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Efficiency and Equity

Many often fall into the trap of false dichotomies. One such false choice is between efficiency and equity in the economy, when we can actually have both.

Written by johnleemk on 12:20:56 pm Feb 27, 2007.

What is the purpose of an economy? To serve society. How is society best served? In economics, there are two goals: efficiency, and equity.

I was reminded of this not too long ago, when I visited the Malaysian Democratic Action Party's website, and pleasantly realised that the party appeared to understand this distinction. It had issued a press release, stating that the free market exists for reasons of efficiency, and that the government provides public goods and services for reasons of equity. It's a very good understanding of the problem — and one that not many people seem to share.

A common trap people fall into is assuming that efficiency and equity are two mutually opposing goals — that you really can have only one or the other. The result is usually total chaos.

On the one hand, you have capitalists trumpeting the efficiencies of the free market. Oh, yes, people suffer due to its attendant inequities, they might say, but it's an acceptable price to pay for efficiency.

On the other hand, you have socialists and communists insisting that although the market may be efficient, its inequities are a too great price to pay. These people insist that it doesn't hurt to have a less efficient economy, as long as inequities are addressed.

These differences of opinion were pithily summed up by Winston Churchill as: "The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of misery."

A slightly more outmoded form of thought would be one that assumes in a communist economy, efficiency and equity are not mutually inconsistent. This viewpoint is demonstrably false, because most people lack the sense to see that it hurts them in the long term to be selfish and greedy.

It is this that really brought about the failure of communism. Communists complain that there has never been a "true" communist state — but they rarely consider that the reason there has never been a "true" communistic nation is because it's impossible to reconcile our short term view of things with the long term benefit.

Today, of course, we rarely stumble across this issues expressed in an explicit form, because communism has been so effectively defeated as an ideology. Even countries with socialised healthcare and education systems like Australia and Canada are relatively pro-business, making it easy to start a new firm and generally ensuring the market is relatively free to operate.

Nevertheless, there are people who do still fall into that trap of assuming we have to choose between efficiency and equity in the modern day amalgamation of capitalism and socialism. It's a false choice, plain and simple.

One example I particularly like is that of free trade. The most common objection to free trade is not that it is inefficient, but that it is inequitable. It is almost impossible to argue that trade is inefficient, unless you are using the "infant industries" argument — and even this argument recognises that at some point or another, the competition brought about by trade will be necessary for efficiency.

When people talk of the ill consequences of trade, they talk about the laid off unemployed and the failed businesses. They argue that these short-term inequities do not justify the long-term efficiencies of the free market.

The traditional capitalist response would be "So what? You are already getting the benefits of low prices and thus greater efficiency from day one." However, this response ignores the very real plight of the unemployed.

Furthermore, both sides tend to overlook the inefficiencies involved when labour is not employed. The failed firms are rarely a problem, because their bankruptcy just frees up capital to enter competitive industries. Labour is nowhere near such a fluid factor of production, however.

Of course, as I have noted before, one could even cast the resulting short-term poverty as an externality. This externality results because even though the son of an unemployed farmer has nothing to do with the reasons for his father's unemployment, when his father cannot pay for his education, it is he that will suffer.

A greater point constantly missed, though, by opponents of free trade, is that this is not an all-or-nothing proposition. We can have both efficiency and equity.

The key to this is government subsidisation of retraining for the unemployed, and making capital more widely available. Capital is often the greatest bar to entrepreneurship, and when you have so many potential entrepreneurs (as is the case when many people are unemployed), it makes sense to provide capital to them. Meanwhile, those not willing to strike out on their own should be able to be retrained for newer industries that the trade has brought in.

When discussing economic issues — and really, any issue at all — we must always be careful to avoid false dichotomies. We do not need to choose between efficiency and equity. We can have both.