X-Efficiency and Underdevelopment: Leibenstein’s Application of

Behavioral Economics

Introduction
Harvey Leibenstein is primarily known for his attempt to reformulate microeconomic
theory which gave rise to what he called X-(in) efficiency theory. According to Roger
Frantz, X-efficiency theory has several postulates: imperfect markets which result from
asymmetric information (mostly in favor of sellers) and monopoly; incomplete
production functions and labor markets; discretionary efforts (on the part of workers);
rationality as a continuum (rather than always being full) and as psychological
phenomenon; and the existence of an inert area which implies a range of effort within
which the individual is mobile. On the basis of these postulates, Leibenstein can be
viewed as one of the pioneers of (modern) behavioral economics,.In fact, he is viewed as
such in Hosseini’s 2003 essay on the arrival of behavioral economics, and Roger Frantz’s
2004 paper on Akerloff and Leibenstein (Frantz 2004).
However, Leibenstein was also known for contributions to development economics.
Specifically, he was interested in the relationship between population growth, fertility
and economic development. Initially, as a development economist, Leibenstein tried to
apply conventional economic theory to the problems faced by less developed economies.
However, in his 1968 AER paper “Entrepreneurship and Development” ,and in his 1978
book General X-Efficiency Theory and Development, Leibenstein applied his theory of
X-efficiency to the study of development. It is worth mentioning that his (initial)
presentation of the theory of X-efficiency had nothing to do with the study of
development. Rather, as argued by Heinz Arndt, he developed this concept: “in the
context of the efficiency of resource use within the (modern) firm, to explain why some
firms in a given industry are more efficient than others” (Arndt, 1988: 223). In fact,
Leibenstein came up with his theory of X-efficiency after the concern of Arnold
Harberger (Harberger, 1954) and Robert Mundell (Mundell, 1962) about the small
welfare impact that results from market power. As argued by Roger Frantz,
Leibenstein came to the rescue when he postulated a non-allocative effect of market
power; market power will not only drive a wedge between price and marginal costs, but
will also raise the firm’s costs above the technically minimum levels. The precise nature
of the inefficiency was unclear to Leibenstein; hence, he named it X. Furthermore, the
data that Leibenstein analyzed suggested that X-inefficiency was often much larger than
allocative inefficiency. The existence of X-inefficiencies meant that improvements in
resource allocation greater than had previously been believed were now possible. It also
implies the possible existence of a free-lunch” (Frantz 1992: 434).

In presenting his theory of X-efficiency, Leibenstein reformulated neoclassical micro

theory. This explains why he changed the basic units in microeconomics from households

and firms to individuals, replaced (as a behavioral economist) maximization and

minimization concepts with selective rationality, and introduced effort (as a discretionary

variable), the idea of inert areas, the agent-principal and impactors and impactees

relations to microeconomic analysis.

Leibenstein had developed the theory of X-efficiency during the late 1960’s.
However, his application of this theory to development occurred a decade later. By
applying his theory of X-efficiency to the problems of development, Leibenstein moved
his theory of economic developed from a conventional approach to an unorthodox
(behavioral) one. As a result, those two aspect of his work become consistent.
My intent in this essay is to discuss and present this new attempt – the application of
the notion of X-efficiency to development economics – which was in particular
developed in his book General X –Efficiency Theory and Development. In this book,
after presenting an overview (chapter one), and his X-efficiency theory (chapter two), he
applies X-efficiency to the problem of underdevelopment (chapters three to eight). This
includes the application of X–efficiency to: the nature of entrepreneurship in the
development process, agricultural surplus labor, migration and urban unemployment,
savings and investment as they relate to development, development and population
growth, and the nature and organization of enterprise (especially state-run enterprises). I
find Leibenstein’s view of development, as discussed in his 1978 work, very positive, for
it brings the realism of behavioral economics to the study of development. However, as I
have discussed in a 2003 paper (which compares development and growth) Leibenstein,
like most other development economists, at times confuses the very complex concept of
development with the simpler notion of economic growth. At times, his application of
the notion of X-efficiency to development is more relevant to economic growth (thus

2
more relevant developed economies) than to more complex notion of economic
development which describes the economies of the LDCs.

