Equity or efficiency?

As I have discussed before, two important concepts in economic theory are equity and efficiency.

By efficiency, economists normally mean a situation in which nobody can be made better off without making someone else worse off. (This is called “Pareto efficiency”. For more, see here.)

Equity, however, is about fairness. What is an appropriate distribution of income within a society? How big should the differences be between those at the top and those at the bottom?

There are no simple answers. People have different opinions, and in a democracy it is the job of politics to collect these opinions and produce an outcome that society feels broadly happy with, for example, via taxation and benefit policies.

The main argument against government interference with the distribution of income to make it fairer is that it might make an economy less efficient in the sense that most non-economists use the word (producing less or producing at a higher cost). Higher taxes, it is said, reduce the incentives for people to work and be innovative.

Let’s consider another possible efficiency/equity conflict. Imagine that a company has 10 workers and it needs to cut costs (and production) by 10 per cent. What is more efficient — reducing everyone’s working hours and pay by 10 per cent or firing one person?

Most people would agree that the first option is more equitable. But I would argue that it is also more efficient operationally. There are two reasons for this. First, the skills, experience and competence of all employees have been retained (assuming that they are all competent).

Second, this solution is more flexible, something we are constantly told that firms need to be. Because everyone has been retained, they can relatively easily work extra hours to fill the gap if one of the employees is ill, on holiday or unable to work for any other reason. There is no need to go through the time-consuming process of finding replacements.

Equity and efficiency (in all senses) are certainly in conflict sometimes. For example, an economy in which everyone is paid the same, regardless of their performance, is unlikely to be very productive. But often, efficiency and equity go hand in hand. That may not fit in with standard economic theory. But, as with so many issues, that doesn’t mean it is untrue.