difference between equity and efficiency

Equity, Equality, Poverty and Efficiency

Learning Objectives

By the end of this lesson you should be able to:

• Define equity, equality, efficiency, absolute poverty, relative poverty, poverty trap, intergenerational equity and social equity.
• Distinguish between equity ↔ equality and equity ↔ efficiency.
• Explain the trade‑off that can arise between equity and efficiency and evaluate policy measures that aim to improve equity with the least possible efficiency loss.
• Apply simple analytical tools (Gini coefficient, Lorenz curve, Pareto and Kaldor‑Hicks efficiency, dead‑weight loss) to assess equity and efficiency.

Key Definitions

• Equity: Fairness or justice in the distribution of income, wealth or public services. It recognises that people have different needs and different abilities to pay.
  • Horizontal equity – equal treatment of persons in similar circumstances (e.g., same tax rate for identical incomes).
  • Vertical equity – unequal treatment of persons in different circumstances, usually meaning that those with a greater ability to pay should contribute more.
  • Intergenerational equity – fairness between present and future generations (relevant for sustainability and development policies).
  • Social equity – broader notion that includes access to education, health, housing and other public services, not just income.
• Equality: Equality of outcomes – the same level of income, wealth or access to services for all individuals, irrespective of need or ability. It does **not** take differing circumstances into account.
• Efficiency:
  • Pareto efficiency – a resource allocation where it is impossible to make anyone better off without making someone else worse off.
  • Kaldor‑Hicks efficiency – an allocation is efficient if those who gain could in theory compensate the losers and still be better off. This is the criterion used when evaluating policy‑induced efficiency losses (e.g., dead‑weight loss).
• Absolute poverty: A condition where individuals lack the resources to meet basic physical needs (food, shelter, clothing). The World Bank defines it as living on less than US $1.90 per day.
• Relative poverty: A condition where individuals have significantly less income than the average in their society, limiting their ability to participate in normal social activities. In the UK, a common benchmark is income below 60 % of median household earnings.
• Poverty trap: A self‑reinforcing cycle in which low income reduces the ability to invest in human capital, health or productive assets, which in turn keeps income low.

Measuring Inequality (Equity)

1. Gini coefficient $$G=\frac{\displaystyle\sum_{i=1}^{n}\sum_{j=1}^{n}|y_i-y_j|}{2n^{2}\bar{y}}$$ where $y_i$ is the income of individual $i$, $n$ the number of individuals and $\bar{y}$ the mean income.
   Interpretation: $G=0$ → perfect equality; $G=1$ → maximal inequality.
   Numerical example (5‑person economy):

   Person	Income ($)
   A	10
   B	20
   C	30
   D	40
   E	100

   Mean income $\bar{y}=40$. Sum of absolute differences $\displaystyle\sum_{i}\sum_{j}|y_i-y_j|=720$. $$G=\frac{720}{2\times5^{2}\times40}=0.36$$ This indicates a moderate degree of inequality.
2. Lorenz curve – a graphical representation of the cumulative share of income earned by cumulative percentages of the population. The area between the line of equality (45°) and the Lorenz curve equals $G/2$.

Measuring Efficiency

• Total surplus = Consumer surplus + Producer surplus. In a perfectly competitive market this is maximised.
• Dead‑weight loss (DWL) – the loss of total surplus caused by a market distortion (tax, subsidy, price control, etc.).
• Kaldor‑Hicks criterion – a policy is considered efficient if the gains to the winners exceed the losses to the losers, even if a compensating transfer does not actually occur.

Equity vs. Equality

Aspect	Equality	Equity
Goal	Same outcomes for everyone	Fair outcomes given differing needs/abilities
Policy focus	Universal provision (e.g., free school meals for all)	Targeted measures (e.g., means‑tested benefits)
Typical metric	Proportion of population receiving a service	Gini, Lorenz, horizontal/vertical equity tests

Equity vs. Efficiency Trade‑off

Policies that improve equity often introduce distortions that reduce efficiency. The relationship can be illustrated by an Equity‑Efficiency Frontier – an inverse curve showing that moving towards greater equity usually entails a loss of efficiency, and vice‑versa.