Liebenstein’s Departure from a Conventional View of Development

Leibenstein’s initial approach to development was conventional. Writing about his initial
approach in dealing with the problems of development, Leibenstein stated in his 1978
book that “As a development economist, I have been interested in most of the problems
for a long time, and I viewed them initially from a conventional theoretical viewpoint”
(Leibenstein 1978: 14). To justify his original position he stated: “when a new problem
arises it is natural for economists to use the theory they know in their attempt to analyze
it. This was true in the Great Depression of the 1930s until Keynes’ General Theory
came along. When economic development became a significant topic after WWII, it was
almost second nature for economists to try to apply conventional micro theory or macro
theory to the new set of problems. After all, we can hardly expect economists to apply
theories that do not exist” (Leibenstein 1978: 3).
In his 1978 book, he argues that a broader and more general theory than that provided
by conventional economics is needed to deal with the problems faced by the LDCs: “The
purpose of this book is to show that at least for some types of problems faced by
developing countries, a broader and more general theory than the conventional one is
likely to be more relevant to a number of issues at hand” (Leibenstein 1978: 4).
Leibenstein seems to apply that his concept of X-efficiency provides that needed general
and broad theory. In his own words, “It seems to me that the application of X-efficiency
theory makes these problems more tractable intellectually than they had been heretofore.
This is itself may be a sufficient raison d’etre for both the choice of the problems and the
nature of the book” (Leibensrein 1978: 14).
Leibenstein’s application of his theory of X-efficiency to the problems of the LDCs is
an indication that he is not an advocate of what Albert Hirschman calls monoeconomics.
He advocates what is called duo-economics, believing that the LDCs should have a
different focus than that offered by conventional economic theory (although sometimes it
is hard to detect this). As he argues “The study of economic development directly

3
focuses attention on the problems of changes of level of output rather than explaining the
actual output level. Hence, an especially important question is to what extent do
economies respond to opportunities which result in changes in the level of output?”
(Leibenstein 1978: 7).
As a result, he finds conventional micro theory less relevant for the economies of the
LDCs. To him, “The main difficulty with the conventional micro theory is that it
assumes away many aspects of reality which are especially significant in determining the
rate of growth of developing countries.” (Leibenstein 1978: 8). One such problem he
finds concerns the role of entrepreneurship in economic development. “One of the
curious aspects of the relationship of neoclassical theory to economic development is that
in the conventional theory, entrepreneurs as they are usually perceived play almost no
role.” (Leibenstein 1978: 9). To explain that he writes: “Let us recall that according to
the neoclassical theory all of the topics are known and the prices of inputs and the output
are also known. It follows that all a potential entrepreneur really has to do is merely to
calculate possible outcomes and make his decision. Entrepreneurship seems to be
reduced to a trivial activity. Yet, at the same time, in the real world there is a general
belief, and a correct one, that entrepreneurial skills are quite rare and that activities
carried out by entrepreneurs are important in determining how well economies operate.”
(op. cit)
For Leibenstein, the uniqueness of the problems faced by the LDCs is also manifested
in the prevalence of market imperfections/failures. Leibenstein, like many other post-
WWII development economists, insisted that market imperfections/failures, although
present in developed economies, are more likely to exist in the LDCs (Hosseini, 2001 and
2003). He argues, “In the real world in which we live, we operate on the basis of
significant market imperfections. While the last factor is certainly true for developed
economies, it is all the more important for developing economies.” (Leibenstein 1978: 9).
For Leibenstein, improving such imperfections is a significant aspect of the process of
development. He relates this concept of market imperfections to his theory of
entrepreneurship, “A theory that does not allow for significant imperfections prevents us
from analyzing the importance of the entrepreneurial role” (op. cit).
Leibenstein’s X-efficiency, Entrepreneurship, and Economic Development.

