Kartik B. Athreya

English

Research Papers in Economics

44 Region Focus • Fall 2009
H
ow do you judge whether the outcomes delivered
by a market or another economic system are good
or bad? One concept that economists use is Pareto
efficiency. To understand Pareto efficiency, it is useful to
first define a Pareto improvement. APareto improvement
is a change in outcomes that leaves no one worse off and
at least some better off. APareto efficient allocation, then,
is simply one from which there are no Pareto improve-
ments: To make someone better off, you would have to
hurt another. Similarly, a Pareto inefficient outcome is one
where Pareto improvements can be made.
Yet, some object to using Pareto efficiency as a guide
for policymaking, in part because it does not place clear
limits on inequality. And, in fact, there are many reasons
why you might generally prefer a more even distribution 
of resources. First, and perhaps most obvious, inequality
might strike you as ethically wrong. No person should be
able to live off his riches while others have to labor long
hours in difficult conditions just to get by, you might argue.
Another objection involves social stability. You might
claim that a society with considerable income inequality is
unlikely to avoid internal conflict over the long run. In
both cases, you might say that to reduce inequality you
would be willing to give up a little efficiency. 
In this column, I will suggest that efficiency is still a
useful guidepost for economists and policymakers. First,
inefficient outcomes are by definition unambiguously
wasteful. Two or more parties could be made better off
without hurting anyone else. Second, there are good 
reasons to believe that a substantial portion of observed
inequality stems from inefficient trading arrangements.
Therefore, improvements in the efficiency of markets —
particularly those markets that help people insure against
certain types of risks such as poor health or other events
that may be difficult to foresee — would likely lower
inequality and make all better off. As a result, there 
are important classes of situations in which there is no
inherent trade-off between equity and efficiency. Third,
over the long run inefficiency is the single biggest source
of inequality. The most profound sort of inequality today
exists between nations. Those countries that have pursued
efficiency-enhancing policies are generally rich and those
that haven’t are not. Thus, trading efficiency for greater
equality is not always as easy as it might seem. 
Inefficiency can cause inequality more locally as well.
Consider a tax on luxury boat purchases, with all revenues
used to fund public expenditures for the poor. On the face
of it, it sounds like if anyone will be hurt by this policy, it
will only be a set of wealthy households who can afford to
pay the taxes. The problem is that such taxes will reduce
the number of luxury boat purchases in lieu of, say, luxury
cruises, or some other activity that is a close substitute.
This means that some boat workers will now have to
search for new employers. And in the event that labor 
and equipment cannot be reallocated seamlessly, 
the consequences are potentially much larger. Therefore, 
inefficiency harms not just the rich, who either pay 
the tax or opt for a less-preferred option, but their 
trading partners as well, most of whom are not rich.
Meanwhile, the revenues — and, hence, resources with
which to make transfers — may not amount to much, since
the demand for luxury items, such as yachts, is sensitive 
to price. 
More generally, concerns about “fairness” or equality
have led to many wasteful interventions — and non-
interventions — in market function. For example, on the
one hand, we often employ inefficient subsidies and forms
of taxation, while on the other hand, we routinely fail to
charge people for congesting roads or emitting carbon
dioxide. Each of these policy choices either creates or
abets inefficiency — and represents a foregone opportu-
nity to make all of us better off. What’s worse, in the 
cases where prices are hamstrung (for example, by rent
controls), inequality may increase. Price-based allocation
may be supplanted with “influence”-based allocation, and
the latter almost by definition will favor the wealthy.
There is a better way. Competitive markets generally
work well. Most of us are routinely able make the pur-
chases and sales we plan on, at prices that we usually are
not surprised by. A central result of economics is that
under ideal conditions the outcome of trade in such 
settings will be efficient. And under realistic conditions, 
it is still likely to deliver a serviceable approximation for
the allocation of many goods and services. This in turn
suggests that we should focus public policy on efforts that
fall into one of three categories: 1) those that remove the
malfunctions in markets that can raise inequality, 2) those
that do not directly alter prices in otherwise well-function-
ing markets, and 3) those that allow most people to gain
from any given Pareto improvement. Efficiency and 
equality are not necessarily at odds; in the pursuit of the
former, society may actually find that it has more of 
the latter.   RF
Kartik Athreya is a senior economist at the Federal Reserve
Bank of Richmond.   
OPINION
Why Efficiency Matters…Even If You Value Equality
BY KARTIK B. ATHREYA
 

Opinion: Why efficiency matters...even if you value equality

http://www.richmondfed.org/publications/research/region_focus/2009/fall/pdf/opinion.pdf

Opinion: Why efficiency matters...even if you value equality

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