Distinction........................................... 2.2 Efficiency and Productivity: Concept, Classification and
and Distinction
We begin by defining productivity of afirm as the ratio of the output(s) to the
input(s), i.e.,“productivity = output/input”. Improving productivity is very crucial
to economic growth, this is a consensus between economists. When measuring
productivity, the calculation will be very simple if the production process involves a
single input and a single output. While in the situation of multiple inputs, we should
aggregate all these inputs into a single index of inputs to obtain a ratio measure of
productivity. When there are multiple inputs, the productivity can be divided into
Total Factor Productivity (TFP) and Partial Factor Productivity (PFP). TFP is a
measurement involving all production factors, which can be defined as the ratio of
aggregated outputs to aggregated inputs. While PFP is defined as the ratio of output
to specific input, for example, labor productivity. Without additional notes, the term
“productivity”used in this book refers to TFP. The prime source of productivity
change is attributed to efficiency change, scale efficiency and technical change
(Coelli et al. 2005 ).
Efficiency is a prime source of productivity change. In production economics,
efficiency reflects the ability of one production unit to achieve minimal cost given
its output. Thus efficiency is also called as Economic Efficiency (EE) or Cost
Efficiency (CE). In 1957, British economist Farrell ( 1957 ) decomposed efficiency
into Technical Efficiency (TE) and Allocation Efficiency (AE). TE is used to
measure the ability of one production unit to obtain maximal output from a given
set of inputs, which reflects the effective utilization of resources being invested into
production process. AE is used to measure the ability of one production unit to use
the inputs in optimal proportions, given their respective prices and the production
technology, which reflects how to allocate all production factors to achieve econ-
omy principle. When doing the calculation, efficiency is the product of TE and AE.
Scale change is another prime source of productivity change. In fact, both TE
and AE are referring to the efficiency of operations of one production unit with
respect to the production technology frontier, at a given level of input and output
prices. It’s possible that a production unit is both technically efficient and alloca-
tively efficient but the scale of operation might not be optimal. For instance, a
production unit may be too small in its scale of operation, which might fall into the
“increasing return to scale”part of the production function. Similarly, a production
unit may be too large in its scale of operation, which might fall into the“decreasing
return to scale”part of production function. In both cases, efficiency of the pro-
duction unit might be improved by changing their scale of operations, i.e., to keep
the same input mix but change the size of operations. In 1998, Fare, Grosskopf and
Roos proposed the definition of scale efficiency and used it in deriving a decom-
position of productivity change over time.
In recent economic literature, the efficiency analysis of a production unit can be
divided into three parts, namely, the analysis of TE, the analysis of AE and the
analysis of SE (Scale Efficiency), with an ultimate goal tofigure out helpful
2.2 Efficiency and Productivity: Concept, Classification and Distinction 13