110 
9 
NG, ŠT. 3–4/2006 PREGLEDNI ZNANSTVENI ČLANKI/REVIEW PAPERS 
UDK: 338.12(477) 
Čeprav velja, da naj bi bila tržna gospodarstva 
učinkovitejša od centralnoplanskih, 
se različne tranzicijske države 
soočajo z upadanjem ekonomske 
učinkovitosti. V prispevku predstavljamo 
osnovni indeks ekonomske učinkovitosti, 
ki smo ga razvili s pomočjo proizvodne 
funkcije. Ocenili in analizirali smo dinamiko 
ekonomske učinkovitosti v Ukrajini, 
ki je bila izpostavljena eni največjih 
tranzicijskih kriz. Pokazali smo, da je 
kljub visoki gospodarski rasti v zadnjih 
letih raven ekonomske učinkovitosti 
ostala relativno nizka oziroma je celo 
upadla. Takšen trend lahko pojasnimo 
z neučinkovitimi investicijami in inovacijami 
ter povečano porabo sredstev. 
Ključne besede: ekonomska učinkovitost, 
produktivnost, delo, kapital, inovacije 
Iz vleče k 
UDC: 338.12(477) 
In spite of the fact that a market economy 
by definition must be more effective than 
a centrally planned economy, the various 
countries in transition from the latter 
to the former are faced with the problem 
of declining economic efficiency. In 
this paper a comprehensive index of 
economic efficiency is developed with the 
application of production function tools. 
The dynamics of economic efficiency of 
the economy of Ukraine, which met with 
one of the most pervasive transformational 
economic crises, are estimated 
and analyzed. It is shown that after a 
high rate of economic growth occurred 
in the Ukrainian economy in recent 
years, the level of efficiency of the 
economy remained quite low and even 
declined. This is explained by ineffective 
investments and innovations as well as 
an increasing intensity in use of materials. 
Key words: economic efficiency, productivity, 
labour, capital, innovations 
A b s t r a c t 
JEL: O47, C51 
Anatoliy G. Goncharuk, PhD 
Odessa National Polytechnic University 
Ukraine 
Ekonomska učinkovitost v tranziciji: primer Ukrajine 
ECONOMIC EFFICIENCY DURING THE 
TRANSITION: THE CASE OF UKRAINE 
Introduction 
The transition from an administrative-command economy to a market economy 
raises many theoretical problems previously unknown (before the 1990s) to 
economic science because the transition from socialism to capitalism is an 
absolutely new historic process. One of the key problems is the decline of economic 
efficiency. 
The centrally planned economy practically divested scientific and technological 
advances. In this connection there was not any effective motivation to improve 
the efficiency of the economic mechanism, either at the level of workers or the 
level or enterprises. Notably this concerned agriculture, consumer goods, and the 
food processing industries. This created a bulky and inefficient economy based 
on planned distribution of resources characterized by: domination of heavy 
industry and the defense sector, large enterprises chiefly oriented to production 
for intermediate use rather than final demand, inability to respond dynamically 
and adequately to consumer needs, slow-moving production apparatus, and 
constantly accumulating pervasive disproportions in production. In addition, 
inactivity of the economy was accompanied by professional inactivity of the labour 
force, and an essential system of employee dismissal, retraining, and reeducation 
could not be built. Increasing crisis in the socialist economies wasn’t accompanied 
by liquidation of low-effective and obsolete enterprises and didn’t favour the 
flow of capital to more effective economic sectors. It didn’t create motives for 
renovation of production, which usually occurs in developed countries, by reason 
of the peculiarities of the administrative-command economy control system and 
the monopoly of state ownership. In a centrally planned economy, in comparison 
with a market economy, a smaller part of GDP was directed to personal 
consumption and public goods. 
Thus, the administrative-command system wasn’t able to provide high 
economic and social efficiency of the economy in comparison with a market one. 
Therefore, the transition process to the market economy model in terms of 
efficiency of the economy could be considered as advanced process. 
