Conceptual Background: Firms’ Objectives, Decision Variables, and Economic Efficiency

In this chapter, we summarize the analytical framework found in the book by presenting the main concepts in an intuitive and accessible way while relying on supporting graphical illustrations to ease comprehension. Arguably, the measurement of economic efficiency dates back to the seminal paper by Farrell (1957), who introduced the definition, decomposition, and measurement of overall (economic) efficiency, which he named productive efficiency. The model is based on the cost function and input-oriented technical efficiency, and we initiate our presentations with this approach to guide and illustrate the different concepts underlying the measurement of economic efficiency. Throughout the text, we use economic efficiency as a measure to compare best and actual economic performance reserving the term productive efficiency for the technical dimension of the analysis, which may include aspects related to alternative characterizations of returns to scale (e.g., constant or variable returns to scale technical efficiency resulting in scale efficiency), disposability (e.g., strong and weak disposability of inputs and outputs), etc.