Insights
This blog is the eighth in our series on the key concepts to consider when thinking about local economic growth policies. We’re using the series to test-drive a way of explaining concepts in economic growth that we hope to use in new training and resources. We are keen to hear from readers, particularly those in local and central government, about whether they find these useful and accessible, and if there are other topics you would like to see us cover.
What are efficiency and equity?
Economists often talk about two reasons – efficiency and equity – why policymakers might want to intervene in the economy.
Economic efficiency is about making the most of scarce resources. For example, a car manufacturer is efficient if it produces cars at the lowest possible cost (subject to the available technologies and the prices it faces for inputs, wages for workers, etc). This is idea of efficiency is closely related to productivity as discussed in our third blog in this series. But economists also use the term efficiency in a broader sense to apply to the way in which whole markets, or even economies, operate.
Economic efficiency is about making the most of scarce resources. For example, a car manufacturer is efficient if it produces cars at the lowest possible cost.
When economists talk about equity they are concerned about fairness. As with efficiency, ideas about equity can apply in different ways – equity might relate to access to goods (for example, housing or education) or to the way in which income is allocated across individuals.
As with broader societal debates, there can be lots of different ways of defining equitable outcomes (for example, should we focus on equality of opportunity or equality of outcomes). Economists will often try to formalise different equality concepts by constructing a ‘social welfare function’ which thinks about how society as a whole values different economic outcomes.
Assessing whether an outcome is equitable involves more value judgement than assessing whether it is efficient. For this reason, economists will sometimes distinguish between ‘positive analysis’ – which describes outcomes but takes no view on their desirability – from normative analysis – which makes a value judgement.
Why do we need to think about efficiency and equity?
While all this may sound a little dry, the distinction between equity and efficiency is an important one for thinking through what justifies policy interventions.
As we discussed in our recent blog there are lots of reasons why markets might fail to deliver efficient outcomes (indeed, market failures are defined as things that stop markets from working efficiently). For example, when firms weigh the benefits and costs of training their workers, the benefits are reduced by the risk that newly trained workers may move to another firm. From the perspective of the wider economy, firms tend to underinvest in training as firms’ private benefits are smaller than the social benefit. Similarly, from the point of view of society as a whole, firms will underinvest in innovation when other firms can benefit from their ideas.
Equity considerations provide another justification for policy. For example, the housing market may be working efficiently – by assigning housing on the basis of demand from households – but we might feel that the outcome is unequitable – because some poorer households end up with living in crowded, low quality housing.
Similarly, the labour market may be working efficiently – by assigning workers to jobs based on their skills and the demand for those skills from firms – but we might feel that the outcome is unequitable because some workers whose skills are ubiquitous, but not in high demand, can end up with low wages.
What to consider when thinking about efficiency and equity?
Thinking about efficiency and equity can help think about what kind of policy intervention might be needed. For example, when the problem is one of inefficiency due to market failure, policy will generally want to try to fix the market failure, so we make the most of scarce resources. In the previous example of training, policy might provide a subsidy to firms to help cover the cost. This would increase training overall and make more efficient use of the labour force.
Thinking about efficiency and equity can help think about what kind of policy intervention might be needed.
In contrast, when the problem is one of equity but the market is working efficiently, we might want to leave the market as it is and instead seek ways to redistribute across different individuals. For example, if we are worried about housing affordability, we might provide housing benefit to some households – to increase the amount of housing they can afford – but leave the market to allocate housing.
Sometimes, however, we might feel that an outcome is inequitable and that the market is working inefficiently. For example, we might think it’s unfair that some families can’t afford enough housing (equity). But the problem may result from a market failure which results in developers undersupplying smaller houses (inefficiency in the housing market).
Sometimes an outcome can be inequitable but efficient. For example, the clustering of R&D around the golden triangle of Cambridge, Oxford and London results in lots of innovation, and higher national output.
Finally, it’s important to recognise that there may often be a trade-off between efficiency and equity. For example, it is often felt that spatial disparities are inequitable especially if similar people living in different parts of a country have different incomes. Such outcomes may also be inefficient – if a more equal spread of opportunities generated higher national output.
But sometimes, an outcome can be inequitable but efficient. For example, the clustering of R&D around the golden triangle of Cambridge, Oxford and London results in lots of innovation, and higher national output. This means government faces a tricky trade-off. Should they intervene in the market – for example by spreading R&D around – even if this lowers national output or should they instead let the market work but redistribute – for example, through a progressive income tax system and financial transfers between regions?
While it can be tricky to figure out whether equity or efficiency considerations justify a policy intervention, understanding the concepts can provide a useful way of thinking about “should government intervene?” and helps to plan better interventions.
How can I learn more?
- In this blog, the Institute for Fiscal Studies considers some of the efficiency and equity arguments for the Educational Maintenance Allowance.
- In this article, economists reflect on increasing gender equality over the last 50 years and set out how policies could help tackle the remaining gaps, with both equity and efficiency benefits.
- The IFS Deaton Review aims to understand how inequalities arise, which ones matter, why they matter, and how they should be addressed.
Up next
The next blog in our understanding key concepts in local economic growth series will be on multipliers. Sign up to our newsletter to get an update on our next blogs, briefings and events.
