390. Forms of efficiency

In economics efficiency is defined purely in terms of costs of input relative to output. Contribution to quality of process, such as labour, or virtues, such as justice, do not count.

Economics recognizes three forms of such efficiency: allocative, productive and dynamic. Allocative efficiency forms the core of market thinking: scarce resources are optimally allocated to where needs are highest. Productive efficiency concerns the use of resources for production. That depends on a number of factors, such as economies of scale. Dynamic efficiency concerns efficiency in innovation.

All three are desirable, and are adduced as arguments for markets, but in fact, they obstruct each other.

Increase of scale can yield higher productive efficiency but tends to reduce competition, lowering allocative efficiency. Concentration in large firms allows firms to hinder entrance of tot the market of new competitors, yields powers of lobbying for advantage, and can slow down innovation by obstructing its development. There is the incentive to protect existing investments and prolong their life. Small innovators may be bought to slow down the further development and introduction of their innovations.

Dynamic efficiency is the most difficult because of the uncertainty involved, which economics cannon well deal with, as discussed in a preceding item in this blog. Because of uncertainty, one needs reserves to absorb misfiring innovation, but for allocative efficiency there should be no such reserves.

In the literature on innovation there has been a long discussion whether large or small independent enterprises are the most innovative. Large firms have the advantage of more financial reserves, spreading risks across a portfolio of products, cross-subsidization of weak products by strong ones, lobbying power to affect the choice of projects for subsidy and its acquisition, and the establishment of technical standards and standards for safety, and that again reduces allocative efficiency.    

Small firms have advantages of speed of development and flexibility to change direction when needed, due to less bureaucracy, more motivation to succeed, since success yields the entrepreneur’s income, and closer proximity of management to the market and to incoming technology. They can suffer from high costs of small scale, lack of specialized support, difficulty of attracting finance, which all reduce productive efficiency.

Which form of efficiency deserves precedence? In fact, there are often combinations and compromises between them.    

Concerning strengths and weaknesses large and small business are complementary. For example, in biotechnology small firms invent and develop new active substances or new processes of production which are then taken over by large firms with advantages for further development, testing, regulatory approval, and large scale production, distribution and brand name of products.

With digitalisation and informatisation, effects of scale in innovation have decreased, since production is now more virtual than physical, machines are replaced by computers, large production facilities are no longer needed, production can be better automated, and testing can often be virtual rather than physical, in computer simulation. On the other hand, new effects of a scale have come up, as in the large internet platform companies where volume of customers is part of the business model.