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Leibenstein’s application of his theory of X-efficiency to entrepreneurship first appeared
in his 1968 AER paper. In was in that paper that he made a distinction between routine
entrepreneurship and Schumpeterian (i.e. innovational) types of entrepreneurship. It was
in discussing the second type that Leibenstein utilized his notion of x-efficiency.
However, it was in his 1978 book that he made a more thorough link between this notion
of entrepreneurship and the process of development.
In chapter three, of the above-mentioned book, Leibenstein applies his general theory
of X-efficiency to the notion of entrepreneurship, which he regards as crucial to
economic development. To him, “the traditional theory of competition gives the
impression that there is no need for entrepreneurship” (Leibenstein 1978: 39), yet for
Leibenstein “entrepreneurship is, of necessity, a rather illusive element in microeconomic
theory.” (Leibenstein 1978: 39). Leibenstein is not satisfied with Frank Knight’s “efforts
to find an ubiquitous function for the entrepreneur within the conventional theoretical
framework.” (Leibenstein 1978: 40). To Leibenstein, Frank Knight’s: “achievement in
trying to ascribe to the entrepreneur the unique capacity to undertake uncertainty is still
the best description of an entrepreneur’s role.” (op.cit). However, he argues,
“Unfortunately it is not a very good description. Quite a few individuals who enter
contracts face uncertainty without being entrepreneurs. In some cases, employees may
face more uncertainty than employers, but it would be using words strangely indeed if we
visualize employees, as entrepreneurs.” (op. cit). To get better results, he argues,
changes in microeconomic theory are necessary.
Leibenstein’s stated aim in that chapter is twofold: “To suggest a theory of
entrepreneurship in which entrepreneurship has a unique and critical role,” and “to use
this theory to indicate why entrepreneurship is significant in the development process.”
(Leibenstein 1978: 40-41). To achieve his aim, he distinguishes between two poles of
entrepreneurship. At one pole he finds routine entrepreneurship, which to him, is a type
of management. “By routine entrepreneurship we mean the activities involved in
coordinating and carrying on a well-established, going concern in which the parts of the
production function in use….are well known for the firm which operates well-established
and clearly defined markets.” (op. cit). And, at the other end of the spectrum, he sees
“Schumpeterian” or “innovational” entrepreneurship. By innovational entrepreneurship,

5
the type he finds relevant to and needed for the process of development, Leibenstein
means: “the activities necessary to create (or carry on) an enterprise where not all the
markets are well established or clearly defined and/or in which the relevant parts of the
production function are not completely known.” (Leibenstein 1978: 41). To him, in both
cases, the entrepreneur coordinates activities that involve different markets and is an
intermarket operator (op.cit). However, ”in the case of innovative entrepreneurship not
all the markets exist or operate perfectly and the entrepreneur, if he is to be successful,
must fill in for the market deficiencies.” (op. cit). (Here, no distinction is being made
between the entrepreneurial activities needed in less than perfect markets of advanced
nations with those for the development process of the LDCs.).
To Leibenstein, there exist great many market imperfections. (We could add that these
imperfections are particularly present in the less developed economies). He sees two
imperfections in particular significant. The first consists of obstacles to the marshaling of
inputs: some inputs may be available but are currently used for other purposes; the input
may be available, but not for sale at any specific or known prices (the value of the input
may not be know except in connection with a set of inputs which produces a valuable
product in the market; and certain goods, such as credit, are for sale to some individuals
but not to others) (Leibenstein 1978: 42). The second imperfection consists of gaps and
holes in various input or output markets (op.cit). Many such gaps and holes that exist in
the markets have to do with information. Some techniques of production may not be
know adequately even though the information and the skills necessary are obtainable. In
these situations the entrepreneur has a very different job to do than in the case of perfect
or even near perfect markets (Leibenstein 1978: 43).
To Leibenstein, the general X-efficiency theory suggests the possibility of industry
equilibrium which contains market imperfections as well as market gaps. Because of the
existence of what he calls inert areas, not all opportunities for profitable economic
activities are filled, and the industry may be in the position in which not all costs are
minimized. And, at the same time, firms do not fight what he calls effort entropy (where
disuse of efforts would lead to higher costs). And, because not all opportunities are
filled, not all possible innovations are adopted (op.cit). Thus, “in general we can see that
both the equilibrium and disequilibrium conditions allow for the existence of holes in the

6
enterprise network. And in some cases (like monopoly), it may pay for markets to
actually create market perfections (op.cit.) (Again, monopoly is not unique to poor
LDCs).
To describe the role of entrepreneurship in the economy, he visualizes the economy as
a net made up of nodes and pathways; the nodes representing industries or households
that receive inputs of goods along the pathway and send outputs or inputs to the other
nodes. The perfect competition model (more or less representing the more advanced
nations) is represented as a net that is complete; one with pathways that are well marked
and well defined, one that has well-marked and well-defined nodes, and one in which
each element of each node deals with other elements on equal terms for the same
commodity (op.cit). In this realistic model (which would also represent a less developed
economy), he visualized holes and tears in the net, obstructions along the pathways, with
some nodes or pathways (when they exist) being poorly defined and poorly marked or
entirely unmarked….. He calls this second net an impeded, incomplete, and dark one, in
contrast to the perfectly competitive one which is unimpeded and well lit. Of course, a
portion of the more realistic one too may be unimpeded. To him, entrepreneurs working
in the well-defined, non-hole, non-obstruction portion of the net carry out routine
entrepreneurial-managerial activities, “while those who operate on the impeded,
incomplete, and dark parts carry out real entrepreneurial activities (op.cit). While
Leibensteinian entrepreneurs may be concerned with a wide variety of things, he focuses
on two of its essential aspects. (1) The entrepreneur as a gap filler, and (2) the
entrepreneur as an input completer. Both of these arise from his assumptions of X-
efficiency (op.cit). “If not all factors of production are marketed or if there are
imperfections in markets, the entrepreneur has to fill the gaps in the market.”
(Leibenstein 1978: 46). Thus, “the more imperfect the markets, the greater
entrepreneurial skills required.” (Leibenstein 1978: 47).
To Leibenstein, economic development requires a large supply of gap-filling
entrepreneurial skills (but a much smaller supply of input competing skills). A less
developed economy most definitely requires innovative entrepreneurs who have the
capacity to start firms, or reorganize existing firms, which reduces the level of X-
inefficiency. The supply of such entrepreneurship is determined by a set of individuals

