What is 'Equity-Efficiency Tradeoff'

An equity-efficiency tradeoff exists whenever activity in a given market simultaneously increases productive efficiency and decreases distributive equity, or vice versa. Explanations for equity-efficiency tradeoffs typically center around transaction costs or other distorting effects of involuntary redistribution within a population, which might prevent actors from reaching their maximum production possibility frontier. Alternatively, advances in production efficiency might incidentally increase circumstantial inequality.

BREAKING DOWN 'Equity-Efficiency Tradeoff'

The equity-efficiency tradeoff commonly refers to economic policy, though there are many different kinds of efficiency and many different interpretations of equity. The treatment of efficiency is distinct in health care, for example, when compared with efficiency in financial markets or efficiency ratios for businesses. Equity is more difficult to define.

Defining and Measuring Equity

The term "equity" is often normative, though it might positively refer to the specific equality of measurable outcomes. Specific academic disciplines, such as welfare economics or utilitarian social justice studies, may arrive at very different or even conflicting understandings of equity.

Those concerned with the unequal distribution of economic resources may advocate public policy to limit productive efficiency, hoping to generate a more equitable outcome. 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 with the efficiency of coercive government policy.

Defining and Measuring Efficiency

In classic welfare economic analysis, total efficiency is sometimes defined in terms of Pareto optimal allocations. In a theoretical Pareto efficient market, no alternative arrangement, via exchanges of resources, could make one person better off without making someone else worse off. However, many modern economists disregard the static conditions of Pareto analysis on the grounds that it creates non-falsifiable predictive statements about how market conditions ought to be, which is necessarily normative.

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, neither of whom thought it was possible to measure a non-static production possibility frontier within this framework. In other words, it may be objectively impossible to confirm or reject an equity-efficiency tradeoff.

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, or between voluntary gains versus 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.

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