Equity-Efficiency Tradeoff

What is the Equity-Efficiency Tradeoff?

The equity-efficiency tradeoff occurs when maximizing the productive efficiency of the market leads to less equitable wealth distribution. In welfare economics, there is said to be a tradeoff between market efficiency and market equity.

An efficient market implying Pareto efficiency refers to the outcome of a set of exchanges between decision-making units in a market, where it would be impossible to modify how the exchanges occurred to make one party better off without making another party decidedly worse off.

Put another way, an efficient market is one that optimizes the production and allocation of resources given existing factors of production. An equitable market means the distribution of goods and services throughout society and the profits received by firms are fair.

What Happens When a Market is Inefficient?

A market operating inefficiently is situationally known as a market failure. Examples of market failure include:

• Market failure as a result of buyer or seller concentration
• Market failure as a result of poor seller or buyer decisions because of insufficient information
• Market failure that occurs from free riders who benefit from, but do not bear the full costs of, market exchanges
• Market failure through an externality

What Happens When a Market is Inequitable?

Inequitable markets can lead to the distribution of a resource that is not distributed normally across the population. Academic research dictates that greater inequity can actually be detrimental to economic growth. If a market is inequitable, market participants would likely not be provided:

• Equal access to income
• Equal access to education
• Equal access to goods and services
• Equal access to housing

How Does Inequality Manifest Itself in the Economy?

Increasing inequality can manifest in three different economic mechanisms – the demand side, the supply side, and the political economy.

Inequality is commonly observed on the demand side through the rich spending a smaller fraction of their income than the poor. It drives a reduction in overall consumer spending, leading to further accumulation of capital for the wealthy.

Inequality is observed on the supply side through credit constraints on education, where poorer students receive a worse education. It is detrimental to long-term economic growth because it leads to further inequitable outcomes. Moreover, the barriers of entry for poorer people to start a business lead to fewer entrepreneurs from underprivileged backgrounds.

The political economy is another common mechanism where inequality manifests itself. Political theory states that too much inequality leads to revolution. Historically, there have been many uprisings that actually led to less income inequality.

What is the Relationship Between Economics and Equity?

Equity stems from normative economics, an ideologically prescriptive field. Normative economics is primarily centered around how things “ought” to be. Many believe that the economy ought to be equitable. Economists concerned with the unequal distribution of economic resources would likely advocate public policy to limit the production efficiency of firms.

How is Inequity Managed?

Inequity is normally addressed through macroeconomic policy. A macroeconomic policy consists of a combination of monetary policy and fiscal policy. The common instruments utilized to manage inequity are:

Income Taxes

Income taxes are imposed on individuals and entities based on their respective taxable income. The tax rate that the entity is subject to depends on if the entity is a person, a business, a partnership, or even a not-for-profit organization. Tax rates are often levied at a flat rate or a progressive rate with tiered taxation.

Welfare Payments

Welfare payments are made by governments to help support members of society to achieve basic human physiological needs like food and shelter. Moreover, welfare can also encompass efforts to provide amenities to improve citizens’ quality of life. Examples can include subsidized education, vocational training, and public housing.

Additional Resources

CFI offers the Capital Markets & Securities Analyst (CMSA®) certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Equitable Relief
• Barriers to Entry
• Social Welfare System
• Economics Interview Questions
• See all economics resources