At the same time, the transition to a market economy was accompanied by a 
drop in indexes of efficiency of the economy in practically all cases. Among the 
special characteristics of that decline, one may highlight the following basic 
principles: 
(a) change in productivity of labour is inevitable under structural transformation, 
liquidation of inefficient manufacturing, creation and increasing of apparent 
unemployment, and changes in social needs for goods and services; 
(b) growth of energy and materials intensity of the economy by reason of 
cancellation of government subsidies and price liberalization; 
(c) rise in social inequality by reason of cancellation of many state social guaranties 
and increased capitalization of the economy.
111 
GONCHARUK: ECONOMIC EFFICIENCY DURING THE TRANSITION:THE CASE OF UKRAINE 
However, while in countries implementing radical market 
reforms (Poland, Slovenia, Hungary, etc.) this decline was 
of short duration (2-3 years) followed by swift and stable 
growth, there were fluctuations of labour productivity in 
countries with gradual reforms (Bulgaria, Romania), and a 
decline in countries with inconsistent reforms (Russia, 
Ukraine etc.). 
The most pervasive and durable bust of economic 
efficiency was observed in Ukraine where during the first 9 
years of transition the labour productivity declined more than 
in 2 times . Despite the certain success of the country in the 
last few years in economic growth, monetary and currency 
stability, expansion of external trade and investments, 
increase of household incomes and savings, there are many 
factors that restrain high-efficient growth of the Ukrainian 
economy and constrain the level and rate of that growth. 
This paper is dedicated to analysing these factors and 
estimating the actual level and dynamics of economic 
efficiency of the Ukrainian economy. 
Definitions and methodology 
There are many approaches to defining economic 
efficiency and its basic indexes. The most common are 
described below. 
Economic efficiency was defined by the Italian scientist 
V. Pareto as »a state which does not allow increasing the 
level of satisfaction of at least one individual without making 
any other member of the society suffer,« i.e. when the needs 
of all society members are satisfied as fully as possible, with 
given limited resources (Kuznetsova, Osadchaya 1993). This 
state is called Pareto efficiency or Pareto optimality. 
According to Pareto theory, resource allocation is effective 
in conditions of perfect competition. In a perfectly 
competitive economy, all benefits are produced (production 
efficiency) and allocated (consumption efficiency) 
effectively. Furthermore, the combination of produced 
benefits cannot be changed to improve consumer positions 
(exchange efficiency) (Vidyapin 1999). 
However, the economy that according to Pareto is 
efficient isn’t socially efficient since optimal resource 
allocation leads to the formation of social inequality. In order 
to reduce this inequality, the social economic policy of the 
government is engaged. Therefore, the concept of Pareto 
efficiency cannot be applied to the majority of factual 
situations where political arrangements improve the position 
of one group of people at the expense of another. 
Moreover, according to Pareto, the shift from a state 
monopoly to free competition during the transition process 
means a rise in economic efficiency. But, as noted in the 
introduction, that process is accompanied by a drop in 
economic efficiency in the majority of transition countries, 
which refutes Pareto’s conception of a transition economy. 
When speaking about economic efficiency one should 
also emphasize the analytical conception of operational 
efficiency developed by Farrell (1957), which divides the 
economic efficiency into technical and allocative 
components (multipliers). Technical production efficiency 
reflects an ability to derive maximum output from a given 
set of production factors. Allocative efficiency (efficiency 
of allocation or »Pareto efficiency«) reflects an ability to 
use resources in an optimal combination, taking into account 
their relative cost and applied production technology. The 
economy may be called technically inefficient if it uses 
excessive resources to produce goods. In terms of allocation, 
the economy is inefficient if it uses a non-optimal 
combination of resources to produce goods. 
The following definition of economic efficiency was used 
as the basis for the present research. Economic efficiency is 
obtaining the maximum output subject to minimum input of 
production factors. It defines the efficiency of the entire 
economy. 
