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The role of information in the relationship between competition and x-inefficiency: theoretical ambiguities of "product market competition"

This work delves into the so far unsatisfactory attempt made by theory to provide formal proof of the thesis, which is widely shared and supported by empirical evidence, that a stronger product market competition reduces the degree of firm x-inefficiency. Both through an in-depth critical examination of existing literature and through the development of a simple but original theoretical analysis, this work tries to grasp and highlight the reasons for the ambiguous and contradictory results achieved in literature so far: faced with a problem of internal inefficiency arising from an information problem, theoretical research has not paradoxically taken into account the major information role which competition may play, acting as an “assessment standard”. Particularly, competition is not enabled to reduce the manager’s information advantage and hence has no direct impact on agency costs. In addition, it has been proved that in the main models defined in literature no economic mechanism actually exists through which product market competition can influence agency costs and accordingly the degree of corporate x-inefficiency. What ensues therefrom is that the ambiguous results attained by literature, showing the existence of a non monotonic relationship between competition and internal efficiency, exclusively stem from the effects of competition on direct and strategic profitability arising from a reduction of unit production costs: the marginal benefit engendered by cost reduction, beyond a certain degree of competition, decreases as competition increases (as the number of enterprises grows), so that the employer is induced to demand to his manager increasingly lower optimal (second best) levels of effort. This conclusion is supported by the fact that many of the models existing in literature feature an implicit hypothesis of increasing returns to scale.

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Paper provided by Cattaneo University (LIUC) in its series LIUC Papers in Economics with number 197.

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Length: 58 pages
Date of creation: Dec 2006
Handle: RePEc:liu:liucec:197
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