Efficiency and Equity

Markets economies tend to be more efficient than centrally planned economies Opens in new window. There are three types of efficiency:

  1. Productive efficiency — When a good or service is produced using the least amount of resources.
  2. Allocative efficiency — When production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.
  3. Dynamic efficiency — Which occurs when new technologies and innovation are adopted over time.
Markets tend to be efficient because they promote competition and facilitate voluntary exchange.

Voluntary exchanges is a situation in which both the buyer and seller of a product are made better off because otherwise the buyer would not have agreed to buy the product or the seller would not have agreed to sell it.

Productive efficiency is achieved when competition between firms in markets forces the firms to produce goods and services using the least amount of resources and therefore at the lowest cost.

Allocative efficiency is achieved when the combination of competition between firms and voluntary exchange between firms and consumers results in firms producing the mix of goods and services that consumers prefer most.

Similarly, competition can lead to dynamic efficiency, as firms seek to adapt their product and use new technologies over time to secure their share of sales in the market.

Competition will force firms to continue producing and selling goods and services as long as the additional benefits to consumers is greater than the additional cost of production.

In this way, the mix of goods and services produced will reflect consumer preferences, achieving consumer sovereignty Opens in new window.

Although markets promote efficiency, they don’t guarantee it. Inefficiency can arise from various sources.

As indicated in the water scarcity post Opens in new window, water is an increasingly scarce resource, which may be overused if government restrictions on water usage and pricing are set at levels that are too low, leading to allocative inefficiency.

Or, if we look at productive efficiency, it may take some time to achieve an efficient outcome. For example, when washing machines were introduced productive efficiency was not achieved instantly. It took several years for firms to discover the lowest-cost method of producing this good.

Governments sometimes reduce efficiency by interfering with voluntary exchange in markets.

For example, many governments limit the imports of some goods from foreign countries.

The production of some goods damages the environment. In this case, government intervention can increase efficiency, because without such intervention firms may ignore the costs of environmental damage, and thereby fail to produce the goods at the lowest possible cost from society’s perspective.

Just because an economic outcome is efficient this does not necessarily mean that society finds it desirable.

Many people prefer economic outcomes that they consider fair or equitable, even if these outcomes are less efficient.

And this brings us to subject of equity.

Equity

Equity is harder to define than efficiency, but it usually involves a “fair” distribution of economic benefits.

Equity refers to the fair distribution of economic benefits between individuals and between societies.

For some people equity involves a more equal distribution of economic benefits than would result from an emphasis on efficiency alone.

For example, some people support taxing people with higher incomes to provide the funds for programs that aid the poor.

Although equity may be increased by reducing the incomes of high-income people and increasing the incomes of the poor, efficiency may be reduced.

People have less incentive to open new businesses, to supply labor and to save if the government takes a significant amount of the income they earn from working or saving.

The result is that fewer goods and services are produced and less saving takes place. As this example illustrates, there is often a trade-off between efficiency and equity.

In this case, the total amount of goods and services produced falls, although the distribution of the income to buy those goods and services is made more equal.

Government policy makers have to confront this trade-off.