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Liu Shangchao: Simple analysis of the trade-off between efficiency and equity

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The world’s economy has been growing rapidly especially in the last few decades. One of the most important reasons for the dramatic economic growth is that governments and businessmen have been concerning about economic efficiency more than equity. Although economic efficiency has been improved, many social problems related to equity may have already emerged. For instance, income gap between rich countries and poor countries which can cause unbalance of the world’s economy and politics reached 74 to 1 in 1997, increased from 60 to1 in 1990 (Health Systems Trust, 2003). One of the principles of economics is that society faces trade-offs including the trade-off between efficiency and equity goals. It means efficiency and equity goals can not be achieved simultaneously. For that reason, it is important to find out which of them should be more concentrated in the economic and social developing process. This essay will interpret the terms efficiency and equity with examples firstly, and then discuss and analyse which of efficiency and equity is more important. Finally, the outcome of analysis together with a brief conclusion will be given.

Firstly, Mankiw (2007) gives two different definitions of efficiency from macro and micro perspectives. The macro definition is “the property of society getting the most it can from its scarce resources” and the micro one is “the property of a resource allocation of maximizing the total surplus received by all members of society”. Members of society in the market can be grouped into consumers and producers. According to Mankiw(2007), consumer surplus can be defined as “the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it”, similarly producer surplus is “the amount a seller is paid for a good minus the seller’s cost of providing it”. Figure one (Mankiw, 2007) may be helpful to understand the term efficiency in a visual way.

Figure One (Mankiw, 2007)

 

 

If the whole economy is assumed as a pie, efficiency is only concerned with how big the pie is. Improving economic efficiency is one of the initial goals of most governments and unions. For example, the EU adopted the Single Market strategy in 1980s and early 1990s. As barriers to market entry were removed, the Single Market Programme has contributed an increase of competition in European market, an enhancement of productivity performance and a boost of innovation incentives.  Thus economic efficiency of Europe has been raised significantly. The world biggest multi-member single market in EU has brought EU an increase of GDP by 1.8% in 2006. (HM Treasury, 2007)

Mankiw (2007) also gives two different definitions of equity from macro and micro angles. The macro definition of equity is “the property of distributing economic prosperity fairly among the members of society” while the micro definition is “the fairness of the distribution of well-being among the members of society”. Other than efficiency, equity refers to how the pie is divided. For instance, the EU re-launched the Lisbon objectives in 2000 to set goals such as increasing labour supply, modernising social protection systems and improving the adaptability of the workforce. All of them are related to enhancing social cohesion. In other words, the commission aimed at increase equity in EU by setting these goals (European Commission, 2006).

Secondly, it is generally known that society faces trade-off between the goals of efficiency and equity. For example, policies which manage to increase equity of economic well-being such as unemployment insurance and individual income tax may result in decrease of productive motivation. Therefore, these policies tend to reduce efficiency. Similarly, pursuing efficiency seems to impair equity. Table One (Clark, 1999) provides information of economic growth and numbers in poverty in the USA from 1979 to1997.

Table One

Year GDP(1992$) Billions Per Capita Income(1997$) Numbers in Poverty Official Poverty Rate %
1979 4,630.6 15,549 26,072 11.7
1989 6,244.4 14,056 31,528 12.8
1997 7,280.0 19,241 35,574 13.3

Source: Clark, 1999

 

It is strange but true that the poverty numbers has been increasing with economic development in this period. Due to these two goals are mutually inconsistent, it is natural to decide one which have priority over the other.

To start with, the two terms should be analysed from perspectives of different social groups. It is generally believed that economic rationalism stresses efficiency more than equity. Whitwell (1998) says that “For economic rationalists, greater efficiency is a sacred goal”. Increasing competition and unlocking market force are the main ways that economic rationalists use to obtain the goal of efficiency. Moreover, efficiency can be improved “when resource-saving technological advances are implemented by exercise of entrepreneurship” (Stanford, 1996).  Unlike economists, politicians care about both efficiency and equity. Governments implement policies like building infrastructure and promoting competition to improve economic efficiency. On the other side, policies such as taxes, insurances and welfares concern about equity more than efficiency and that might be the reason why economic rationalists are sometimes suspicious of government intervention. It is often the case that some governments care about efficiency more than equity. China is a good example as one of the basic policies of China is to give priority to efficiency and give attention to equity. Thus, generally speaking, efficiency are preferred than equity in most social groups.