Poverty‑Related Concepts

• Absolute vs. Relative Poverty – absolute poverty is measured against a fixed standard of basic needs; relative poverty is measured against the prevailing standard of living in a society.
• Poverty trap – low income reduces the ability to invest in education, health or capital, which in turn limits future earnings. The diagram below shows a downward‑sloping investment incentive as income falls.

Policy Instruments and Their Impact on Equity & Efficiency

Policy Instrument	Effect on Equity	Effect on Efficiency	Typical Example
Progressive Income Tax	Improves vertical equity – higher earners pay a larger share of income.	May reduce labour supply and investment, creating a dead‑weight loss (Kaldor‑Hicks loss).	UK income‑tax bands (basic, higher, additional rates).
Universal Basic Income (UBI)	Boosts horizontal equity – every adult receives the same cash grant.	If financed by lump‑sum taxes it is theoretically efficiency‑neutral; financing via distortionary taxes can lower work incentives.	Finland pilot (2017‑2018); proposed UK UBI.
Minimum Wage	Raises earnings of low‑paid workers – vertical equity.	Set above the market‑clearing wage can cause unemployment among low‑skill workers (efficiency loss).	UK National Living Wage (2024).
Subsidised Education & Training	Reduces long‑term inequality by expanding human capital – both horizontal and vertical equity.	Short‑run tax financing creates a small efficiency cost; long‑run productivity gains usually outweigh it.	Free university tuition in several EU states; student‑loan subsidies.
Targeted Transfer (e.g., Child Benefit)	Directly raises the income of low‑income families – improves vertical equity.	Financed by general taxation; efficiency loss depends on marginal tax rates applied to the funded revenue.	UK Child Benefit, US Earned Income Tax Credit (EITC).

Illustrative Example: Taxation and Dead‑Weight Loss

Consider a market with linear demand and supply:

Demand: $Q_D = a - bP\qquad$Supply: $Q_S = c + dP$

A per‑unit tax $t$ shifts the supply curve upward by $t$. The new equilibrium yields:

Price paid by consumers: $P_c = P^{*} + t\frac{d}{b+d}$

Price received by producers: $P_p = P^{*} - t\frac{b}{b+d}$

Quantity falls to $Q^{*} - \Delta Q$, where $\displaystyle\Delta Q = \frac{b d}{b+d}\,t$.

Dead‑weight loss (DWL) is the triangular area between the original and new supply/demand curves:

$$\text{DWL}= \frac{1}{2}\,t\,\Delta Q = \frac{1}{2}\,t\left(\frac{b d}{b+d}\right)t = \frac{b d}{2(b+d)}\,t^{2}$$

This shows that raising revenue for redistribution (equity) creates a loss in total surplus (efficiency) measured by the DWL.

Key Points to Remember

• Equity concerns the fairness of distribution; equality concerns identical outcomes.
• Efficiency concerns the optimal use of scarce resources – no one can be made better off without making someone else worse off (Pareto) and, in policy analysis, we often use the Kaldor‑Hicks criterion.
• Perfect competition delivers efficiency but not necessarily equity.
• Government intervention can improve equity but usually introduces distortions that reduce efficiency.
• The policy challenge is to achieve an acceptable level of equity while minimising the efficiency loss – the “optimal point” on the equity‑efficiency frontier.
• Understanding absolute vs. relative poverty and the poverty trap helps evaluate whether policies address the root causes of inequality.
• Intergenerational and social equity broaden the discussion beyond income to include sustainability and access to public services.

Discussion / Evaluation Questions

1. Explain why a perfectly competitive market is efficient but may produce inequitable outcomes.
2. Using the policy table, evaluate which instrument offers the best equity‑efficiency trade‑off and justify your choice with reference to the underlying economic mechanisms.
3. How can a government design a progressive tax system that minimises efficiency losses? (Consider tax structure, exemptions, and the use of lump‑sum financing.)
4. Distinguish between absolute and relative poverty. Why is it important for policymakers to consider both measures?
5. Describe the poverty trap and suggest one policy that could help families escape it. Explain how the policy affects both equity and efficiency.