4) In the modern industrial economies, economic efficiency seems to have been bought at the cost of

increased inequality. Conversely, economies which have sought equity in distribution appear to have
sacrificed efficiency. Do efficiency and equity necessarily conflict in an economic system? Isnt it
possible to have the best of both worlds?
In this essay I am going to explore whether an economy can be equitable without sacrificing
efficiency or growth. I aim to look at whether or not there has been a trade-off between efficiency
and equity then determine whether inequality has a positive or negative influence on society. Lastly I
want to examine the effects of income redistribution on efficiency. Every nation on the planet
undergoes some form of income redistribution, whether its aimed at raising equality or for some
political gain; people pay taxes and governments spend money across the globe on a daily basis.
In economics, equity is a measure of how close the incomes of the poorest are to those of the
richest in society. In an egalitarian society the gap is relatively small whilst in a more elitist society
the gap is comparatively very large. Economic equality can be measured using a number of different
indices but the most commonly used, and the one Im going to focus on, is the Gini Index. Other
frequently used methods include: the 20:20 Ratio, a comparison between the incomes of the richest
and poorest 20% in society, and the Palma ratio, founded by economist Gabriel Palma, which
compares the richest 10% to the poorest 40% of society. He found the incomes of the middle group
remained nearly constant across the globe and made up approximately half the countrys GDP whilst
the remaining half was shared out very differently between countries.
The diagram below shows a visual representation of the Gini indices of many countries across the
Globe. The information, collected by the World Bank between 1994 and 2011, shows the Gini index
on a scale of zero to one hundred with zero being perfect equality and one hundred representing
total inequality. The green regions are nations whose GDP is distributed relatively evenly, such as
Scandinavia, Germany and Kazakhstan who are some of the most egalitarian regions of the planet. In
Contrast, the red regions are areas where a large amount of the countrys wealth is controlled by a
small social elite. South Africa, Colombia and Bolivia are all nations that fall into this category.

Efficiency on the other hand is not so easy to define. Efficiency can be split into two different types,
static and dynamic efficiency. Static efficiency is the efficiency of a firm at a given point in time and
can be looked at from both a productive and allocative perspective, whereas dynamic efficiency is a

measure of how efficiency changes over a period of time. For a firm to be dynamically efficient they
must invest and innovate the optimal amount in order to improve production processes and reduce
their long run average cost curves. It is possible for resources to be allocated in a productively
efficient manner while being allocated inefficiently. At the same time a firm that does not invest the
right amount will not dynamically efficient in the long term even if it is both productively and
allocatively efficient at that moment in time.
Productive efficiency is perhaps the simpler of the two types of static efficiency. A firm is considered
productively efficient if its producing at the lowest point on its average cost curve meaning that its
producing the maximum possible output per unit of input. This can be measured with relative ease
by looking at if a firm is able to cut costs anywhere while maintaining the same level of output. If its
operating at its lowest possible cost then the firm is considered productively efficient.
Allocative efficiency is harder to measure as, in order to be allocatively efficient, you have to operate
at the socially optimum level of production so all externalities must be considered. This can be
difficult as it involves placing a monetary value on externalities like pollution, which is in itself very
hard to measure. However if the externality is not internalised into the production decision then
there will be a welfare loss to society due to over or under consumption of the merit or demerit
good.
In this example we are looking at the effects of a
negative externality on society. The social cost
of producing is higher than the private cost to
the firm as production has some form of
negative impact on a third party who is not
involved in the production decision. The firm will
then produce where their private cost is equal to
their private benefit at quantity Q1. This is
higher than the socially optimum Q* and results
in a loss of welfare equal to the shaded area, as
too much is being produced. Positive
externalities in consumption have the reverse
effect. When the social benefit of consumption
is higher than the private benefit, as in the case
of education and healthcare, the good will be under consumed which again results in a welfare loss
to society. Neither of these two situations are allocatively efficient so regulation must occur in order
to reach the social equilibrium.
Now that Ive outlined the different types of efficiency, Im going to look at the extent to which they
are tied to equity in different markets. Since the rise of industrial economies we have seen the
structure of markets change and evolve. Following this change there has been a general divergence
in the incomes of the capital owning elite and the working poor, with the wealth gap today being
higher than ever. I now want to examine whether this inequality was necessary to raise efficiency
and whether its been a hindrance or help to economic growth.
Industrialisation, and the rising economic integration that followed, has paved the way for large
multinationals dominating global markets. Today there are a wide array of multi billion pound
companies whose annual revenues dwarf those of some governments. This has come about because
these firms generally operate at a lower cost than smaller firms due to economies of scale or

