X-efficiency theory of entrepreneurship
X-Efficiency Theory: Why Incumbents Waste Resources and Startups Win
Why do big, established companies waste so much money? And why does this waste create the perfect opening for entrepreneurs?
American economist Harvey Leibenstein (1966) developed X-Efficiency Theory to answer these questions. While traditional economics assumes companies always maximize profits, Leibenstein argued that, in reality, most firms operate far below their potential due to "X-Inefficiency."
The Problem: X-Inefficiency
X-Inefficiency occurs when a firm fails to utilize its resources efficiently. This "gap" between actual performance and maximum potential emerges due to:
- Inertia: "We've always done it this way."
- Organizational Bloat: Excessive middle management.
- Lack of Motivation: Employees (and managers) who are not incentivized to work hard.
- Lack of Competitive Pressure: Monopolies get lazy.
The Entrepreneur as "Gap-Filler"
Leibenstein views the entrepreneur not just as an innovator, but as a Gap-Filler and Input Complementor.
If the maximum productive use of a resource is greater than the actual use by incumbents, an arbitrage opportunity emerges. The entrepreneur steps in to "fill the gap" by:
- Correcting Inefficiencies: Using resources that incumbents are wasting.
- Completing Inputs: Finding missing pieces of the supply chain that incumbents are ignoring.
Real-World Example: Labor Costs
A classic example is the startup entering a market dominated by unionized incumbents.
The incumbent may suffer from X-Inefficiency due to rigid labor contracts and high overhead costs. A startup, lacking these structural constraints, can operate with a low-cost business model. This allows them to thrive at the bottom of the market with margins that are uneconomical for the bloated incumbent to pursue.
Connection to Kirznerian Alertness
This theory aligns closely with Kirzner’s view of entrepreneurship.
- Kirzner: Entrepreneurs are "alert" to opportunities caused by market ignorance.
- Leibenstein: Entrepreneurs are "gap-fillers" who repair the inefficiencies caused by that ignorance.
Video: Understanding Economic Efficiency
References
Leibenstein, H. (1966). Allocative efficiency vs. "X-efficiency". The American Economic Review, 392-415.
Leibenstein, H. (1978). On the basic proposition of X-efficiency theory. The American Economic Review, 328-332.
