The equity-efficiency trade-off, what’s the point?

Posted by: Matt Nolan on: February 29, 2008

• In: Methodology | Political economy
• 9 Comments

Sorry about the constant methodology talk lately, rauparaha and me have just have methodology on the mind 😉

I wish to focus on a subject that is a little different than the rationality definition that my esteemed colleague has been looking at. I plan to look at the equity-efficiency trade-off.

The trade-off between equity and efficiency is one of the primary lessons of first-year public economics. It takes two concepts and illustrates how they behave in the framework of scarcity – which is where the trade-off comes from. As long as we have scarce resources there will be an efficiency-equity trade-off.

However, digging a little further, we might ask why does equity matter? A potential answer is that people value equity, and thereby it is something that needs to be taken into account (something that was described here). But if we care about equity because individuals value it, then why can’t we just introduce equity into the individuals utility function – then the optimal choice will automatically take into account the trade-off between our original idea of efficiency and equity and the new solution will simply be – ‘efficient’.

Is there a reason why we are so keen to divide efficiency and equity – and what does this tell us about economics?

In the efficiency equity trade-off we are discussing two types of efficiency – productive and allocative. Economists assume that the determination of productive efficiency is exogenous from their models, so this leaves us with allocative efficiency to work on. Allocative efficiency is meet when in the market price=marginal cost. There are a number of factors that make us deviate from this – however looking in a broader public economics sense we are only interested in ‘intervening’ when the cost of solving such deviations is less than the benefit.

If we focus on allocative efficiency solely in technical terms, economists feel as though they are providing an ‘objective’ analysis. By looking only at the allocation of resources and not the inherent value that people may place on certain aspects of it economists can define something as efficient.

Equity is a value-laden concept, it is the determination of what is fair. Although we might discover that the allocation of resources is efficient somewhere, it may not be socially preferable as the allocation is unfair. In some sense this is related to the idea of distributive justice – and can be proxied by way of an externality.

So the idea of equity is normative – ergo why economists ignore it and focus only on the aspects of ‘efficiency’.

However, over time this trade-off has become confused. The idea of externalities and social values has allowed economists to also use the term efficiency when describing the socially optimal solution. This is a problem.

If economists believe that the ‘efficient’ solution is the optimal solution, it can give rise to people ignoring the effects of equity – thereby making an implicit value judgments that the equity impacts are equal to zero. This is of course false.

The economists of yesteryear had a good point when they split up objective measures of efficiency from subjective measures of equity, and it is a point we economist can forget only at our peril.

However, should we continue using our method to only derive efficiency? Can we not provide a framework that looks at both efficiency and equity, but leaves the derivation of parameters (the value judgments) to policy analysts? Sure we only be able to quantify efficiency, but our framework is a lot more powerful than that – I would like to hear your thoughts.

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