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“ Public finance ” course. First term 2010/2011 Instructor Dr. Mo’een Rajab E.mail: moeenrajab@hotmail.com. Palestine University Finance and business college. Chapter Two Efficiency & Equity. Equity versus Efficiency.
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“Public finance” course First term 2010/2011 Instructor Dr. Mo’een Rajab E.mail: moeenrajab@hotmail.com Palestine University Finance and business college
Chapter Two Efficiency & Equity
Equity versus Efficiency • Efficiency is a criterion that is used to evaluate resource allocation. • Many citizens argue that outcomes also should be evaluated in terms of equity, that is, in terms of the perceived fairness of an outcome. • The problem involved with applying criteria of equity is that persons differ in their ideas about fairness.
Economists usually confine their analyses of questions of equity to determinations of the impact of alternative policies on the distribution of well-being among citizens. • For example, many people are concerned about the impact of government policies on such groups as the poor, the aged, or children.
Positive economic analysis of the out-comes of market and political interaction is useful in providing information about the effects of policies on income distribution.
In the field of public finance, analysts usually try to determine the effects of government actions on both resource allocation and the distribution of well-being.
Thus providing useful information that citizens can use to judge the equity of alternative policies in terms of their own notions of fairness.
The Trade-Off between Efficiency and Equity: A Graphic Analysis • The trade-off between improvements in efficiency and changes in the distribution of welfare can be illustrated with a utility-possibility curve. • This curve gives the maximum attainable level of well-being (or utility) for anyone individual, given the utility level of other individuals in the economy, their tastes, resource availability, and technology.
The next figure gives us all the efficient combinations of well-being between two individuals, A and B, per year as following.
A Utility_Possibility Curve: UA E1 Z ● UA2 ْX E2 UA1 ● Annual Well-Being of A E3 ● UB1 UB2 UB Annual Well-Being of B
Points on the Utility-Possibility Curve give the maximum level of well-being for any one person, A, given the level of well being of any other person, B. points E1, E2 and E3 are all efficient.
Point Z is unattainable, But point X is inefficient . • However, a movement from X to E3 will be opposed by A, because it would make him, or her worse off.
It is impossible to increase…… • If, for example, resources are allocated in such a way that the distribution of well-being between A and B is given at point E1 then E1 is efficient because, at that point, it is impossible to increase either A or B's utility without reducing the other's.
Similarly, E2 is also an efficient point. Points E1 and E2 differ in the distribution of well-being between A and B over a given period such as a year. • Both, however, are efficient. • Points above the utility frontier, such as Z, are unattainable.
What are the given available? • Given available are resources and technology, the economy is simply incapable of producing enough goods and services to achieve the combinations of well-being, represented by points outside the frontier.
Points within the frontier are inefficient in the sense, that it is possible to reallocate resources to improve one person's well-being, without hurting another's.
The case of increasing the Utility of A & B: • At point X there would be incentives for either A or B to increase their individual utility. by attempting to change resource allocation so as to arrive at some point on the section of the frontier E1E2.
"Whichever one makes the attempt, the other will not oppose it because that person would not be made worse off as a result of the change.
The only reason for a move from X to a point on E1E2 might be opposed would be if one individual were ill-informed about the impact of such a move. • Suppose, however, that B wants to move to point E3.This will be opposed by A because that move would reduce A's well-being.
A move from an inefficient resource allocation, such as that represented by point X, to an efficient one, represented by E3, results in losses to certain groups. • The movement from X to E3 will make B better off at the expense of making A worse off.
The improvements in efficiency: • Those improvements in efficiency represented by the movement from point X to point E3 are vigorously opposed. • Often the losing groups are effectively organized and work tirelessly through political institutions to block the change.
It is no surprise that the policy recommendations of many normative economists for elimination of minimum-wage laws and international trade restrictions, on grounds that such elimination would improve efficiency, are continuously defeated in the political arena.
These restrictions provide significant benefits to certain groups that prefer to resist losses in income.
The protection of gainers & Losers: To understand why inefficient government policies and functions persist • It is necessary to investigate the opportunities that exist for both gainers and losers to protect their interests through political action.
