levels
• Essential to make it empirically relevant
• No unique method of measurement for the industrial efficiency
• Physical indicators such as capital-output ratio, capital-labor ratio, or
actual cost-standard cost ratio, etc.
• Three methods are generally used for measurement of productive or
economic efficiency:
• Some type of optimization model such as the linear programming,
• the use of the ratios like total productivity or profitability ratios and so on,
and
• the use of econometric methods.
Contd.
• It is true that the programming techniques are ideal for determination of
the efficiency conditions but there is a big question-mark about their actual
uses in the business circles.
• Few large corporations having sophisticated planning machinery may, of
course, be adopting them, but by and large the firms, in general, adopt
their own ad hoc methods for the efficiency maximization.
• They will select some performance indicators consistent with their desired
intentions in the business. For example, firms may set some target for total
factor-productivity or profitability for themselves. If they achieve that one,
then they may be called efficient, otherwise not.
• The choice of the indicators for the efficiency or performance
measurement depends on the goals of the firm.
Some Efficiency Conditions in the Theory of
Production
• CASE 1: Constrained Output maximization
• CASE 2: Constrained Cost Minimization
• CASE 3: Profit Maximization
• CASE 4: Revenue Maximization
Efficiency and Decision-Making Process
• Appropriate decision-making and efficient implementation of the
decisions are the vital determinants for the efficiency conditions in
business.
• There are two basic methods by which a society can make its
economic decisions:
• Free market mechanism
• Central planning
Free market economy
• Making efficient decisions lies on the prices
• Perfect competition prevailing in the economy
• Price system will be doing the rationing activities in the economy.
• Nothing more is needed to be done. The whole economy will be at
the maximum efficiency level.
Central Planning
• In the second method, all major decisions about consumption,
production and distribution of wealth a taken by the Government
with or without use of money prices.
Which method is better?!
• Debatable question
• Most of the economics follow the course of the mixed economy in
which both the methods of decision-making operate in some
coordinated way.
Conclusion
• A firm is an organizational unit: it has some well-defined goal or goals
for itself. The same firm is also a technical unit engaged in the,
transformation of a set of inputs into some output for the consumers.
• Both, the setting of goals for itself and carrying out the production,
require well coordinated planning and coordination mechanism
within the firm.
• If there are imperfections in the market, the decision-making process
will be adjusted accordingly to supersede or control the market, to
control the prices. or any other act directed for the reduction of the
business uncertainties and thus enlarging the scope for more efficient
performance.