Efficiency and equity of a market economy
Jacob Lundberg
Efficiency and equity of a market economy
”Market economies may be efficient, but they are inherently inequitable and there is
little a government can do to change this.” Discuss.
A central issue in economics is how much, if at all, the government should intervene in the
markets through taxes, subsidies, regulations and prohibitions. The answer depends on the
magnitude of efficiency losses from deviation from free markets, the degree of inequality in a
market economy, the moral judgement of these and the state’s competence and ability to intervene.
The first theorem of welfare economics states that an equilibrium on a competitive market is
always Pareto efficient. This means that no person can be made better off without making
somebody else worse off. It is true under some fairly strict assumptions: perfect (and thus
symmetric) information, rational agents, no transaction costs and convex preferences and production functions. If these conditions are fulfilled, there is no way a government could intervene to make the economy work more efficiently. Any attempt by the government to make
some person better off would make somebody else equally or more worse off. Of course, it
follows that if any of the conditions are not fulfilled, a market failure may occur, thus justifying government intervention.
Critics of this neo-classical view (for example the Austrian School; see Cordato 1980) claim
that it is static, not considering that profit-seeking entrepreneurs may alter the way the market
works. An example is television, which seems like a pure public good that would not be provided at all on a free market. But of course, the market has come up with ways of dealing with
this through commercials, subscription cable television and television funded from donations.
Another example is when cattle owners in the western United States established property
rights and thus eliminated the tragedy of the commons. (Anderson & Leal 1997)
A more pragmatic approach towards market failure than the Austrian denial of its existence is
the one taken by David Friedman (2008). His position is that market failures exist and cause
inefficiencies, but that government failures are worse and more frequent, because of e.g. information costs in the democratic system.
“Economic freedom” and GDP per capita in the countries of the world
Adopted from Gwartney & Lawson (2008), p. 18.
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Efficiency and equity of a market economy
Jacob Lundberg
Empirical data from “Economic Freedom of the World” (Gwartney & Lawson 2008), an index of government intervention produced by a network of pro-market think-tanks, shows a
high degree of correlation between GDP per capita and laissez-faire economic policies. It also
shows that the quarter of countries with the least economic freedom grew the least, and that
the other three quarters experienced a similar growth rate, despite the fact that the middle 50
percent is significantly poorer than the freest quarter of countries and should enjoy catch-up
effects (see diagram).
That markets, at least under certain conditions, produce efficient outcomes is fairly uncontroversial. The other justification for government intervention – equity – is more hotly debated.
An important feature of market transactions is that they are, by definition, mutually voluntary.
As Robert Nozick (1974) notes, if we consider a distribution A legitimate, we would normally
consider another distribution B legitimate as well if it occurred through voluntary exchanges
from the first distribution. If, for example, wealth was distributed equally among the population, but many people subsequently chose to pay one person for a service – in Nozick’s example, a basketball game – it is hard to see any reason for not considering the new, unequal, distribution just. The second theorem of welfare economics also tells us that B is Pareto efficient
if all exchange opportunities have been exhausted.
In 2005, the Swedish capital stock
depreciated at a rate of 7 percent per
year, and net growth was 3 percent.
This means that by 2030, 90 percent
of all capital will have been produced
Swedish capital stock
30
25
Trillion SEK
It has been argued that today’s wealth
distribution comes from historical
wealth distributions which were
largely the result of oppression and
theft. Since yesterday’s wealth distribution was not legitimate, neither is
today’s, argues for example Carson
(2008). On the other hand, capital
depreciates quickly, and as the following calculation will show, most
capital has been created fairly recently.
20
15
10
5
0
2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055
2005 capital stock
Post-2005 cumulative investment
Projection based on Statistics Sweden (2008).
after 2005. After 50 years, only one
percent of the capital stock will have
its origin before 2005. (Statistics Sweden 2008) Of course, capital yields income which may
be invested, but it may also be consumed and on average, only about one fourth of income is
saved. In the long run, the bulk of the capital stock will have come from invested labour income – provided labour and capital income are saved to the same degree. Seen from this point
of view, today’s wealth distribution can be seen as legitimate.
