Efficiency Effects in Supply Chain Management: A Production Frontier Approach

Introduction

One of the most important hypotheses in modern economic theory is based on the assumption of optimizing behavior, either from a producer or a consumer approach. As far as producer behavior is concerned, economic theory assumes that producers optimize both from a technical and economic perspective:

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  From a technical perspective, producers optimize by not wasting productive resources.

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  From an economic perspective producers optimize by solving allocation problems involving prices.

However, not all producers succeed in solving both types of this optimization problem under all circumstances. In real economic life, it is unlikely that all (or possibly any) producers operate at the full efficiency frontier, with failure to attain the efficiency frontier implying the existence of technical or allocative inefficiency (Reifschneider and Stevenson, 1991). More precisely, as described in Levitt and Joyce (1987), as well as Worthington (2001), respectively, for a producer to be efficient, there are three requirements to hold:

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  The first requirement of technical efficiency is that the maximum possible amount is produced with the resources used, or in other words, it must be impossible to reduce the volume of any input without reducing the volume of output. Technical efficiency may then refer to the physical relationship between the inputs used (i.e. capital, labour and equipment) and output. These outcomes may either be defined in terms of intermediate outputs or final output.

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  The second requirement is that the cost of any given level of output is minimized by combining inputs in such a way that one input cannot be substituted for another without raising the total cost. This is allocative efficiency, where an allocatively efficient producer would produce that output using the lowest cost combination of inputs.

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  The third requirement is that the mix of outputs of different goods and services produced form the given resources maximizes the benefit to consumers.

For these reasons, it is important to analyze the degree to which producers fail to optimize and the extent of any resulting distances from the frontier of full technical and economic efficiency, mainly due to the following reasons:

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  First, only by measuring efficiency, and by separating the associated effects from those of the operating environment, it is possible to explore hypotheses concerning the sources of efficiency, essential to improve performance.

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  Second, efficiency measures are success indicators by which producers are evaluated and the ability to quantify efficiency provides a control mechanism with which to monitor the performance of a production unit.

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  In addition, if policy and planning is to concern itself with the performance of a particular economic unit, it is important to know to what level a given producer may be expected to increase output by simply increasing efficiency, without absorbing any further resources.

Efficiency measures can be defined as relative productivity over time or space, or both. For instance, it can be divided into intra- and inter-firm efficiency measures. The former involves measuring the use of the firm’s own production potential by computing the productivity level over time relative to a firm-specific production frontier, which refers to the set of maximum outputs given the different level of inputs. In contrast, the latter measures the performance of a particular firm relative to its best counterpart(s) available in the industry (Lansink et al, 2001).