Equity and Efficiency Trade-Off

EQUITY AND EFFICIENCY trade-off refers to the idea that while free markets perform quite well in producing economic efficiency, the market mechanism does not necessarily produce outcomes that a society would judge to be equitable. If a society values equity, it may be willing to sacrifice some efficiency in order to gain additional equity. A society can become more equal through a redistribution of income that removes some of the incentives to work and produce, which results in a smaller overall size of the economic pie to be shared. This is the essence of the trade-off.

To obtain a more clear idea of this trade-off, it is important to understand what economists mean by efficiency and equity. Efficiency refers to Pareto-efficiency, which is a condition in which no one in the society can see his situation improved, in terms of having a larger amount of resources available for consumption, without someone else being made worse off.

If someone can be made better off without anyone being worse off, then the economy is not working efficiently, because there is a chance to improve the situation for some members of the society at a cost to no one. Such efficiency works along with the compensation principle, meaning that a change to the economy may make one person better off and another person worse off, but it is still possible to improve the efficiency of the economy if the winner can compensate the loser and still have something left. This meets the criterion that no one is made worse off by the change.

In a free-market economy with perfect competition, where no one consumer or business is large enough to influence prices, and where a market exists for all goods, the first fundamental theorem of welfare economics indicates that the “invisible hand” of the market will guide its participants to a Pareto-efficient outcome.

Indeed, the market mechanism has not met a match in producing goods efficiently. However, the market mechanism does not provide any feature to necessarily ensure that the efficient outcome it produces will be considered equitable by society. An economic outcome that results in some extremely rich people and some extremely poor people can be considered efficient, if it is the case that the only way to improve the situation of the poor is to take some of the resources of the rich. This is the implication of the Pareto-efficient criteria. A society that also has concerns for fairness in the distribution of resources may seek to strike a balance between efficiency and equity.

Equity refers to how the resources and production of an economy are distributed among its members. A society's views of equity can be reflected through the social welfare function. Such a function shows how the utility or welfare of each member of the society should be weighed to determine the overall welfare of the society. A utilitarian social welfare function attempts to maximize the combined utility of each individual in the society to achieve the largest total utility.

On the other hand, a Rawlsian social welfare function only seeks to maximize the utility of the worse-off person in society. Though utility is not a measurable concept, incomes are often used to replace utility in practical social welfare functions. Questions of equity can then be considered through examination of the income distribution.

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