ciency improvement measured by the distance (OA’- OA”)/OA’. Technical efficiency is usually measured by checking whether inputs need to be reduced in equal proportions to reach the frontier. This is known as a “radial contraction” of inputs because the point of op- eration moves along the line from the origin to where the organization is now.
measured by the ratio TE1=OQ/OP, which is equal to one minus QP/OP. It will take a value between zero and one, and hence provides an indicator of the degree of technical inefficiency of the firm. A value of one indicates the firm is fully technically efficient. For ex- ample, the point Q is technically efficient because it lies on the efficient isoquant.
Farrell (1957) illustrated his ideas using a simple ex- ample involving firms that use two inputs (x1 and x2) to produce a single output (y), under the assumption of constant returns to scale. Knowledge of the unit isoquant of the fully efficient firm represented by SS’ in Figure 2 permits the measurement of technical ef- ficiency. If a given firm uses quantities of inputs, de- fined by the point P, to produce a unit of output, the technical inefficiency of that firm could be represented by the distance QP, which is the amount by which all inputs could be proportionally reduced without a re- duction in output. This is usually expressed in per- centage terms by the ratio QP/OP, which represents the percentage by which all inputs could be reduced. The technical efficiency (TE) of a firm is most commonly
If the input price ratio, represented by the line AA’ in Figure 2, is also known, allocative efficiency may also be calculated. The allocative efficiency (AE) of the firm operating at P is defined to be the ratio AE1 = OR/OQ, since the distance RQ represents the re- duction in production costs that would occur if pro- duction were to occur at the allocatively (and techni- cally) efficient point Q’, instead of at the technically efficient, but allocatively inefficient, point Q. The to- tal economic efficiency (EE) is defined to be the ratio EE1 = OR/OP where the distance RP can also be inter- preted in terms of a cost reduction. Note that the prod- uct of technical and allocative efficiency provides the overall economic efficiency TE1 × AE1 = (OQ/OP) × (OR/OQ) = (OR/OP) = EE1. Note that all three mea- sures are bounded by zero and one.
Figure 3 Illustration of different efficiency concepts
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