Microeconomics Monday-Efficiency vs Equity
- Posted by Jeff Carter
- on February 11th, 2013
Last in the series. The entire series covers my Microeconomics course that I took while getting an MBA at the University of Chicago. Obviously, it’s a lot more in depth in the classroom because I had a great prof-but I had great classmates to interact with.
Today we cover Efficiency vs Equity.
Markets if run right are efficient. That means there is no dead weight loss and everything is allocated correctly. Sometimes though, it means the winner takes all the spoils. Markets don’t care about who wins or who gets what. It’s a system for distribution.
A market is Pareto Efficient if there is no alternative that makes some better off, without making at least one person worse off.
There is a sliding scale in Pareto efficiency over who gets more of the surplus in the market. The best policies create marketplaces that have the potential to create more value. The pie gets bigger. Market efficient policies shouldn’t worry about who gets the pie.
Perfectly competitive markets are often Pareto Efficient.
However, there is also equity in the marketplace as well. But sometimes, giving all the resources to one person is Pareto efficient, along with being equitable. JK Rowling demolishing a home to make way for a personal garden was a Pareto efficient transaction.
Property rights were clearly assigned and everyone bargained in good faith. Rowling paid money for the property and the market allocated the resources equitably. On a personal level, I had a home once that my wife and I had spent extensive time and money putting a massive garden in. Virtually every inch of the yard had a bulb, plant or something. When we sold our house, the new owners ripped out most of the garden. It was Pareto Efficient.
Efficiency values the willingness to pay. That willingness depends on two things. The ability to pay because of budget or wealth. It also depends on the utility or intrinsic value to the person paying.
Because all of us have our own budgets/wealth and version of what’s important to us-we all have our own personal markets. I might think its nuts to spend $200k on a sports car, but you might get great enjoyment out of it. Even when we interact in the same market, buying groceries for example, we all enter with different budgets and goals to buy what’s important to us.
As long as the marketplace is free of subsidy, tax, regulation and other artificial inputs, the market will be efficient and often times Pareto efficient.
Understanding and internalizing the concept of Pareto efficiency is a core concept of microeconomics. It’s one of the splits between Keynesians and Classical economists because Keynesians view the world more normatively. Normative economics are rarely if ever Pareto efficient.
Start to analyze the world around you. What policies can you think of that cause economic disruption, even though their original intent wasn’t to cause economic disruption? What policies make economics in society function better?
Everything, every action that you take has a cost/opportunity cost. We started this series by showing that economics/markets exist even when there is no currency. World War Two POWs had a market economy. There is in fact, a marriage market. The trick is to identify what factors are making that market, and how you can adjust your behavior to maximize your utility in that marketplace. Because of costs, sometimes maximizing your utility means not participating at all.
Markets are powerful. Using them and understanding how they work can solve the problems of the world, if we let them.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
Jeffrey Carter is an angel investor and independent trader. He specializes in turning concepts into profits. He co-founded Hyde Park Angels one of the most active angel groups in the United States in April of 2007. He previously served on the Chicago Mercantile Exchange Board of Directors. He has done market commentary for (More...)