The following measures of using of particular production 
factors (i.e. labour, capital) are often used to estimate 
economic efficiency: labour productivity, capital 
productivity, materials-output ratio, etc. The other common 
indicator of efficiency that estimates influences of more than 
one factor is multifactor productivity, which is defined as 
the ratio of total output to input resources (total costs). 
Practically, multifactor productivity considers the influences 
of two factors, labour and capital (The Economist 2004). 
Formally, multifactor productivity A can be recorded in the 
following way: 
, (1) 
where Y denotes total output (fixed base index of output), 
F (K, L) is a production function and denotes average level 
of capital input (K) and labour input (L). 
There A can be seen as an aggregate indicator of economic 
efficiency in contrast to particular indicators like average 
labour productivity (y) or average capital productivity (g). 
Furthermore A can be expressed as the average of y and g 
(with expedient measure). Assuming that F (K, L) = K. L1–. 
is a Cobb-Douglas production function, then: 
A = g. y1–., (2) 
where A is the weighted geometrical average of y and g. 
That means that the fixed base index of A must be set between 
the fixed base indexes of y and g with the same base. As the 
weights . and 1-., the estimations of elasticity of output of 
the two factors use estimations of shares of the capital and 
the labour, received from the national accounts system often. 
Standard practice presumes setting the estimates of factor 
shares via expert evaluation at 0.3 and 0.7 respectively for 
capital and labour (OECD 2001, Dolinskaya 2002, Bessonov 
2004). The given parameter values of production function 
(2) play a key role in determining the efficiency of labour 
and are very close to the values obtained by P. Douglas in 
the 1920s. During the last few decades the role of labour in 
the production of output declined essentially as a result of 
industrialization and an increasing degree of mechanization 
and automation processes. Indeed, given the existing level 
of technology, when the role of a person in various branches
112 
consists of merely operating machines, it’s impossible to 
talk about the domination of labour in the economy. As 
evidence one may adduce the empirical values of production 
function parameters obtained from statistical data of the 
Soviet economy for the years 1960-1985, which amount to 
0.5382 and 0.4618 for labour and capital, respectively 
(Granberg 1988). 
In addition, the approach described above is imperfect 
mostly because it overlooks the other key production factors 
– inventory and entrepreneurship. The latter is the fourth 
factor of production. It consists of the most effective 
arrangement of all other factors for the purpose of producing 
goods and services. In the current situation, process 
innovations, new products, organizational innovations, etc. 
are necessary features of entrepreneurship. Relative 
economic efficiency denotes a choice of such a combination 
of limited quantity of production factors that permits 
achieving the results with the least cost using business, 
production and management know-how. 
Scientists justify excluding all factors but labour and 
capital from production function by the following: labour 
and capital are the results of production processes in the 
previous stages, where capital assets and labour force were 
also used and, therefore, all factors can be reduced to those 
two (Chetyrkin, Klas 1986). However, a factor such as 
inventory is the primary factor of production and it would 
be incorrect not to consider it. This is especially true for 
economies that do not possess ample raw materials of their 
own, such as the Ukrainian economy, and are reluctant to 
import those in sufficient quantities for their production 
needs. Therefore, it is necessary to develop a comprehensive 
measure of economic efficiency where influences of all basic 
factors must be considered. 
Departing from the Cobb-Douglas function with constant 
returns to scale (scale effect) and adding to it factors of 
production which, in our view, are missing, the following 
production function was obtained: 
Yt = ALa1 Ka2 Ma3 Ea4, (3) 
where Yt is total output (GDP), A is total factor 
productivity, L, K, M, E are the factors of production, 
employment (labour), fixed capital stock (means of labour), 
material resources and contributions of innovations 
(entrepreneurship), respectively. a1, a2, a3, a4 are parameters 
of function that define elasticity of output with respect to 
particular input resources. 
Variable A in Equation (3) is standard »Solow residual« 
and indicates the return (output) from all used basic factors 
of production. In fact, A is a comprehensive measure of 
economic efficiency of the economy. 
