Question

Discuss the trade-off between efficiency and equity that arises when policy makers pursue policies that redistribute income. In your answer define deadweight loss and Pareto Efficiency.

Answer 1

Efficiency refers to the optimum outcome that an economy can reach out of its scarce resources . Equity determines the fairness of distribution of resouces among all the members of the society . One is the size of the economic pie and another is the distribution of the economic pie . Now let us assume an example of reduction of income inequality by progressive taxation on income and redistribution of wealth to the poor . Now if taxes are raised on the comparatively rich or people with higher incomes , that dampens their incentive to work harder . This causes loss of efficiency . But since there is redistribution of wealth we achieve equity . So there is a trade off between the two .

A deadweight loss is an excess burden or allocative inefficiency . It is a loss of economic efficiency that can occur when equilibrium for a good or a service is not achieved . So raising taxes creates a tax burden which causes DW loss . There is a gap between price paid by consumers and price received by producers . This is the DW loss which reduces efficiency . Pareto efficiency refers to the state of allocation from where it is impossible to reallocate so as to make any one individual better off without making at least one individual worse off . The efficiency is defined as pareto optimal outcome . It is impossible to make the poor better off without making the rich worse off in this case .