Furthermore, the two terms should be analysed from perspectives of different economic and political systems which are capitalism and communism. Capitalism may be defined as a political and economic system in which individuals and corporations can maximise the profit because they own the means of production. Private ownership of property appears to improve economic efficiency to a certain extent because people will get more awards if they produce more. The market economy, which is adopted by most capitalistic countries, improves economic efficiency of capitalism countries by using market force to determine levels of production, consumption, investment, and savings without government intervention. In terms of equity, capitalism believes inequalities are the necessary outcome of providing sufficient incentives for economy. The reason for this may be that the trade-off between efficiency and equity is real and efficiency is favoured by capitalists. On the other hand, communism, which is opposite to capitalism, may be defined as a political and economic system in which means of production is owned by the people of the community collectively through the state. Communism concentrates on equity more than efficiency as its belief system is “grounded in the common ownership of property” (Election Commission, 2007). Instead of market economy, most communistic countries adopt planned economy in which state authorities determine production, consumption and investment. Planned economy improves equity at the cost of efficiency because government can not allocate resources as efficient as market power. With this background information, it can be simply assumed that the cold war between United States and Soviet Union represents the conflict between two opposite ideas which are “efficiency first” and “equity first”. The fact that the biggest communistic regime Soviet Union has collapsed in 1991, leads to the inference that efficiency is more important compared with equity. In addition, the market approach which stands for the idea “efficiency first” seems more successful than the central planned approach which stands for the idea “equity first”. China is a good example. After adopting market approach instead of central planned approach in 1976, it has reached unprecedented development in economy.

Finally, there are differences between the two terms of efficiency and equity. Efficiency appears to be an objective goal that can be evaluated quantitatively; nevertheless, equity tends to be a subjective goal and it has different meanings to different people. The reason is that ideas about equity are not exclusively economic ideas, “they touch on politics, ethics and religion” (Parkin, Powell and Matthews, 2005).  The different fields they involve in make the comparison difficult. Moreover, the importance of efficiency and equity varies from different actual economic conditions. For example, if a country’s economy is well developed, it may consider that equity is more important than efficiency. However, for a poor country, efficiency first policy might be more feasible.

To sum up, the term efficiency means the property of society and social members getting the most they can while equity refers to the fairness in allocating the economic prosperity among the social members. As there is a trade-off between goals of efficiency and equity, it is necessary to find which one is more important. It could be argued that efficiency is more important than equity from perspectives of different social groups and different political or economic styles. However, the terms efficiency and equity are related to different fields of science. Therefore there is no simple answer to the question whether efficiency or equity is more important. Moreover, the importance of efficiency and equity change with different specific economic conditions. So policies vary from government to government and period to period. For example, China transformed its fundamental policy to “efficiency first” in last decades to promote its economic growth while policies like high rate of both tax and welfare in some western developed countries appear emphasize equity more than efficiency.

 

 

 

 

References:

Clark, C.M. (1999) Basic Income: Promoting Economic Efficiency and Equity

Through Tax and Benefit Integration. Taxation Alternatives for the 21st Century September 30-October 1, [online]. Available at: <http://www.stjohns.edu/media/3/821c205738d74f7b943c00d46686c788.pdf > [10 November 2007]

Election commission (2007) People hold different views on political issues New Zealand Elections. [online], 11 September. Available at:                                          < http://www.elections.org.nz/people-hold-different-views.html > [16 November 2007]

Equity (2003) Health Systems Trust [online], 28 February. Available at: <http://legacy.hst.org.za/hlink/equity.asp> [10 November 2007].

European Commission (2006) European Business facts and figures. Belgium:  Office for Official Publications of the European Communities

HM Treasury (2007) The Single Market: A vision for the 21st century [online]. Available at :< www.dti.gov.uk> [2 November 2007]

Mankiw, N.G. (2007) Principles of Microeconomics. China: Thomson Higher Education

Parkin, M.,Powell, M.& Matthews, K. (2005) Economics. Spain: Pearson Education Limited

Stanford, R.A. (1996) efficiency. Furman University [online] December.  Available at: < http://facweb.furman.edu/~dstanford/relecon/equity.htm > [2 November 2007]

Whitwell, G. (1998) what is economic rationalism. Money, markets and the economy [online]. Available at:                                                                            < http://www.abc.net.au/money/currency/features/feat11.htm > [15 November 2007]

By: Liu Shangchao, NAES
Time: May, 2012

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