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Govt microeconomic objectives: efficiency, equity

Asked by ichigo | Oct 14, 2007 | A Level > Economics > Revision
ichigo asks:

Please, can somebody explain to me what efficiency and equity are, and why they are objectives of the Government.

etutor answers:

There are several meanings of EFFICIENCY; they all relate to how well an economy allocates its scarce resources to meets the needs and wants of consumers over time. In macro-economic terms, an economy is said to be efficient when it is producing on its production possibility frontier, hence using all available resources.

Static efficiency occurs at a point in time and focuses on how much output can be produced now from a given stock of resources, and whether producers are charging a price to consumers that fairly reflects the cost of the factors used to produce a good or a service. There are two main types of static efficiency:

Allocative Efficiency

Allocative efficiency occurs when the value consumers place on a good (reflected in the price people are willing and able to pay) equals the cost of the resources used up in production. The condition required is that price = marginal cost. Pareto defined allocative efficiency as where no one could be made better off without making someone else at least as worth off. This can be illustrated using a production possibility frontier – all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available.

Productive Efficiency

Productive efficiency refers to a firm's costs of production and can be applied both to the short and long run. It is achieved when the output is produced at minimum average total cost (AC). For example we might consider whether a business is producing close to the low point of its long run average total cost curve. When this happens the firm is exploiting most of the available economies of scale. Productive efficiency exists when producers minimise the wastage of resources in their production processes.

Dynamic Efficiency

Dynamic efficiency occurs over time. It focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available. For example – the opening up of the market for parcel deliveries has had an impact on price and output levels (these are changes in static efficiency). However we have noticed the entry of new suppliers into the market, an increase in the level of capital investment and improvements in the quality and reliability of services in local, regional, national and international parcel deliveries – this represents an improvement in dynamic efficiency.

Social Efficiency

The socially efficient level of output and or consumption occurs when marginal social benefit = marginal social cost. Social benefit is the sum of private benefit and external benefit. Social cost is the sum of private cost and external cost. At this point social economic welfare is maximised. The presence of externalities means that the private optimum level of consumption / production often differs from the social optimum. A private producer not taking into account any negative production externalities would choose to maximise his own profits where private marginal cost = private marginal benefit. This divergence between private and social costs of production can lead to market failure i.e. where negative externalities occur, the good is over-produced and under –priced by the market mechanism.

Technical Efficiency

Technical efficiency is best defined as producing an output at the minimum average cost level of output (where average cost equals marginal cost). Costs are minimised when efficiency and productivity is maximised


Libenstein (1966) pointed to potential cost inefficiencies arising from a lack of effective competition within a market. These are known as X-inefficiencies and are often used as part of the case against pure monopoly. Companies that face little or no real competition often allow their fixed costs of production to rise – for example by running inefficient administration systems and allowing the build up of sizeable expense account systems that bear little relationship to the output / performance of the company’s employees. X-inefficiencies cause an increase in average total costs at each level of output. X-inefficiencies are less likely to occur when a specific market is genuinely contestable – i.e. where the threat of new competition and the presence of actual competition places a pressure on businesses to keep their costs under control and gives them little leeway to exploit monopoly power.

EQUITY is quite a slippery concept in economics. It occurs where income is distributed in a way that is considered to be fair or just, though 'fair' and 'just' are often regarded as very subjective ideas. A wealthy person is likely to favour a much higher degree of income inequality than will a poor individual. Similarly, socialist governments will generally be in favour of a greater redistribution of income from the rich to the poor than will more conservative governments. An equitable distribution of income is NOT the same as an EQUAL distribution.

Efficiency is no guarantee of equity. In particular, allocative efficiency simply provides for an equality between marginal cost and price in each market. It says nothing about the fairness, or equity of the resulting allocation of resources. Poor people will be unable to pay the market price. This is of course why governments redistribute income in the form of benefits via the tax system. This in turn brings up the distinction between HORIZONTAL and VERTICAL equity.

According to the principle of HORIZONTAL equity, people in the same CIRCUMSTANCES should be taxed equally. For example, people earning the same level of income and with the same personal circumstances (e.g. number of children) should pay the same level of income tax. According to the principle of VERTICAL equity, taxes should be 'fairly' apportioned between rich and poor. This raises the problem that a rich person's idea of a fair tax is unlikely to be the same as a poor person's, There is also the benefit principle, which argues that those receiving the greatest benefits from government spending ought to pay the most in taxes. In practice, of course, this principle, if applied, would tend to increase the burden of tax on poorer people (who are the greatest recipients of benefits), and would thus run counter to the principle of vertical equity.

In conclusion, efficiency is straightforward, while equity is not!!

I hope this is helpful.

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