Principles of Microeconomics

Principles of Microeconomics

Principles of Microeconomics

7. Equity and Efficiency

 Up to this point in the course, we have focused only on the outcomes generated by the market and their efficiency properties. Competitive equilibria in a market are typically efficient, but they may not be equitable: Some people may benefit greatly from the market's operation, while others do not. As a society, we may decide we want to alter these outcomes in a way that seems more equitable, but such changes typically come at the cost of efficiency. In this lecture, we will begin to learn about the efficiency-equity trade-off.

Economic efficiency and equity:

Economics is the study of how scarce resources are allocated; that is how a society answers the questions what, how and for whom? The objectives of equity and efficiency can help us judge how well we are managing to answer these questions.

Efficiency

Economic efficiency looks at whether we could, as a society, produce more or make some people better off without making others worse off . If this is the case, then we are not economically efficient. This concept can be illustrated by the production possibility frontier. In the diagram below, the point inside the ppf is economically inefficient. We could produce more apples and more pears, therefore making some people better off and nobody worse off. All points on the ppf itself will therefore be economically efficient.

ppf_unemp

Figure 1 Inefficient resource use

Economic efficiency requires the following conditions to be met:

Efficiency in production - productive efficiency requires firms to be producing goods at the minimum possible level of cost.

Efficiency in consumption - this means consumers spending their money as efficiently as possible to maximise the utility (satisfaction) they get from their limited incomes

Efficiency in specialisation and exchange

The last two of these are collectively known as allocative efficiency. Allocative efficiency occurs when consumers are gaining the maximum possible satisfaction at their current level of income.

Equity

Equity is another objective that may be pursued by governments and economic policy makers. Equity is a situation when income is distributed in a way that we could consider to be fair or just. This is NOT the same as an equal distribution of income. Equity is possible when income is unevenly distributed, so long as this distribution is considered fair and just. The problem is that people and governments will differ significantly on what they consider to be fair. A more laissez-faire government is likely to consider a more unequal distribution of income to be fair, while a more socialist government will want a more equal distribution of income as their objective.

Economic efficiency does not in itself lead to greater equity, indeed there may be conflicts between these objectives.

A big issue in economics is the trade off between efficiency and equity.

Efficiency is concerned with the optimal production and allocation of resources given existing factors of production.

Equity is concerned with how resources are distributed throughout society.

Vertical equity is concerned with the relative income and welfare of the whole population e.g. Relative poverty when people have less than 50% of average income. Vertical equity is concerned with how fairly resources are distributed and may imply higher tax rates for high income earners.

Horizontal equity is treating everyone in same situation the same. e.g. everyone earning £15,000 should pay same tax rates.

Concepts of efficiency may imply a lack of equity.

For example, the Community Charge (Poll tax) was considered to be economically efficient because a poll tax doesn’t distort economic behaviour. (e.g. doesn’t reduce incentives to work). However, by making a millionaire pay the same tax as a poor pensioner, it was considered to be unfair.

A tax on cigarettes can be said to increase social efficiency. The tax makes people pay the social cost of smoking. However, a cigarette tax is also highly regressive. It takes a bigger % of income from low income earners.

Pareto efficiency is concerned with creating a situation where we cannot make one party better off without making another party worse off.

For example, a country may devote 60% of GDP to the manufacture of armaments. In doing this, they may achieve technical and productive efficiency and produce on their production possibility frontier. Therefore from this perspective they are efficient. But, such an economy may have a great deal of inequality, with large portions of the population struggling to have enough to eat.

Bank Bailouts and Equity.

From one perspective we may say bailing out banks is an economic necessity as it prevents a collapse in confidence in the banking system. By bailing out banks, we enable a more productively efficient economy. However, from another perspective it seems unfair that the government enables bankers to retain high paying jobs whilst they implement cuts for workers on lower income.

Increased Inequality and Increased Growth.

Sometimes, economic policies create a situation where everyone becomes better off (rising real incomes across population). However, those on high incomes gain a bigger % rise in real incomes. The result is that everyone becomes better off, but, there is also greater income inequality. Therefore, some people may feel that relatively they appear worse off compared to others in society.

This is a pareto improvement in economic welfare but also an increase in inequality.

The final point is that there doesn’t have to be a trade off between equality and efficiency. An improvement in efficiency, should generally make the economy better off. There is no reason why improved efficiency has to lead to inequality. It is compatible to improve both efficiency and equity within society. 

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