The efficiency-equity tradeoff

Abstract

A cliché of introductory economics courses is the trade-off between efficiency and equity. A market economy, it is said, is efficient: national income is maximized as profit-maximizing businesses and utility-maximizing consumers meet in the marketplace. The resulting market equilibrium may, however, be inequitable (unfair), with an excessive gap in income between the rich and poor. Taxing the rich to give money to the poor can then raise equity (fairness) but at the cost of distorting market incentives (such as incentives for hard work) and thereby lowering national income. The proverbial pie is shared more equally but the pie is smaller.