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.
For example, the Community Charge (Poll tax) was considered to be economically efficient because a poll tax doesn’t distort economic behavior. (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 EquityFrom 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.
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.