7
with gap-filling and input-completing capacities, and by “the socio-cultural and political
constraints which influence the extent to which entrepreneurs take advantage of their
capacities, and the degree to which potential entrepreneurs respond to different
motivational states, especially where nontraditional activities are involved.” (Leibenstein
1978: 50).

X-Efficiency and Agricultural Surplus Labor

In chapter four, Leibenstein applies his general theory of X-efficiency to the question of
disguised unemployment, which is one of the oldest controversies in development
economics, and which played a prominent role in the work of Rosenstein-Rodan, Nurkse,
Lewis, and other pioneers of development economics. According to this concept, the
densely populated agricultural sectors of many LDCs have resulted in more (unneeded)
people working on land, thus, disguised unemployment.
Nurske (1955), among others, argued that this surplus (which appears in the form of
disguised unemployment) should be viewed as an advantage rather than a disadvantage.
To him, it represents a resource that can be used elsewhere in the economy, substituting
capital when labor shifts from the agricultural to other sectors of the economy.
That view of disguised unemployment was opposed by various economists on two
grounds-empirically, and theoretically. Leibenstein focuses on the theoretical argument,
which assumes an actual or implicit positive wage in the agricultural sector. In the words
of Leibenstein: “It is argued that if the wage is positive, then the value of the marginal
product of labor must also be positive. As a consequence, if such labor is removed, the
marginal product that it previously created is also removed thereby, and, as a result, the
smaller labor force cannot possibly produce the same output as was formally produced
with the large labor force if non-labor inputs are kept constant.”(Leibenstein 1978: 58).
Economists Jacob Viner, and later T. W. Schultz, argued that while the marginal
productivity of agricultural labor may be quite low, it is not zero and hence surplus labor
does not exist (op.cit.).
According to Leibenstein, whether or not surplus labor exists in a specific country or in
a portion of it is an empirical question. To him, “we can use theory to argue whether or
not the presumed measurements are appropriate, but we cannot argue what the

8
measurements would show, without actually making measurements, from a purely
theoretical viewpoint.” (Leibenstein 1978: 59). What Leibenstein does in chapter four is
examine if it is possible to have a positive wage rate and to have simultaneously the
existence of surplus labor. Introducing the X-efficiency concept of effort and developing
various models such as the basic-productivity-effort model, and the peak labor demand
model, he came up with the following conclusions.
First, it is possible to have surplus labor and the simultaneous existence of a positive
wage rate in the agricultural sector. Furthermore, he argues, surplus labor can exist even
if the marginal product of labor is positive, provided this is interpreted in terms of a given
effort level. But effort is a variable and its average level may change as a consequence of
some of the labor migrating to the urban center (Leibenstein 1978: 75).
Second, we are left with two concepts of surplus labor under conditions of disguised
unemployment. In both cases, he indicates, there is in a sense an underutilization of the
capacity of labor, although there is a full utilization of manpower. But he believes we
must distinguish between: “the case in which there is simply incomplete utilization of
effort and for which more effort would be forthcoming if less labor existed, as against the
case of underutilization of effort without it necessarily increasing as labor is withdrawn.
The existence of potentially additional effort versus actually obtaining additional effort
out of this potential are two completely different matters” (Leibenstein 1978: 70).
Third, according to Leibenstein “Whether or not additional effort is put forth as a
consequence of the removal of some manpower from the agricultural sector will depend
on the distribution by farms of those that leave and the incentives created by the removal
of manpower from specific farms. Such questions cannot be answered on a priori basis,
but they are critical questions in determining what happens when manpower is removed
from the land” (Leibenstein 1978: 76).

