Efficiency and equity, and why policy makers must trade one against the other

Efficiency. Resources are scarce and have other uses, so economics asks how to use them to satisfy as many wants as possible. An economy is efficient when it gets the most it can out of what it has. On a production possibility frontier, every point on the curve is an efficient level of production, while a point inside it means labour and capital are not fully and efficiently used. Efficiency is therefore about the size of the total output, the size of the economic cake.

Equity. Equity is about how fairly that output is shared among people: how evenly income, wealth and economic well-being are spread, and whether those most in need are helped. Where some people get so small a share that their survival is at stake, the state may step in to make the distribution more equitable.

How they differ.

Why policy makers face a trade-off. The two goals often pull in opposite directions, so a policy that serves one usually costs something of the other.

• Redistribution weakens incentives. To make incomes more equal, the government taxes the better off, who pay more than others, and helps the poor. This lessens inequality, but it also lowers the reward for working hard, and so efficiency falls. People respond to incentives, so changing the reward changes what they do.
• Taxes waste some gains from trade. A tax opens a gap between the price buyers pay and the price sellers get; some trades that would have benefited both sides no longer happen, and the surplus lost on them is a deadweight loss to society.
• Controlled prices cut the quantity traded. Holding the price of a necessity below its market level makes it affordable to the poor, but sellers then offer less than buyers want, which brings shortages.

Every benefit has a cost, and choosing more equity usually means accepting a smaller cake. The government is needed to pursue both goals, but it cannot always improve on the market; it has to decide how much of one it will give up for the other.

Example: a ceiling on the price of wheat. Our own example. Suppose wheat would sell at ₹30 a kg in a free market and a state caps its price at ₹22 so that poor families can afford it.

• Equity gains: households that get wheat pay ₹8 less a kg. The cap is meant to bring wheat within reach of families who could not afford it at the market price; how far the gain actually reaches them depends on who gets the limited supply, which is why it is usually shared out through ration coupons.
• Efficiency loses: at ₹22 sellers bring less wheat to market than buyers want, so less wheat is traded than at ₹30, and the shortage has to be handled through ration coupons and fair price shops, with queues and a risk of a black market.

The policy buys fairness with a smaller and less smoothly working market, which is the trade-off in miniature.

Conclusion. Efficiency concerns how much is produced from scarce resources and equity how fairly it is divided. Policy makers face a trade-off because the usual tools of fairness, such as taxing the rich to help the poor or holding down prices of necessities, weaken incentives or cut the quantity traded, so more equity is usually bought with some loss of efficiency.