3.1.2  Productive efficiency

This form of efficiency determines the level of cost at any level of output. It results from the management of the firm and has been termed x-efficiency by Leibenstein (1966) who proposed that it was more important than allocative efficiency. Productive efficiency may be affected by the smallness of an economy, but it is as likely to be affected by the barriers to entry of that economy. While profit maximisation provides strong incentives for productive efficiency, competition arguably strengthens them. Companies with listed shares are pressured to be productively efficient by the threat of takeover: the market for control. This particular pressure is weaker for cooperative governance structures: although both forms of governance can make their management contestable the incentive to do so is weaker in cooperatives because these are not subject to the threat of loss of control.[30]

3.1.3  Dynamic efficiency

Investment and innovation are key elements of dynamic efficiency. Both economic arguments and empirical studies of the literature confirm dynamic efficiency gains are more important for social welfare than static (allocative and productive) efficiency gains. Goolsbee (2000), for example, points out that delayed innovation and investment lead to missing markets where both consumers’ and producers’ surplus is missing, not just a welfare triangle. He estimates significant losses attending impediments to broadband investment. There is an extensive literature on this subject.[31] This subsection restricts to cases that could plausibly arise from the small size of the economy (ie, Q* < QMES).[32]

Innovation itself can be transported across international boundaries at little or no tariff or transportation cost. So even if the market for the output produced by the innovation is not international, its firms should not have a scale inefficiency argument. Even if the domestic market is small, access to foreign markets—if not by setting up their own facilities, at least licensing it abroad—should enable actual and prospective expansion.

Innovation investment (including basic research and knowledge) typically has externality and public good elements and thus enabling cooperation in research and development is important to foster innovation. However, it is not obvious that, excepting perhaps the scale of research budgets, the relative size of the New Zealand market places firms at a disadvantage in research and development. It may be that because of communication externalities in research that New Zealand’s isolation is something of a factor. New Zealand’s success relative to other countries in innovation will reflect a complex array of factors; such as the country’s comparative advantage and communication networks. Assuming that international obligations to protect intellectual property are fully complied with,[33] the geographic market for innovation is by assumption international, and thus there is no need to take any special account of the small size of the small countries’ domestic market in regard to the innovation itself.

With respect to adoption (or diffusion), what are the incentives to make additional up-front expenditures in order to effectively invest in innovation and employ the innovation within the small country? The adoption of such intellectual and/or intangible capital[34] to the legal, cultural and other characteristics of a particular small country may often require additional expenditures in order for them to be effective.[35]

The question of when to modify the intangible capital for use in a small country has been considered extensively in the literature.[36] The following example is illustrative of the analysis. Consider the case where there is an existing technology available to market players (summarised by the cost function depicted as AC₀ in Figure 3) and assume that the initial market price is P. Assume further that, either by de novo innovation or adoption of innovations (or other intangible capital such as copyrights or trademarks), one or more of these firms could produce output with the cost function AC₁. It is assumed that the cost of the resources to achieve this new innovation or adoption must be incurred up-front and do not vary with the amount of output produced after it has been developed. The amount of this cost is denoted F.

The significance of Figure 3 lies in the fact that the choice of producing with AC₀ or AC₁ is endogenous. Specifically, as the demand for a product in a market is initially relatively small, the firm has a relatively small incentive to make the investment F. As the demand grows, the case for making these investments improves but the firm has an incentive to delay these investments and instead rely on imports. The reason is that the firm earns the revenue from exports even if it does not invest in F (eg, Dunning 1969 and Markusen 1995). If a country can induce the firm (usually a multinational firm) to invest in F (eg, establishing local plants or brands), there may be economic benefits to the local economy. With intellectual property rights in place, the welfare effects are ambiguous and depend upon the structure of the market, the behaviour of costs as output changes and the size of the upfront cost.

A point often made in reference to dynamic efficiency is that new entry can be a particularly important force. Protected incumbents facing no competition have limited incentive to innovate and/or bring the benefits of the innovation to a small economy because they are able to maintain a customer base even if they do not innovate. This result holds generally and is due to Arrow (1962). Arrow’s argument is called the “replacement effect”.

Figure 3 – A graphical depiction of the effect on production cost of adapting foreign innovation or other intangible capital for use in the home market