The second theorem of welfare economics states that by changing the starting position of
market actors, any desired Pareto efficient outcome can be attained. This means that the government can redistribute resources without causing market inefficiencies through distorted
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Efficiency and equity of a market economy
Jacob Lundberg
incentives by making lump-sum payments. Identifying appropriate lump-sum redistributions
may be difficult, though.
A controversial issue is that of biological differences between humans. If everyone was born
as “blank slates”, most deviations from average income could be explained by individual
choices to e.g. get an education. But if it is not – which seems likely (Pinker 2002) – inequality arises as a consequence of differences in genes. In theory, the government could tax those
who seem to have an unfair advantage from their genes, but this procedure faces serious practical and moral problems.
Similarly, if one believes that women or non-Europeans are structurally discriminated, it
makes sense to advocate a lump-sum tax on men – as Swedish feminists have – or white people. This would level the playing field without changing incentives and thus making the market work less efficiently.
Another justification for redistribution may be risk aversion – people could get compensation
if they get financial difficulties because of bad luck. Depending on how risk averse the population is, the gains from lower risk may outweigh the efficiency losses caused by the taxation
necessary for such a programme. Such policies risk causing moral hazard problems, though,
and it may prove difficult to distinguish what has been caused by bad luck from what has been
caused by choice.
The normal assumption in economics is that people only seek to maximize their own allocation of goods, being “weakly” indifferent to other people’s situation. This is obviously not an
accurate image of reality. Many find it in their self-interest to give money to charity. This
constitutes a free-rider problem since a person who e.g. does not like to see beggars can benefit from other people donating money to this cause without contributing herself. It can be argued that taxation would solve this problem.
Even if government interventions improving equity at a low dead-weight cost could be identified, it is not obvious that the political system would be capable of implementing them. Today’s politicians seem to wish to pose as Rawlsian (1971) redistributors to the very poorest,
but we see that most actions of rich-country welfare states, e.g. rent regulation and subsidised
higher education or culture, benefit the middle-class – which make up the bulk of the electorate – while immigration from developing countries is severely restricted and international aid
at a very low level compared to what would be needed for total income equality. Moreover,
research in the public choice field has highlighted information imperfections in the political
system which give disproportionate power to special interests, suggesting that democracy is
not even capable of producing a best outcome for the majority, let alone for the poorest.
In sum, both theory and empirical data suggest that government attempts to increase equity
come with a price tag, if not lump-sum redistributions can be carried out – but it seems difficult to find justifiable lump-sum redistributions. Risk aversion may justify a redistribution
programme on an economic basis, as may the free-rider problem posed by people’s willingness to give money to charity. On the other hand, the political sector is hardly perfectly functioning and its ability to deliver the desired results can be questioned.
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Efficiency and equity of a market economy
Jacob Lundberg
Literature
Anderson, Terry L. & Leal, Donald R. (1997), Marknadsliberal miljöhushållning [Free Market Environmentalism] (Stockholm: Timbro), ISBN 9-175-66343-0
Carson, Kevin (2008), “The Subsidy of History”, The Freeman, June, 58 (5)
Cordato, Roy E. (1980), “The Austrian Theory of Efficiency and the Role of Government”,
Journal of Libertarian Studies, autumn, 4 (4)
<http://www.mises.org/journals/jls/4_4/4_4_6.pdf>
Friedman, David D. (2008), “Market Failure: The Case For and Against Government”, lecture
24 October in Balliol College, Oxford <http://oxlib.blogspot.com/2008/11/video-of-davidfriedmans-talk.html>
Gwartney, James & Lawson, Robert (2008), Economic Freedom of the World: 2008 Annual
Report (Vancouver: Economic Freedom Network)
<http://www.freetheworld.com/2008/EconomicFreedomoftheWorld2008.pdf>
Nozick, Robert (1974), Anarchy, State, and Utopia (Oxford: Basil Blackwell), ISBN 0-63115680-1
Pinker, Steven (2002), The Blank Slate: The Modern Denial of Human Nature (London: Allen
Lane), ISBN 0-713-99256-5
Rawls, John (1971), A Theory of Justice (Cambridge, Mass.: Harvard University Press), ISBN
0-674-88010-2
Statistics Sweden (2008), ”Detailed annual national accounts 1993–2006”
<http://www.scb.se/statistik/NR/NR0102/2008A06C/
Nationalräkenskaper_detaljerade_årsberäkningar_1993-2006.xls>
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