Trade-Off Between Equity and Efficiency: Meaning & Example

Read First: Concept of Equity & Efficiency

By definition, Economics is the allocation of scarce resources between alternate uses. As per the Macmillan Dictionary of Modern Economics, a trade-off can be defined as a conflict of policy objectives with the result that one objective can be attained only at the cost of moving away from the other.

Meaning of Equity-Efficiency TradeOff

It is argued that there exists a trade-off between equity and efficiency in relation to taxes. If the concern is more about equity, taxes are levied, and tax revenue is redistributed more equitably among individuals, but taxes cause market inefficiencies such as higher prices, lower output, and lower incomes. In contrast, if efficiency is preferred to equity and resultantly, taxes are not imposed, it will surely result in lower prices, higher output, and higher incomes, but there would be greater social inequalities as well since there are no tax revenues to be distributed across society in an equitable manner.

Hence, markets function more efficiently without taxes but tend to be more inequitable, whereas the equitable distribution of income requires the provision of public goods and, hence, tax revenues to be generated since tax revenues are used in providing such goods, but markets tend to be relatively inefficient with taxes.

Equity-Efficiency TradeOff: Explanation

To explain the concept, we shall again assume two individuals, Mr. P and Mr. Q, living in an economy. As we can see in the figure, the utility indices of P and Q are given on the X and Y axes, respectively. B* is the bliss point, showing where the grand utility frontier between P’s and Q’s utility index touches the highest possible social indifference curve (here, we are assuming the society to consist of only two individuals, P and Q).

If initially, the distribution is such that the individual is at a point such as T, A parallel movement along the Y axis towards S will be better, as Q will gain, while P will not lose anything. Similarly, a parallel movement on the X axis towards U will be better, as P will gain, while Q will not lose anything.

But, if we see the societal welfare, S is better than U, as S is on a higher social indifference curve.

Let’s assume that the market mechanism leads the economy to point S, which is on the indifference curve IC3. If society moves further from S to B*, the welfare will increase from IC3 to IC5. In this movement, though society as a whole is gaining, P is better off, while Q is worse off. This movement, therefore, is not Pareto efficient.

Now, an attempt towards redistribution, i.e., compensating Q for its loss, will be an attempt towards equity. This movement towards equity may lead to some loss in efficiency. This shows that in the quest towards equity, efficiency may be compromised.

On the other hand, if the focus of the policymakers is to achieve efficiency only, they will have to accept a distribution which may not be equitable.

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