X-Efficiency, Migration, Urban Unemployment, and the Absorption Problem in

LDCs

According to Leibenstein, while a great deal is known about migration, the application of
microeconomic theory cannot explain and predict what in fact occurs (Leibenstein 1978:

9
77). (Even econometric studies, are unable to explain this, he argues). If individuals
(i.e. workers) were completely responsive to wage differentials we would expect the
elimination of wage differentials for labor of equal skills and, internationally, the
elimination of economic underdevelopment (op.cit.). To Leibenstein, “An application of
the X-efficiency theory reality fits some of the broad empirical results and known
patterns in developing countries (Leibenstein 1978: 79). In other words, if individuals
behave in concert with the theory of selective rationality, and that they do not respond to
all economic opportunities, then the existence of dualism in LDCs becomes much easier
to understand. If responses to superior opportunities are imperfect, and if we assume the
concept of inert areas (where many potential migrants do not respond to all economic
opportunities which are currently within their insert area), it would be easy to understand
the disparities in incomes of the urban and rural sectors in the LDCs. Viewing superior
economic opportunities as innovative processes that individuals can adopt, Leibenstein
utilizes the X-efficiency of innovation (while individuals in their inert areas) to analyze
the process of migration (op.cit.). Utilizing this type of analysis, he finds three reasons
for inadequate rate of migration to achieve higher incomes. The first is peer group
pressures, i.e. the desire of individuals to remain with one’s peers, which includes the
nuclear family or extended family (and also other elements and motivations which
involve group membership).These motivations/desires go counter to income
maximization. Secondly, knowledge of alternative opportunities whose extent differ
among various individuals. The availability of this knowledge is also related to two
elements “access to knowledge and the use of such access (i.e. the motivation to take
advantage of the known information. This can lead to X-efficiency). And thirdly,
relative versus absolute incomes. In other words, many individuals in the low income
sector (i.e. with low absolute income) may not be induced to migrate because relative
income is high (Leibenstein 1978: 82).
In spite of the above, there has been a great deal of migration to urban areas in the
LDCs (much of it for non-economic reasons). In fact, there seems to be excess migration
to urban areas (in which, due to what Leibenstein calls inertia, individuals would not
return to the countryside even if their incomes were higher there). This excess migration
has led to the employment absorption problem. To explain this problem, Leibenstein

10
constructs/demonstrates several models of labor market: the neoclassical wage-offer
function, the efficiency wage hypothesis, and his own model of the X-efficiency ratchet.
In his X-efficiency ratchet model, he proposes the possibility that the wage rate is
determined by historical conditions in the industry and cannot be changed by deviations
in the demand or supply of labor unless the excess demand or excess supply becomes
exceptionally large (Leibenstein 1978: 93). For example, if the firm hires additional
workers in order to lower wages, the labor force, in addition to a formalized strike, can
slow down the pace of its effort as well as the quality of its work. Thus, it can “exact a
psychological and economic cost.” The rational employer has to take this cost into
account-and would not attempt such reconstructing if the disutility of the cost is greater
than the utility of the gain.”(op.cit.). This is Leibenstein’s application of his concept of
inert areas (in X-efficiency), since economic agents do not move to what appear to be
superior positions because the utility cost of such movements are greater than the utility
of gain (op.cit).
A relevant question (in particular in LDCs) is: what kind of capital should firms choose
in the face of unemployment? Leibenstein is in particular interested in this question
because of: “the observation and frequent assertion that capital equipment installed in
developing countries is inappropriate in view of the transfer wage (or the shadow price)
of labor, i.e., the equipment chosen is more capital intensive than warranted.”
(Leibenstein 1978: 94). At the outset, he criticizes the traditional view for failing to
distinguish between (1) the market for and buying of labor time and (2) the provision of
labor effort (op.cit). By introducing a case where capital, instead of being effort neutral,
is effort stretching, (and by constructing a model), he demonstrates that relatively small
increases in the price of labor can result in a considerable shift in the degree of capital
intensity of the technique of and equipment adopted. Thus, Leibenstein argues, “once we
allow for effort stretching capital, we have a rationale for introducing fairly capital
intensive techniques in relatively low wage countries” (Leibenstein 1978: 96). To him,
unfortunately such responses (in the urban areas of LDCs) turn out to be consistent with
the existence of actual disguised unemployment. On the positive side, he sees limits to
the extent of to which increases in capital per person can continue to be effort stretching,
since, beyond some point, the effort stretching advantage of mechanization should peter

