Measuring Efficiency in Imperfectly Competitive Markets: An Example of Rational Inefficiency

The standard assumption in the efficiency literature, that firms attempt to produce on the production frontier, may not hold in markets that are not perfectly competitive, where the production decisions of all firms will determine the market price, i.e., an increase in a firm’s output level leads to a lower market clearing price and potentially lower profits. This paper models both the production possibility set and the inverse demand function, and identifies a Nash equilibrium and improvement targets which may not be on the production frontier when some inputs or outputs are fixed. This behavior is referred to as rational inefficiency because the firm reduces its productivity levels in order to increase profits. For a general short-run multiple input/output production process, which allows a firm to adjust its output levels and variable input Communicated by Kaoru Tone. Electronic supplementary material The online version of this article (doi:10.1007/s10957-014-0557-z) contains supplementary material, which is available to authorized users. C.-Y. Lee Institute of Manufacturing Information and Systems, National Cheng Kung University, Tainan City 701, Taiwan e-mail: [email protected] C.-Y. Lee Research Center for Energy Technology and Strategy, National Cheng Kung University, Tainan City 701, Taiwan A. L. Johnson (B) Department of Industrial and Systems Engineering, Texas A&M University, College Station, TX 77840, USA e-mail: [email protected] A. L. Johnson School of Business, Aalto University, 00100 Helsinki, Finland