What is an Equity-Efficiency Tradeoff?

An equity-efficiency tradeoff results when maximizing the productive efficiency of a market leads to a reduction in its equity—as in how equitably its wealth is distributed. Debate around the tradeoff often focuses on addressing growing economic inequality within a country or region where the economy and GDP are growing. The concern for some is that the least affluent members of society receive an disproportionately small share of the increasing wealth. Academic discussion of equity-efficiency revolves in part around whether equity and efficiency are always inversely related or whether they can both rise at once.

Key Takeaways

  • Trading off economic efficiency for broader distribution of wealth is often seen as a desirable societal goal.
  • Some economists see such a tradeoff as inevitable to achieve such equity.
  • Other economists, however, assert evidence that greater equality and greater efficiency can co-exist.

Defining and Measuring Equity

The term "equity" is often normative. That means it is associated with a school of economics that is ideologically prescriptive. Normative economics heavily concerns itself with value judgments and statements of "what ought to be," rather than facts based on cause-and-effect statements. That school lies in contrast to positive economics, which relies on objective data analysis, though it might positively refer to the equality of measurable outcomes.

Those concerned with the unequal distribution of economic resources may advocate public policy to limit productive efficiency. The aim of such advocacy is to generate a more equitable society. In these circumstances, an equity-efficiency tradeoff is either assumed or artificially introduced to a market. Natural-rights theorists, on the other hand, may be more concerned with the equitable access to property and self-ownership. This could create a tradeoff through the use of coercive government policy.

Defining and Measuring Efficiency

The term efficiency ranges in meaning and scope depending in part on the economic sector involved. The term has a distinct meaning in healthcare, for example, that differs from efficiency in financial markets or efficiency ratios for businesses.

In classic analysis of economic welfare, total efficiency is sometimes defined in terms of Pareto optimal allocations. In a theoretical Pareto-efficient market, no exchange of resources can make one person better off without making someone else worse off.

However, many modern economists now disregard Pareto analysis and its zero-sum resolutions. In fact, recent studies from such distinguished bodies as the OECD, IMF, and World Bank have suggested that economic performance and income equality can indeed rise in concert. Based on analysis from multiple countries, these studies conclude that countries with greater income equality tend to have a better economic performance than countries with a lower degree of equality.

A broader and more dynamic definition of economic efficiency, adapted from the process of human-resource coordination, relates not only to the quantity of produced goods and services but also to the discovery of new ends and means. The pioneers of identifying and measuring dynamic efficiency include Joseph Schumpeter and F.A. Hayek. They concluded that it may be objectively impossible to confirm or reject an equity-efficiency tradeoff.

The equity-efficiency tradeoff is often associated with normative economics that emphasizes value judgments and statements of "what ought to be."

The Problem of Distributive Justice

As human societies escape dire poverty, certain individuals or groups tend to gain faster than others. The problem of distributive justice—how groups of individuals best organize and distribute produced goods in a "just" way—is one of the oldest subjects in moral philosophy. Closely related tensions exist between equality and freedom, and between voluntary gains vs. involuntary gains.

A microcosm of this concept exists in modern financial markets, where those who risk the most capital may realize much larger windfalls than the average trader. To some extent, a more efficient and prosperous financial market may promote inequality of distributed gains.