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
Productive Efficiency:
• Productive efficiency has been defined by Farrell' in terms of two
main components:
1. Technical Efficiency
2. Factor price Efficiency
• 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!
Economic Efficiency
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
2. External Forces
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.
Some of the m constraints may be related to allocation of the inputs, some to sales potential for h. products and some to
the other things which the firm encounters in connection with its business. The objective function need not to be revenue
maximization only. It may be profit maximization or cost minimization or anything else which is to be maximized or
minimized. To solve such a problem, there is an algebraic method known as Simplex Method.
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.
• Small firms may 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.
(Total factor-productivity is a ratio of the gross revenue divided by the total cost of
production. Profitability is the return on the capital invested in the business.)
• 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. It
will ration out the scarce commodities among the competing needs
and, similarly, it will be doing the rationing or allocation of the factors
production for the competing lines of production.
• 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 are taken by the Government
with or without use of money prices.
• The decision will be, by and large, administrative in nature.
• They are deliberate and conscious, conforming with the overall goals
of the society.
Which method is better?!
• Debatable question
• While the free market mechanism is ideal in principle to achieve the
optimum economic efficiency, its operational side is very weak in the
sense that there is no regulatory mechanism to keep its basic
foundation intact.
• Because of this defect, the alternative mechanism, that is, the central
planning is supported and which is perhaps more popular because of
its political implications.
Contd.
• However, this system has its own limitations such as
• delays administrative decision-making
• low participation of masses in the achievements of the social goal
• influence of the pressure groups on the decision-making process
• personal biases of the decision make
• As a compromise, now-a-days, 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.
• The planning process at the firm level generally consist of the following
elements: (i) setting of goals, i.e., objectives; (ii) identification of
alternative strategies for achievement of the goals; (iii) making the choice
of the strategy from alternatives; (iv) execution of the strategy; (v)
evaluation of the results; and (vi) revisions in the plans necessary.
Contd.
• 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.