innovative production techniques. Over time they expanded and drove out less productively efficient
firms, causing their market share to rise until they came to dominate an industry.
Prior to industrialisation markets were comprised of many small local firms as high transportation
costs prevented trading over large distances. In micro-economics this system resembles that of a
perfectly competitive market, where there are a large number of producers who compete for
consumers. In a perfectly competitive market a firm can only make supernormal profit in the short
run. Over time new firms will see the profit made by the original firm and enter the market which
drives the price downwards. The price will continue to fall until its in line with the average cost
curve where firms are unable to reduce it any more or they would no longer be making a profit. In
many industries this is considered to be the optimal outcome as resources are allocated as efficiently
as possible whilst firms are still operating at the lowest point on their individual cost curves.
During the industrial revolution, the cost of transporting goods fell considerably allowing firms to
operate over much larger distances. In time the most efficient firms grew and took over smaller less
productive firms to form what we might today recognise as monopolies, firms with a majority
market share. The monopoly power enjoyed by these firms allows them to prevent others from
entering the market to compete with them. The monopoly firm will again begin by making
supernormal profit, however unlike in perfect competition, the price wont fall to meet the average
cost as new firms are unable to enter. This means the monopoly can continue making supernormal
profit in the long run and
produce an output that is below
the socially optimum level. In
the diagram the monopoly firm
will produce where marginal
cost is equal to marginal
revenue as this is the profit
maximising output for the firm.
That means the firm will
produce at Qm where the price
charged by the firm is Pm. The
average cost of production is AC
so the firm then makes
supernormal profit
Qm * (Pm-AC).
The important point to note is that although firms today are more productive than ever before, they
are not necessarily allocating resources efficiently. Arguably, this makes them less efficient as they
are not producing where price equals marginal cost, the allocatively efficient level of output. If a
perfectly competitive market is more equitable, as the market share is distributed more evenly, and
also more efficient then efficiency has not been bought at the cost of inequality, but in fact both
have decreased following industrialisation.
In societies where wealth is very unevenly distributed a small number of individuals are in control of
a large portion of the productive potential of the economy. There is little incentive for these already
incredibly rich individuals to remain competitive and diversify. A modern day example is Saudi Arabia
who rely on oil for 90% of their export revenue and oil makes up approximately 80% of government
revenue. This has caused a massive gap in wealth between the rich oil owning individuals and the
rest of society, carrying with it many problems. Today, poor education is one of an abundance of
factors that prevents many Saudi workers from competing for highly skilled jobs. In April 2013, Arab

News estimated that there are approximately 9 million foreign workers in Saudi Arabia, many of
whom are western Europeans and Americans filling highly paid jobs in the oil industry. Here is
another example of a potentially positive correlation between equity and efficiency where a more
equal society provides a greater opportunity for its citizens to thrive.
The article History Lessons: Institutions, Factor Endowments and Path of Development in the New
World presents another compelling argument against highly elitist societies concerning their output
and long term growth. The authors start by comparing the pre-industrial GDP of colonies in North
America to those in South America and the Caribbean. At this time in history, the southern colonies
were viewed far more highly and were far wealthier than their northern counterparts, however
today we can see that the North was far more successful over the centuries to come. The authors
look at a number of traditional explanations for the growth disparity between the two regions, but in
their eyes the commonly used arguments of climate or national institutions fall short. Instead they
conclude that the initial inequality in the colonies had a far greater influence on their later growth,
and then affected how quickly they began to industrialise. The authors suggest that the initial power
held by the social elite provided a strong platform for them to almost institutionalise the inequality,
which occurred as they set up political and then economic systems that favoured themselves. In the
long run this prevented a large portion of the population in southern colonies from fulfilling their
economic potential. As a result, educating and training workers in order to improve their efficiency
began much later. This made workers less productive and now less able to compete on the
international stage which has hindered, and still slows down economic growth in those nations. In
terms of efficiency poorly educated, untrained workers are far less productive than higher skilled
educated ones. Therefore they found there hasnt been a trade-off between equity and efficiency,
but in fact a lack of equity led to inefficiency.
The authors ideas can be applied to a surprising number of nations today but one I want to take a
particularly close look at is South Africa. South Africa offers a strong insight into the relationship
between equity and efficiency as there was a sudden change in social equality whilst other factors
remained unchanged. The economic data is recent and extensive making it relevant to todays
modern globalised economy.
Two decades on from the end of racial segregation and white minority rule, the economy of South
Africa has seen rapid growth becoming the largest economy on the worlds second largest continent.
A report released by investment bank Goldman Sachs back in 2011 quoted the total GDP of South
Africa to be $402 billion, having nearly tripled since its 1996 valuation at $144 billion. This means
over the fifteen year period South Africa averaged an annual growth rate of over 7%, compared to
an average of 3.4% for the previous decade and a half. In contrast, UK GDP rose from $400 billion
(256.7 billion) to $583.1 billion (374.3 billion) over the same period, averaging an annual growth
rate of just over 2.5%. The data hardly presents a conclusive argument over the effects of equality
on growth and efficiency, but it certainly begins to offer some sort of insight into the economic
effects of reducing inequality.
The graph on the next page shows data collected by the South African Reserve Bank. It provides a
clear visual representation of the sudden boost to growth that South Africa experienced following
racial desegregation. The dark line shows the maximum productive potential of the economy at any
particular time whilst its gradient shows the rate at which this boundary is increasing. Data collected
by the South African Reserve Bank supports the idea that making society more equal provided the
basis for raising output. The reason for this sudden rise in growth is the removal of laws that
restricted the productive output of blacks in South Africa. An example of such a law is the 1951
Native Building Workers Act. This act prevented blacks from performing skilled labour whilst in the