11
out and the normal relationships between wage rates, choice of technique, and
employment absorption should re-emerge.(op.cit.).
Even if the underdeveloped economy has both the capacity to use new technology of
production as well as the possibility of borrowing technology from more advanced
economies, still, as argued by Leibenstein, it would have problems of absorption. These
are (1) how to choose among the variety of new techniques available the type (of
techniques) which are more suitable to it, (2) how to adapt some of these new techniques
to its not very skilled labor force which is different from the labor force on the basis of
which the new techniques were developed in the advanced nations, and (3) how to
increase its savings rate to take advantage of the new opportunities in investment
(Leibenstein 1978: 104). There is the possibility that new savings may not be invested
effectively. In other words, there is the problem of the absorption of investment. This
problem, as argued by Leibenstein, involves two interrelated problems: the supply of
entrepreneurship in the not-so-developed economy, and the extent to which potential
investment can lead to the effective utilization of increased inputs and if the inputs cannot
be utilized effectively, then it is unlikely that there would be sufficient entrepreneurial
supply to create demand for the investment goods (Leibenstein 1978: 106-7). This is the
degree of X-efficiency in production utilizing new and improved types of capital. In his
own words, “difficulty in absorbing additional capital may arise on the one hand because
of insufficient entrepreneurial supply and on the other because of low levels of X-
efficiency in production involving the new capital and new techniques” (Leibenstein
1978: 107). To Leibenstein, entrepreneurship does not represent a universal skill-one
capable of entrepreneurial activities in agriculture may not be capable of it in
manufacturing. Some (entrepreneurs) might be gap fillers and input completers in some
sectors, but not others. And, as he discussed before, not all who possess entrepreneurial
skills will necessarily use them since they might receive more utility using their skills in
other pursuits (Leibenstein 1978: 108). Thus, (particularly in a less developed economy),
“the psychological reward to entrepreneurship may not be enough to shift individual
away from their application of effort from non-entrepreneurial pursuit to
entrepreneurship.”(op.cit).

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 Leibenstein introduces another difficulty in connection to the problem of capital
absorption (in the LDCs), when in some industries a country may not be in a position to
take advantage of the technical knowledge available. “The reason for this is a mixture of
gaps in the types of capital goods produced, even though in principle there is a continuum
of such goods that are produceable, and an inability in the country to adapt capital
equipment that is imported from abroad but that is entirely unsuitable given the prices of
capital and labor in the country in question. This latter problem in part will arise because
innovations are likely to be of localized character. That is to say, improvements in
techniques do not take place for the existing techniques but only for a subgroup of such
techniques” (Leibenstein 1978: 113). To Leibenstein, this may lead to one of two
possibilities: a country being locked-out of new techniques of production, or a country
being locked-into other techniques. When the country is locked out, certain techniques
are not accessible to a country because the improvements take place at relative capital-
labor scarcities which are irrelevant to the country in question. In the second situation “a
country is stuck with a certain technique because, if it tries to shift to other techniques, it
finds that labor becomes X-inefficient to a sufficient degree as to overcome that
advantage of what would be the superior technique if X-inefficiency did not accompany
the shift in techniques.” (Leibebstein 1978: 113-114).
In terms of switches in techniques, Leibenstein discusses two types of X-inefficiencies-
transitional X-inefficiency and comparative X-inefficiency. Transitional being the degree
of inefficiency which occurs as the result of a technical switch but which is temporary in
nature. Two factors may cause workers to resist new work arrangements, first these
techniques may clash with traditional work habit or second they cause unemployment
among fellow workers. By comparative X-inefficiency he means the ratio of the degree
of X-inefficiency prior to the switch compared to what it is afterwards, inclusive of some
allocation of the transitional costs involved.
To Leibenstein, X-efficiency changes when we switch from one technique of
production to another (thus causing difficulties for the LDCs that wish to industrialize).
He identifies numerous causes of this change. For example, the degree of coordination
and factory discipline required may be greater for the new technique than for the old, the
system of personnel selection appropriate for the first technique may not be appropriate

13
for the second, the balance of fears and hopes existing in a certain job situation may
change when the technique changes leading to a change of morale for workers, etc
(Leibenstein 1978: 114-15).