Re-denoting the given measure as EE after a usual 
transformation, the following formula for comprehensive 
measure of economic efficiency was obtained: 
EE = yb1 gb2 mb3 eb4, (4) 
where y is the average efficiency of direct labour (labour 
productivity), g is the average efficiency of application of 
the means of labour (fixed capital productivity or outputcapital 
ratio), m is the average efficiency of the material 
inputs (output-materials ratio), e is the average efficiency 
of entrepreneurial innovations (output - innovations cost 
ratio). b1, b2, b3, b4 are parameters of function defined by the 
following formulas:
, , , 
. 
Rationally one should use as benchmark data the ratios 
(indexes) and not the absolute values since factors may have 
various dimensions during the construction of production 
functions. Accordingly, benchmark data about resource 
inputs, efficiency of resource application, and production 
output must be time series of corresponding economic 
indexes. Thereby the dynamics of economic efficiency may 
be measured by following index: 
Iee = Iy
b1 Ig
b2 Im
b3 Ie
b4, (5) 
where Ig, Iy, Im, Ie are indexes of average fixed capital 
productivity, labour productivity, output-materials ratio, and 
output - innovations cost ratio, respectively. 
Equation (5) is a four-factor production function and 
averaging function. That is, the dynamics of economic 
efficiency are a certain average value of the dynamics of 
efficiency of direct labour, means of production, material 
inputs, and entrepreneurial innovations. 
Estimate of function parameters 
Practical application of the equations described above 
requires an actual estimate of factor costs and corresponding 
function parameters. 
The estimate of employment level, particularly in a period 
of economic depression in Ukraine, is plagued by problems 
of underemployment and latent unemployment. The high 
percentage of registered employment observed during the 
entire transformation period on a number of the legal and 
morally-ethical reasons is connected to the impossibility of 
dismissal of a part of employees liberated during decline of 
production. This led to a reduction in the workweek and in 
the length of the work day, an increase in the number of 
employees on administrative leave and part-time employees, 
which is an increase in underemployment. Thus actual 
working hours will be used below in lieu of number of 
employees to estimate the real value of direct labour costs. 
Hourly output per employee will be used to estimate labour 
productivity. 
In measuring fixed capital stock, one faces the problem 
of adequate estimate of the value of fixed capital that is 
actually used in business activity. As noted by R. Solow, 
»capital in stock doesn’t mean capital in work« (Solow 
1957). The estimate of fixed capital unadjusted for 
depreciation and not taking into account the share that is 
unused prevents measuring the actual efficiency of its usage. 
NG, ŠT. 3–4/2006 PREGLEDNI ZNANSTVENI ČLANKI/REVIEW PAPERS
113 
When fixed capital in stock is idle during a period of 
economic depression, the estimate of fixed capital depends 
on its utilization rate. Moreover, the balance sheet estimate 
of the value of fixed capital during the transformation period 
in Ukraine did not correspond to its market value, which 
has never been precisely estimated because of inadequate 
indexation, especially during hyperinflation. This resulted 
in a distorted system of capital depreciation that didn’t reflect 
the actual usage of fixed capital in the production process. 
According to various authors (Griliches, Jorgenson 1967, 
Costello 1993), the problem of fixed capital utilization 
records and their inadequate estimate may be solved by using 
data on power usage as an indicator of the rate of fixed capital 
utilization. However, that necessarily leads to overestimating 
the capacity utilization and couldn’t provide a realistic 
estimate for fixed capital stock, taking into account the 
significant scope of the ‘hidden’ sector of the economy. 
Therefore, it is impossible to obtain a realistic estimate 
of fixed capital stock due to the distorted systems of 
estimated balance sheet values and depreciation, the 
difficulty of estimating the actual utilization rate, and the 
absence of any market value data. In this case, it seems 
appropriate to apply an amount of annual fixed asset 
formation (in comparable prices), which are realized 
purposely for use in the production process as an evaluation 
of the dynamics of capital value. Correspondingly, we define 
assumptions about full utilization and application of invested 
fixed capital in the production of GDP. 
