Competitive markets and efficiency in production

In addition to the above three crucial assumptions (which are complementary for some purposes, mainly that of analyzing the markets that surround organizations, and to some extent may be considered more technical, though they have considerable implications), economic approaches typically assume: (i) that the output to be obtained from the inputs is determined by a production function; and (ii) that all transactions between firms and consumers go through competitive markets.

If the production function entirely determines the output from a given mix of inputs, then production is “efficient” (that is, it is impossible to produce more output from the same inputs, or the same output with fewer inputs). This is what Leibenstein (2002) calls X-efficiency, to distinguish it from other concepts of efficiency (for example, Pareto efficiency, in the sense used above). Needless to say, this hypothesis is at odds with learning because, in practice, learning means expanding the efficient frontier. The hypothesis also excludes bounded rationality, because efficiency means that the firm knows all the possibilities and is able to choose the best one. Self-interest, then, leads to profit (or value) maximization.

Markets are perfectly competitive when a single producer can sell as much of the product as it produces, and a single consumer or firm can buy as much of it as it wants, without affecting the price in either case. Again, this is incompatible with learning, because if you accept the competitive hypothesis, all firms are at the efficient frontier.

Suppose the two hypotheses hold, that is:

  • 1. The firm can find a supply of the kind of labor it needs at a known price in a competitive market and the same applies to raw materials and intermediate products, financial inputs, and so on. Also, the firm can sell as much as it wishes of an undifferentiated product at prevailing market prices.
  • 2. Production is X-efficient: that is, the production function completely determines the output given the inputs.

If these two hypotheses hold, together with unbounded rationality, then the classical argument of profit maximization (or value maximization, in more modern terms) is unassailable. A “dollar taken out of the economy”, to use Jensen’s (2000) expression, is perfectly well defined and the amount of product to be obtained is also known, so that the comparison between the value of the product and the value of the input can readily be made.

These hypotheses do not hold in practice, however. One crucial factor is labor. With the possible exception of unskilled workers, by definition there cannot be a competitive market for labor. In today’s economy, where an employee’s specific knowledge is crucial and part of that knowledge is implicit, embedded and useful only to a specific firm, it is impossible to find that kind of knowledge readily available in the market (Polanyi, 1958; Nonaka, 1994; Andreu, 2009). Therefore, the meaning of “a dollar taken out of the economy” is ill-defined. And of course, the more differentiated the product and the more specific the knowledge required, the more ill-defined that dollar becomes.

To the extent, therefore, that the firm has a differentiated product and needs specific raw materials or supplies, the same is bound to be true of most suppliers. The same can be argued, of course, for all other stakeholders.

The efficiency assumption is quite a strong one too. From the point of view of the whole economy, again the Darwinian hypothesis is right. Given equal technology, a firm that is not X-efficient will disappear because efficient competitors (which always abound in competitive situations) will take the whole market. This does not solve the problem of a specific firm, however.

For a specific firm, achieving efficiency is one of the basic goals. X-efficiency is therefore endogenous, just one of the variables that will determine a firm’s success or failure.

Hence, if “a dollar taken out of the economy” is likely not to be well defined, the amount of product obtained may not be well defined either, and still less what can be obtained in an imperfect market for a unit of product. Therefore, the value maximization rule may not be applicable. What in fact happens is that in every interaction between “the firm” and another party a relationship is created that may be either satisfactory for both, unsatisfactory for one and satisfactory for the other, or unsatisfactory for both. In practice, “the firm” means any person who belongs to the firm; and “another party” means any person that represents that other party.

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