Population Growth and the Economic Theory of Fertility

In chapter seven, Leibenstein tries, essentially, to explain that sustained economic growth
(development?) is associated with the eventual decline in fertility. He begins the chapter
by arguing that population growth frequently puts pressure on attempts to increase per
capita income growth, since per capita income growth is defined as the difference
between aggregate income growth and population growth (Leibenstein 1978: 123).
Realizing that in most cases population growth is not an insurmountable obstacle to
achieving some steady per capita income growth, he argues that population growth would
have income effects in the LDCs: it tends to increase the burden of dependency on the
working population, may reduce/eliminate household savings, and, in the long run, it
determines the rate of labor force growth of various sectors (Leibenstein 1978: 124). To
Leibenstein, population growth, like the movement of workers to urban centers creates
the problem of employment absorption.
Population growth is determined by mortality and fertility rates. (Mortality rate has
declined considerably since WWII, because of the availability of inexpensive public
health measures). To him, fertility rates are high in the LDCs, especially in the early
stages of per capita income growth. This rises initially, then declines. To develop his
arguments (as a behavioral economist), he utilizes the element of selective rationality
(and shows that cost of children rises fundamentally as we proceed from lower social
status groups to higher ones and as per capita income of the group increases in the course
of economic development).
Fertility, Leibenstein argues, is significantly influenced by events that accompany
economic development. Basic to the development process is a persistent shift of labor
and households out of agriculture and into urban pursuits (Leibenstein 1978: 127). These
labor shifts are associated with increases in workers’ education, job training, and human
capital (op.cit). In terms of occupation skill content, education, and asset per household,

14
labor force becomes highly differentiated (All these factors being indices of status). With
these developments, and its urbanization and occupational shifts, we expect to observe
growth of per capita income, and the shift of the population to higher socio-economic
statuses. Leibenstein maintains that while these two factors influence the utility attached
to children and the utility of the typical expenditure patterns of households, which in turn
determine the utility costs associated with children, the status-shift effects and income
effects play very different roles. “They may even affect fertility in opposite ways.”
(Leibenstein 1978: 128).
Leibenstein’s analysis is based on an (unorthodox) variant of the theory of consumer
that differs from conventional theory. In this theory, he assumes the existence of goods
that are subject to increasing marginal utility up to some level and to normal diminishing
marginal utility beyond that level (he calls them IMU goods). These goods have four
characteristics: (1) consumer durables subject to physical divisibility or economies of
scale, (2) what he calls commitment goods, (say provision for age-old security) (3) status
or lifestyle goods, and (4) “target goods in the sense that there is some target quantity or
expenditure that is especially significant for some reason and anything less than the target
amount is of little utility.” (Leibenstein 1978: 130). To him, “Some expenditures may
fall into all categories, others may not” (op.cit). Expenditure on commitment goods are
different from short-run costs. Once the commitment is made, it continues for some time,
even if taste changes (such as expenditure on children or other household members).
By utilizing utility cost curves that are functions of status and income, Leibenstein
proves that economic development (growth?) leads to immediate or eventual fertility
decline.

Concluding Remarks: X-Efficiency and Organizational Structure

According to Leibenstein, a basic question rarely considered by development economists

deals with the relationship between the organizational structure of the economy and the
motivating factors that influence organizational behavior. In other words, how well do
the economic units/organizations carry out the expected economic activities (Leibenstein
1978: 156). This question is relevant to both consumption and production activities, but,

15
because of the importance of production to the process of development, Leibenstein
focuses on the productive activities. Applying the notion of X-efficiency, he makes the
argument that a given organization with given resources can lead to wide variations in
productivity (op.cit). (Again, it is difficult in this last chapter to distinguish between X-
efficiency implications for economic growth and those for economic development).
Leibenstein recognizes different types of economic structures. However, he makes no
direct attempt to examine the implications of all the alternative ways of organizing
economic activity. Rather, he focuses on the relevance of his general X-efficiency theory
to one type of productive organization-the state enterprise(which at the time of writing
the book existed in many countries, in particular in former communist countries as well
as all less advanced nations). To him, a great many considerations enter the evolution of
the state enterprises. Among these considerations are those related to the market
structure, the relationship to government, to equity, and so forth, all of which influence
the degree of efficiency. However, Leibenstein focuses only an “X-efficiency aspects”
(which have relevance to all alternative structure) (Leibenstein 1978: 158).
Conventional economics assumes that “government interference with private
enterprises do not lead to allocative efficiency,” since such interferences distort the prices
upon which economic decisions are made. Subsidies, taxes, or other controls that result
in deviations from free market equilibrium prices must result in decisions that misallocate
resources (Leibenstein 1978: 159). However, to Leibenstein, “even if prices are right,”
so to speak, the inputs may still be used ineffectively.” (op.cit.). To him, this is because
of X-efficiency, thus, in order to determine to what extent X-efficiency exists under the
circumstances in question, we must examine the nature of economic organization and its
environment.
To him, we must analyze both X-efficiency, and allocative efficiency (which depends
on X-efficiency), and try to separate demand for factors of production in the marketplace
from the utilization of these factors in terms of the effort inputs; we must realize that: “for
a given output the greater the effort input the less the demand for specific factors in the
marketplace…”(op.cit.). According to Leibenstein, equilibrium prices of factors depend
on the productivity of these factors, thus on the degree of X-efficiency of effort input use
in firms (while Leibenstein views X-efficiency as a variable, he believes, conventional