There are annual data about material costs in the economy 
(in comparable prices) used as material resources in 
production. 
The value of contributions to innovations is defined as 
the amount of funding for research-and-development 
activities by domestic entrepreneurs. 
To define the parameters of function (5), elasticities of 
GDP with respect to particular measures of resource costs, 
a multiple regression analysis was carried out based on 
annual data (chain indexes) for 1991-2003, and the following 
equation was obtained: 
Yt = L0,428 K0,212 M0,160 E0,201. (6) 
Whereas the amount of factor elasticities equals 
approximately 1 (precisely 1.001), the scale effect is 
practically absent and the obtained function (6) may be 
considered as linear homogeneous. The parameters of the 
obtained model demonstrate its high accuracy and closely 
related variables. According to the estimates, 95% of real 
GDP dynamics is explained by the dynamics of four factors: 
number of hours worked, fixed asset formation, material 
costs and entrepreneurial innovations. Parameter A’s 
proximity to 1 shows that it is not important, and this in turn 
shows that the average productivity of all factors hardly 
fluctuated during the period considered. 
The elasticity of economic growth with respect to hours 
worked turned out to be the highest (0.428), which is 
evidence of the determinative influence of the human factor 
on the economic dynamics in Ukraine. This is certainly lower 
than the value of the same estimate (0.4618) calculated for 
the Soviet economy for the years 1960-1985 (Granberg 
1988). This indicates increasing influences of other 
production factors for GDP dynamics. The obtained value 
of elasticity of output growth with respect to labour for 
Ukraine in comparison with the corresponding parameter 
of production function for most developed capitalistic 
countries during the post-war period (1950-1977), is lower 
than in the USA (0.447) and Great Britain (0.506), and higher 
than in Japan (0.397) (Chetyrkin, Klas 1986). 
Parallel analysis carried out using fixed base indexes 
(1992=1) yielded rather different results for parameters of 
production function: 
Yt = 0,929L0,383K0,292M0,190E0,061. (7) 
The obtained regression equation is significant according 
to the parameters. The independent variables included 
explain 99% of Ukrainian GDP dynamics. In comparison 
with the function based on chain indexes, the given function 
shows the reduction of multifactor productivity that 
constrained GDP growth during the analyzed period in 
Ukraine. Moreover, the magnitude of parameters for all four 
factors in the last equation (7) being less than 1 (0.926) 
suggests diseconomies of scale, i.e. the influence of 
production consolidation on efficiency of the Ukrainian 
economy is negative. One should also note the considerable 
increase of elasticity of output with respect to capital (fixed 
capital and inventory investments) at the expense of 
elasticities with respect to labour and entrepreneurial 
innovations. 
Estimate of economic efficiency of the economy 
Whereas the parameters ai of production function 
describe the dependence of economic growth on four key 
factors of production (7), here we proceed to the estimate 
of a comprehensive measure of economic efficiency. The 
results of this estimate in comparison with the dynamics of 
the productivity of social labour (ratio of GDP to actual 
working hours by all employees of the economy) are shown 
in Figure 1. 
It can be seen that the economic efficiency of the 
Ukrainian economy declined over the last 12 years, and 
towards the end of 2004 was approximately at the level of 
1995. The increases in 1996-1997 and 1999-2002 years were 
short-lived. This may be explained by the following reasons: 
(a) the currency-financial crisis in 1998 adversely affected 
the economic efficiency of the economy, which fell to 
the lowest level in the history of Ukrainian independence; 
in contrast to the period 1993-1994, the drop in 1998 
was related to the decline in productivity in practically 
all four factors of production; 
(b) in the years 2003-2004, the decrease in economic 
efficiency was the result of a simultaneous decline in 
productivities of fixed capital investments, material 
resources, and innovations. 
