Course: Economics and Public Finances Student: Jeler Maria MA Program: Community Development and Urban Planning Academic

Year: 2013-2014 Individual Assignment

Equity-Efficiency Trade-Offs

A controversial theme developed in modern societies is represented by EquityEfficiency Trade-Offs. Following Fayols general principles of management we can define equity as a combination of kindliness and justice1. Moreover, equity depends on peoples perception about fairness. It all relies on the way people perceive the terms of fairness and distribution. Obviously, notions of fairness are not well defined; fact that may generate conflicting views of what is actually fair2. Because of these ambiguities, fairness is avoided in analysis projects because it doesnt have a good approach. As Richard Vedder and Lowell Gallaway debate in their study, The EquityEfficiency Debate, the two themes tend to dominate the history of economic thinking, the efficient use of available resources and the equitable distribution of the claims to the output generated by those resources3 . Related to the economic field, efficiency is concerned with the optimal production and allocation of resources in a society while equity is concerned with how resources are distributed throughout this society. Concerning equity, the literature describes two types: vertical equity and horizontal equity. The first one is related to the relative income and welfare of the whole population and is concerned with how fairly resources are distributed (it may imply higher taxes for high income earners.) On the

Robert, E.Quinn et.al.,Becoming a Master Manager, New York, 1990, p.6. Joseph, E . Stiglitz Economics of the Public Sector 3rd Edition, Norton & Co., New York, 2000, p.263. 3 Richard Vedder, Lowell Gallaway, The Equity-Efficiency Debate, Ohio University, p.1.
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other hand, horizontal equity is treating everyone in same situation the same (everyone earning a certain amount of money should pay same tax rates).4 All this competition between equity-efficiency usually ends with a compromise, a trade-off between the two, because concepts of efficiency may imply a lack of equity. This leads us to the principle of Pareto or near-Pareto improvements individual better off without making at least one individual worse off.6 Analyzing Stiglitzs study regarding equity, we can notice that the author treated the evaluation of distributional consequences. Government programs are debatable in terms of how society is affected by them, who are the real beneficiaries and how much they benefit. As it was mentioned above, due to the fact that fair is an ambiguous term, economists try to avoid it and rather focus on identifying the impact of programs, usually, by using specific indicators when analyzing the impact. Unfortunately, in many expenditure programs, trade-offs exist between the objectives of efficiency and equity (for instance, redistribution of income to the needy). The questionable aspect is related to the disagreements about the desirability of different programs, which in turn arise from disagreements about the values, meaning the relative importance of equity vs. efficiency considerations and the nature of trade-offs, or in other words, how much loss of efficiency is needed for social equity. The equity-efficiency trade-off emphasizes the distribution effect, which may be either progressive (when a programs benefit increases disproportionately to the poor) or regressive (when the benefits increases disproportionately to the rich)7. Thus, the
5

(264), which

shows that in a society/economy the allocation of resources is impossible to make any

Pettinger, Tejvan, Efficiency vs.Equity, UK, Nov.2010, http://www.economicshelp.org/blog/2473/economics/efficiency-vs-equity/.

5 6

Joseph, E . Stiglitz Economics of the Public Sector 3rd Edition, Norton & Co., New York, 2000, p.264. Barr, Nicholas Economics of the Welfare State (5th ed.). Oxford University Press, 2012 p. 46, http://www.investopedia.com/terms/p/pareto-efficiency.asp
7

Joseph, E . Stiglitz , op.cit., pp.264-265.

questionable idea about equity-efficiency is how much loss of efficiency may create progressive distributional impact8. Another perspective, proposed by Arthur Okun in his study Equality and Efficiency: The Big Tradeoff (1928-1980) brings another approach upon the concepts of equity and efficiency. These two concepts are associated with terms as rights and dollars, meaning that the market needs a place and the market needs to be kept in its place. How can this be achieved? Obviously, by establishing a set of rules and rights in the society, in order to protect the society from the market domination, which would arise if everything could be bought and sold for money9. Regarding the fact that material gain is one of the many motives that propel the economic activity, we should understand that in an economic environment all tradable goods and services are assigned their prices, and their values become dimensionally comparable (eg: a book is cheaper than a car, etc. ) Furthermore, income and wealth are the main factors in peoples economic position. The income provides the basic for maintain a standard of living and, going further; the income distribution reflects holdings of wealth10. Apart from equity of income, the equity of opportunity reflects the notion of a fair race, where people are equal at starting line. The main problem is to determine that starting line. An evident inequality of opportunity is the idea that success depends on whom you know rather than what you know. Okun highlights the fact that another tradeoff that is not discussed in the real world is the one between equity of opportunity and equity of income. Generally, these two are complementary rather than competitive objectives11. The area of compromise appears when we want to increase equity in an efficient economy. As Okun states, if both equity and efficiency are valued, and neither takes absolute priority over the other, when conflicts appear, definitely the compromise ought to be considered. In such cases, some equity will be sacrificed for the sake of
8 9

Ibidem. Arthur, M.Okun, Equality and Efficiency: The Big Tradeoff, Washington, D.C., The Brookings Institution, 1975, pp.4-6. 10 Ibidem, p.7. 11 Ibidem, p.11.

efficiency and some efficiency for the sake of equity. These sacrifices should be justified so that people know what the gain of a certain loss means12. Naturally, a society system that generates a productive activity leads to an efficient economy. But that pursuit of efficiency creates inequalities and, therefore, society faces a trade-off/compromise between the two. In other words, equity means paying some costs in terms of efficiency. Stiglitz shows the difference between these two terms through equity-efficiency frontier:

13

12

Ibidem, pp.11-13.

Scrooge focus on efficiency rather than his brother, Spendthrift who thinks that one can get a large increase in equity with just a slight loss in efficiency14. Equity is produced at a vertical level, which is concerned with the relative income and welfare of the whole population. Horizontal equity is treating everyone in the same situation the same. All in all, this matter remains debatable in the sense that the consequences of redistributive measures on both equity and efficiency are uncertain15. In spite of this fact, a democratic capitalist society will keep searching for better ways of drawing the line between right and dollars. However, the imminent conflict between equity and efficiency will never solve the problem. As the author Okun concludes, we have to put some rationality into equity and some humanity into efficiency to gain an equityefficiency balance.

13 14

Joseph, E . Stiglitz , op.cit., pp.264-265. Ibidem. 15 Arthur, M.Okun, op.cit., pp.12-16.

References:
1. Arthur, M.Okun, Equality and Efficiency: The Big Tradeoff, Washington, D.C., The Brookings Institution, 1975.

2. Barr, Nicholas Economics of the Welfare State (5th ed.). Oxford University Press, 2012 p. 46, http://www.investopedia.com/terms/p/pareto-efficiency.asp.

3. Quinn,E. Robert et.al.,Becoming a Master Manager, New York, 1990.

4. Stiglitz, Joseph, E. Economics of the Public Sector 3rd Edition, Norton & Co., New York, 2000.

5.

Tejvan,Pettinger,

Efficiency

vs.Equity,

UK,

Nov.2010,

http://www.economicshelp.org/blog/2473/economics/efficiency-vs-equity/.

6. Vedder,R., Gallaway,L. The Equity-Efficiency Debate, Ohio University.