Notes on Efficiency and Equity Tradeoffs

Allocative Efficiency:

Scarce resources are channeled to produce goods and services most valued by society ie the right amount of the right goods are produced.

Productive Efficiency:

Goods are produced using the least cost methods of production. There is no wastage of scarce resources.

(We skip Dynamic Efficiency here)

Equity:

Fairness in the distribution of resources and goods and services across society. Major concern here is that lower income is able to fulfil basic human needs such as healthcare, education, food and housing.

3 Examples of How Achieving Efficiency may lead to Inequity

• 1) Globalisation - freer movement of goods and services, labour and capital internationally promotes economic efficiency. For example, a key theory of international trade, the Theory of Comparative Advantage shows how free trade can allow for productive efficiency (goods are produced in countries that incur least opportunity costs in producing those goods) and allocative efficiency globally as there would be deadweight welfare losses to society if trade restrictions are imposed as free trade actually increases societal welfare. (You will learn all these under International Trade and Globalisation.) Unfortunately, especially in developed economies, globalisation has led to a lot of job losses for the locals due to competition from foreigners. Entire industries may relocate and thus disappear, leaving workers structurally unemployed. Low skilled workers may face intense competition from foreign labour, which will keep their wages depressed whilst high skilled workers see their wages soar as the industries serve a global market and there is higher demand for their skills due to global competition. In short, this means that the income gap widen whilst the economy may be booming due to globalisation and the increased efficiency globally. Widening income gap will lead to issues of inequity as the lower income may be "out-priced" in markets for housing, education etc. You can learn more about how globalisation has led to widening income gap through this video.

• 2) To correct the over-consumption of demerit goods, such as cigarettes, indirect taxes may be imposed. ((Check out our Video on Indirect Tax.) However, as indirect taxes are regressive in nature (hurts the lower income more so than high income earners due to higher tax burden as a proportion of income), it may be considered inequitable. Also, as it may cause the lower income to have to forgo other necessities even if they were to cut back on cigarettes. (Counter argument: Since it is a demerit good, it may be a good thing for them if they are forced to completely give up smoking. This can improve their health and increase their productivity, which can help them earn more. This view is of course rather subjective.

• 3) In the pursuit of productive efficiency, capital goods and technological advancements may be adopted at the expense of low-skilled workers. Demand for low-skilled workers fall while demand for high-skilled, for example those with robotics programming skills would increase. Once again, this can lead to widening income gap and this issues of inequity.

3 Examples of How Achieving Equity May Lead To Inefficiency

1) A minimum wage is quite common across the world and is a means to reduce the income gap and help enable the lower income to afford necessities and merit goods. However, retrenchments and higher unemployments occur with implementation of minimum wage. This leads to deadweight welfare losses in the labour market and hence inefficiency occurs. (Details are covered under minimum wage topic.)

2)  Food subsidies may be provided to ensure affordability by low income and thus achieve equity. However, this would increase supply (assuming indirect subsidies), leading to an increased allocation of resources to the production of food, than is socially optimal (assuming the free market equilibrium is allocatively efficient). Thus, allocation of resources to food and allocative inefficiency now exists. (More details done in Subsidy and Market Failure topic.)

3) Progressive income tax system is one whereby higher income earners will pay a higher proportion of their income in taxes. This will help reduce the income gap and also yield substantial tax revenues that can be redistributed to the low income earners through transfer payments and subsidies, who can thus better afford necessities. This obviously improves equity but can lead to inefficiency. For example, it can lead to a fall in incentive to work as the marginal tax rate increases as income increases. If skilled labour are now working fewer hours as a result of this, it can be deemed that productive inefficiency is occurring in the economy as scarce resources are not well-utilised and will lead to lower production of goods and services.