GONCHARUK: ECONOMIC EFFICIENCY DURING THE TRANSITION:THE CASE OF UKRAINE
114 
The total decrease in economic efficiency during the 
entire analyzed period amounts to 8.5%. 
While comparing the two lines in Figure 1 one may notice 
the following: 
(a) while in 1992 the decrease in labour efficiency 
accelerated the decline in overall economic efficiency, 
in the years 1995-1996 the former already constrains the 
gain of the latter; 
(b) the similarity of dynamics of both measures in 1997- 
1998 indicates the essential role of labour in the formation 
of economic efficiency for those years; 
(c) the high growth rate of labour productivity in 1999-2002 
compensated for the decreasing efficiency of use of the 
other factors and largely supported a gain in overall 
economic efficiency of the economy; 
(d) in 2003-2004 the overall value of economic efficiency 
declined because of inefficient utilization of investments 
and innovations, as well as increasing intensity of 
materials use (materials-output ratio), and in spite of 
growth in labour productivity. 
Conclusion 
During the estimation of value of economic efficiency 
of the economy, it is necessary to apply comprehensive 
indexes that consider the efficiency of utilization of all key 
factors of production. 
The estimates of parameters of the model developed here 
show that economic efficiency is for the most part explained 
by labour efficiency (working hours), but the influences of 
other factors (investments, materials costs, entrepreneurial 
innovations) on economic efficiency are also significant. 
In spite of the high rates of economic growth that 
occurred in Ukraine during the years 2000-2004, economic 
efficiency remained quite low and even declined (during the 
years 2003-2004). This may be explained by ineffective 
investments and innovations as well as an increase in 
intensity in use of materials in the Ukrainian economy. 
References 
1. Bessonov, V. A. (2004). O dinamike sovokupnoy 
faktornoy proizvoditel’nosti v rossiyskoy perehodnoy 
ekonomike. Moskva: Institut ekonomiki perehodnogo 
perioda. 
2. Chetyrkin, E. M., Klas, A. (1986). Teoriya i praktika 
stratisticheskogo modelirovaniya ekonomiki. Moskva: 
Finansy i statistika. 
3. Costello, D. M. (1993): A Cross-Country, Cross-Industry 
Comparison of Productivity Growth. The Journal of 
Political Economy, V 101, 2: 207-222. 
4. Dolinskaya, I. (2002). Explaining Russia’s Output 
Collapse. IMF Staff Papers, V 49, 2: 155-174. 
5. Ferrell, J. M. (1957). The Measurement of Productive 
efficiency. Journal of the Royal Statistical Society, Series 
A, 120, Part 3: 253-290. 
6. Granberg, A. G. (1988). Modelirovanie socialisticheskoy 
ekonomiki. Moskva: Ekonomika. 
7. Griliches, Z., Jorgenson, D.W. (1967): The Explanation 
of Productivity Change. The Review of Economic Studies, 
V 34, 3: 249-283. 
8. Kuznetsova, V., Osadchaya, I. (1993). Kapitalizm i rynok: 
ekonomisty razmyshlyaut. Moskva: Nauka. 
9. OECD (2001). Productivity Manual: A Guide to the 
Measurement of Industry-Level and Aggregate 
Productivity Growth. Paris: OECD. 
10. Solow, R. M. (1957). Technical Change and the 
Aggregate Production Function. The Review of 
Economics and Statistics, V 39, ą 3: 312-320. 
11. The Economist (2004). A productivity primer. The most 
common way to measure economic efficiency is not the 
best, Nov 4th. 
12.Vidyapin, V. (1999). Bakalavr ekonomiki. Moskva: 
Triada. Available: http://lib.vvsu.ru/books. 
Figure 1: Basic dynamics of economic efficiency and productivity of social labour in Ukraine from 1992-2004 (1992=1) 
1 – growth rate of economic efficiency, 2 – growth rate of productivity of social labour 
NG, ŠT. 3–4/2006 PREGLEDNI ZNANSTVENI ČLANKI/REVIEW PAPERS