Economics: Equity vs. Efficiency

Efficiency and equity are two values that any company or country would be proud to uphold. After all, no one ever says, "Let's do this the hardest way possible" or "How about we give a raise to everyone who is over 6-feet tall." It is absurd to be so blatantly unfair or to encourage inefficiency, but it often happens on accident.

In fact, what is often the most efficient ends up being inequitable and vice versa. Business owners may get caught up in trying to be as efficient as possible in all their proceedings and may not realize that inequity was an unintended consequence. On the other hand, when business owners try to be completely equitable, they miss the mark and end up creating poor efficiency. To make things more complicated, efficiency in the world of economics is a little different than what you might automatically expect since different types of efficiency exist.

Especially in terms of economics, there is actually a big trade-off between efficiency and equity. It seems that it is difficult to have both in equal balance, even though this would be the goal in an ideal world. As a business owner, what can you do to promote equity while also paying attention to efficiency? Consider some definitions and examples of equity vs. efficiency to gain a clearer perspective.

Different types of efficiency exist, but economists like to look at Pareto efficiency, which describes the optimal production and distribution of resources. As a business owner, you are probably used to thinking about efficiency in terms of optimal production, but what is optimal distribution?

First, consider what optimal distribution typically is not: perfectly equitable. The optimal distribution of resources doesn't always meet everyone's wants or needs, but it allocates resources in such a way that, according to the Pareto efficiency model, "no one can be made better or happier without making at least one other party worse off."

Equity means that everyone gets the same amount of resources, even if each person doesn't need or want those resources. For example, let's say that you have $400 to distribute between two people. One of those people (person A) earns $400 in a day, and the other (person B) earns $400 in a week, so they have different ideas of the value of $400.

To be completely equitable, you would split the $400 in half and give each person $200. However, person A would be pretty happy with a gift of $100, and person B was really hoping for $300. Knowing this information, you could redistribute the $400 to make person B happy without causing person A to be worse off or unhappy, thus achieving Pareto efficiency even though the distribution is not equitable. However, if you took too much money from person A to give to person B or vice versa, you would be making at least one person unhappy or worse off, and this would be inefficient.

Pure Pareto efficiency is theoretical and would allow everyone to live at the highest-possible standard of living. Note that this doesn't mean that everyone's highest-possible standard of living is the same. Instead, efficient distribution exists on a curve known as a "production possibilities curve" that pits two different products or resources against each other.

A production possibilities curve has space under the curve, space above the curve and points on the curve. Any scenario that falls below the curve is inefficient, whereas any scenario that falls above the curve is impossible. Scenarios that fall exactly on the curve are efficient.

For example, if you run a cafe and are able to produce and distribute 15 sandwiches and 30 bowls of soup in an hour when you are most efficient, producing 20 sandwiches and 30 bowls of soup is impossible. However, producing five sandwiches and 30 bowls of soup is inefficient because you are capable of making more sandwiches. In fact, you can make 20 sandwiches in an hour but only if you simultaneously make fewer bowls of soup.

This model can be applied to efficient distribution as well if we put the population on the graph instead of different goods or services. On one extreme, we could give all of our resources to one person, which could be on the Y axis. The other extreme would be to distribute all of our resources to everyone else, which could be the X axis. Obviously, one person hoarding all the resources is not fair to the rest of the population, but what is a way to compromise and efficiently distribute resources so that most people have what they need?

The answer lies on the production possibilities curve, but it is difficult to put this theory into practice since real-world variables change all the time. Plus, there are many factors to consider, such as the relative wealth of the people involved. It is certainly not fair to distribute most of the resources to the wealthiest population, is it?

Tax brackets are a great example of equity vs. efficiency in action and demonstrate how these issues are hardly black and white. It might seem efficient and equitable to ask everyone to pay the same tax percentage, but is it fair to ask someone who makes $30,000 per year and someone who makes $3,000,000 per year to pay the same tax rate of 33%?

The first person would have $20,000 to spend after taxes, which would cause many people to struggle to meet their needs. The second person would still have $2,000,000, which might not be enough to meet his preferred standard of living but certainly would not cause the same struggle as $20,000. Therefore, tax brackets exist to redistribute some of the burden of taxes, taking it off those who earn less and would struggle under higher taxes and distributing it to high earners who can handle it while still meeting their basic needs.

One scenario in which business owners should remain aware of the big trade-off between efficiency and equity is when giving raises. You may have a certain amount of profit from the last year that you plan to redistribute among your employees, and your first instinct may be to make it completely equitable in terms of the dollar amount. However, raises are often given in terms of a percentage of a person's annual income to try to strike a balance between efficiency and equity.

Weigh the pros and cons of equity vs. efficiency when making other financial or strategic decisions that would affect your employees, such as when creating a schedule or deciding on policies for vacation days and sick days. Remember that optimal efficiency is often theoretical. Do your best to make things fair, even if fair doesn't always mean perfectly equitable or perfectly efficient.