Equity and Efficiency in Economics. Overview and Explanation

When we say that an allocation of goods in the economy is efficient, what we really are talking about is Pareto efficiency and that means that we're at a point where no one could be made better off. We can't make any person better off without making at least one person worse off. So if we're in some kind of allocation, where there's no way that we could change the way the goods are divided to make someone better without at least hurting one other person then we say that we are at a Pareto efficient allocation. However, a Pareto allocation might not be an equitable allocation and by what we mean by equitable is we're really talking about fairness, the way that the goods are distributed in society fair to all the people in society.


So let me give you an example let's talk about the market for cars. Let's say in our society that there we live in, a small community and there are a hundred cars produced and we have this community consists of Jay Leno and everybody else. So everybody else is all of us and then there's Jay Leno. This is the different ways, this is a set of Pareto efficient allocations all lie along that curve.


but let's say that we happen to be here at point "A" where Jay Leno gets a hundred of the hundred cars that are produced and everyone else gets zero. So at this point, because it lies along the PPF, we can think of this curve as the production possibilities frontier. This is the set of all the possible efficient in production allocations because we're in this Pareto optimal or this is optimal in terms of production. What we mean by that is that we couldn't give everyone else a car without hurting Jay Leno. So we can't have any situation where Jay Leno will still get a hundred cars and then we get two cars or three cars or anything for everyone else at this point. The best that can happen without screwing over Jay Leno is that everyone else gets zero cars. So although that's efficient we would say that that's not equitable.


So that's efficient but it's not equitable it's not fair and the reason is people would say "Hey, wait a minute why does Jay Leno need a hundred cars, I know he has a big garage but so why does he need all a hundred cars, what about everybody else?" and so you might say "Hey, let's get the government here to come in and force Jay Leno to transfer some of his resources, we'd really like to be at point Z". We say that would be efficient in production too but as part of the transfer we end up somewhere inside the PPF at point X.


So at point X, this is inefficient in production, and why? The reason is that we're wasting some resources, for example, we try to transfer six cars that we have the government says "Hey, look we will give Jay Leno ninety-four and everyone else is gonna get six." but then maybe throughout that process everyone else ends up getting four cars or five cars and it's sometimes referred to as the leaky bucket. It's an issue with government transfers and the reason is that when you do this transfer you change people's incentives. If we can think about this in terms of income, for example, in the number of hours people are working and think about it in terms of income instead of cars. 

When you transfer some income from someone who's wealthy to someone who's not as wealthy you've given the person who's wealthy less of an incentive to work. I'm not saying they're not going to continue working or something like that but you've changed their incentives as you transfer resources from somebody you change their incentives. So that's why we say the taxes are distortionary unless there is a lump sum tax most taxes are distortionary and that they change people's incentives. The people who are having their income transferred away or the cars transferred away have now got a strong incentive to work and then the people who are receiving the transfer have less of an incentive to work.


Now that's not to say that we shouldn't have any transfers, it's not saying just because of this incentive problem that we're not going to have any transfers and we're just going to let jay leno have all 100 cars. So this really gets into the heart of public sector microeconomics is this idea of there's an equity efficiency trade-off. What we're saying here is it's not fair for Jay Leno to have 100 cars, we know that but how many cars are we supposed to transfer? What will the loss be, how will it change people's incentives? What's the best way to achieve this? Do we want to try and transfer 50 cars? if so, what is going to happen how much equity do we need? Do we want where everybody has the exact same number of cars? Some people say that's too extreme now we're getting into communism or socialism so this is a trade-off that you should be aware of.

Now there are a couple ways that you can think about it. So some people will say instead of thinking about this transfer business what we need to think about is how can we grow the pie. If we think about it as a pie with different slices and you've got different slices one way of thinking about it is, there some way I can make this pie even larger. 


So here with our PPF, we're just assuming that the technology is fixed but that's just in the short run, in the long run, technology is not fixed. We can make it we can come up with new technology and stuff like that. So if we make the pie larger then we might have a situation where Jay Leno is able to have a hundred and fifty cars and everyone else gets fifty wouldn't that be great? That's kind of a win-win situation. It's still kind of inequitable and that is why does Jay Leno needs so many cars but we've helped both groups in the long run. So some people say look we need to grow the pie if we can't if we can grow the pie then everybody is better off and other people would say look that that's a nice theory but we might have difficulties growing the pie. So we need to re reallocate or figure out a different way so that we don't have all of the parts of the pie is going to Jay Leno and then we have the small part is for everybody. So we might say to reallocate it we need to change the way, we need to do some transfers so again once you do that you change people's incentives and you get to where you might be at an inefficient allocation and so that's the heart of the crux of this equity and inefficiency trade-off.