The equity-efficiency trade-off, and whether the government can improve both

Efficiency and equity.

• Efficiency means getting the most out of scarce resources: economics studies how to use limited resources to satisfy as many wants as possible. On a production possibility frontier, an economy producing at a point inside the curve is wasting resources, since capital and labour are not fully and efficiently used, while every point on the curve is an efficient level of production. Efficiency is about the size of the economic cake.
• Equity is about how fairly that cake is shared: how evenly income, wealth and economic well-being are distributed among people, and whether the most needy are helped.

The trade-off. The two goals often pull against each other. One of the principles of economics gives the reason:

• To make the distribution more equal, the government taxes those who are better off, the rich paying a larger share, and uses the money to help the poor.
• This narrows inequality, but it also reduces the reward from working hard, earning more and taking risks. When people respond to that weaker reward, the economy produces less, so efficiency falls.

People respond to incentives, so a policy that changes rewards changes behaviour. Taxes also have a direct cost in efficiency: a tax drives a wedge between what buyers pay and what sellers receive, some trades that both sides would have gained from no longer take place, and the surplus lost on them is a deadweight loss to society. So the more the government redistributes through taxes, the more output it tends to give up. Every benefit has a cost, which is why choosing between equity and efficiency is a trade-off like any other.

Example: a surcharge to fund cash support. Our own example. Suppose the government levies an extra surcharge on high incomes and pays the money out as a monthly allowance to poor households. The allowance makes the distribution of income more equal. But some high earners now find it less worthwhile to take on extra work or start a new business, and fewer of those trades take place, so total output is a little lower than it would otherwise be. Society gains in equity and loses some efficiency.

Can the government improve both at once? Sometimes, yes, though not as a rule. The SOL notes that the government is needed to achieve both efficiency and equality, but also that it cannot always bring about the improvement it wants. Both can improve together where the market itself is leaving resources unused or misallocated:

• Putting idle resources to work. Unemployment is one of the main causes of poverty, and idle labour means the economy is inside its frontier. A public works programme that employs idle rural workers to build useful assets, such as check dams or village roads, raises output (efficiency) and the incomes of the poorest (equity) at once, provided the assets are worth what they cost.
• Supplying public goods the market under-provides. Left to the market, public goods are supplied in an inefficient quantity; the government decides which to provide by checking that their total benefit exceeds their total cost. Spreading access to basic services such as education, sanitation and nutrition also promotes equality of opportunity. A storm-water drainage network for a crowded urban settlement serves every resident at once and no one can be kept from it; if it passes the cost-benefit test, building it improves efficiency, and its benefit goes mainly to poor households.

The limits. These gains hold only where a scheme passes the cost-benefit test. Where markets are already working well and the only aim is to share income differently, redistribution through taxes still carries the deadweight loss described above, and the trade-off returns.

Conclusion. Efficiency concerns the size of total output and equity its fair division; redistribution through taxes usually buys more equity at some cost in efficiency, because it weakens incentives and creates deadweight losses. The government can improve both at the same time only in particular cases, such as employing idle resources or supplying public goods whose benefits exceed their costs, and not as a general rule.