employ of whites. As the demand for skilled labour came mainly from wealthy white citizens a large
number of skilled black workers were excluded from the work force. This contributed heavily to the
staggeringly high unemployment rates in black communities during the apartheid, which in turn held
back growth.

The effect of this discrimination mirrors that found in both colonial America and modern day Saudi
Arabia. If a group in society are unable to fulfil their economic potential due to laws or inherent
oppression then they are going to be less efficient. In a market system they are then going to be paid
less as their output is lower, so the inequality between them and the social elite will be higher. This
again leads me to believe that inefficiency comes as a direct result of inequality and that they do not
conflict in an economic system. Worse still, these groups are often caught in a poverty trap, where
their low productive efficiency maintains the inequality, which then prevents them from
accumulating skills needed to become more efficient so the vicious cycle continues.
Although naturally occurring equality within a society seems beneficial to efficiency, it is still possible
that intervention to raise equality may reduce efficiency. A frequently used argument against
taxation is that it shifts production away from the free market equilibrium, with artificially high costs
that create productive inefficiency. If this causes a firm to no longer operate at its lowest possible
cost then improving equality will lower efficiency. Lower incentives to work can also play a part
because if rewards for work and investment are lower, then the economy may become less
productive.
These are all valid arguments against raising equality but for a truly fair evaluation of the effects of
redistribution we must also look at the benefits it brings. This goes back to my earlier point of the
productivity gained from training and educating workers. Taxation and redistribution enables access
to education and healthcare for a large percentage of the population which provide massive,
widespread economic benefits. So with respect to income redistribution, I think there is definitely an
argument to be made concerning the trade-off between equity and efficiency. South Africa saw
major economic benefits from raising social and economic equality but this may not be true for

every nation. There is without doubt a point where raising equality will have a negative effect on
efficiency, where the economy becomes less inclusive and workers are deterred from working rather
than brought into the workforce.
Even though raising equality may not always have a positive effect on efficiency, I do not believe that
raising efficiency must ever be bought at the cost of equality. However in many industrialising
societies inequality seems to have come as a by-product of growth; occurring due to faults in a
capitalist system which places power in the hands of the capital owning elite who are able to exploit
the average worker for personal gains. In such a system it is no wonder that there is inequality but it
is a problem that can be rectified. So to answer the question, I believe it is in fact possible to have
the best of both worlds; for an economy to be equitable and efficient.

References:
Table 2.9 of World Development Indicators: Distribution of income or consumption, The World Bank (1994-2011)
Monopoly Diagram: http://www.economicshelp.org/microessays/markets/monopoly-diagram/
http://www.heritage.org/index/country/saudiarabia
CNN: http://edition.cnn.com/2013/11/27/business/south-africa-since-apartheid/
BBC: http://www.bbc.co.uk/news/world-africa-20138322
Guardian: http://www.theguardian.com/news/datablog/2009/nov/25/gdp-uk-1948-growth-economy
South Africa GDP: http://www.indexmundi.com/facts/south-africa/gdp
Externality Diagram: http://12congwi.wordpress.com/2011/02/09/evaluate-the-measures-that-a-government-mightadapt-to-correct-market-failure-arising-fron-negative-externalities/

Reference Number:
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