16
theory implicitly assumes that it is fixed ,op.cit). For Leibenstein, a firm’s X-inefficiency
determines demand for factors and for intermediate goods; it also determines the supply
of factors. And, even if a given factor market approximates an equilibrium price, the
input in question may be used in a variety of industries, from monopolistic structure to
very competitive. Thus, deviations in utilizations of effort will not be uniform. In
general, he expects that the nature of the productive organization and the environment in
which it is embedded to generate two opposing sets of forces: one of these leads to a
tendency towards increasing costs, while the other generates costing containing
influences.(Leibenstein,1978, p.160). The struggle between these two forces will
determine actual costs.
To determine how well an organization uses the factors of production, we must
examine the relationship between the “impactors” and the “impactees” of effort
discretion(Leibenstein 1978: 163). To explain what is involved, he proposes two extreme
cases. On the one extreme: complete individual responsibility; on the other, complete
individual irresponsibility. In a one-person firm, the entrepreneur, manager, and worker
are all the same individual. Since the individual is completely responsible for the
consequences of his/her efforts, if his/her effort is less, he/she has less of value to offer in
the marketplace, and receives, less in return; no losses can be imposed as a consequence
on others. To Leibenstein, “this is basically the case that best fits the neoclassical micro
theory” (Leibenstein 1978: 164). In the other extreme case, all individual firm members
are hired on a time basis, but are not directly responsible to stockholders, and there is
considerable effort discretion. In this case, activities (or effort positions) which impose
costs on the organization are passed to others (thus costs are borne by others, and not the
individuals concerned). Or, it is possible for all intermediate impactees to pass on the
consequences of their activities (ERCs) to others outside the organization. Thus, if ERCs
are kept within the organization, the individual is completely responsible. But if ERCs
go beyond the individual, the responsibility would be shifted. The point is that
irresponsibility increases costs (Leibenstein 1978: 165). Leibenstein relates this to the
process of development in the sense that irresponsibility increases costs of production and
that these costs are important: “in determining the rate of development.” (op.cit.). In fact,
high enough costs of production can nullify the value of new investment, and thus lower

17
the rate of economic development. However, Leibenstein proposes measures that can
lead to cost containment: (1) standards of performance (in terms of the maximum degree
of costs per unit at the time), (2) the maximum revenue available to the organization, (3)
the degree of competition, and (4) the degree of bureaucratic control (Leibenstein 1978:
158).
The general theme of the last chapter is that the organizational arrangements within an
economy determine the degree of X-efficiency in that economy. Leibenstein’s approach
is that the motivational aspects inherent in economic organization can be studied. To
pursue this study, the chapter focuses on state enterprises. However, to him, the ideas
applied to state enterprises can also be applied to other types of productive organization.
He recognizes three types of pressures that influence X-efficiency; (1) those that stem
from the environment in which the organization is located, (2) the internal structure of the
organization, and (3) the traditional procedures that exist in the organization which in
turn are a consequence of its history (Leibenstein 1978: 179). He emphasizes that: “the
essential element of our analytical scheme depends on the examination of the extent to
which individuals are really responsible for the productive results of their activities.
According to the neoclassical view, individuals are supposed to be paid a reward (wages,
or profits, etc.) equal to the monetary value of their marginal productivity. But this is the
result of an ideal case. It is the situation that comes about when firms minimize costs,
which is to say when X-inefficiency is equal to zero. But of course this is exactly the
special case we are not interested in. In fact this approach to the problem may be said to
close analytical doors.”(op.cit). Leibenstein tried to show that it is through his general X-
efficiency analysis that such analytical doors can be opened. This, to him, is also
applicable to the case of economic development.

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Frantz, Roger, 1992, “X-Efficiency and Allocative Efficiency: What Have

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Frantz, Roger, 2004, “The Behavioral Economics of George Akerloff and

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