Economic Efficiency and Equity

The two primary criteria used to evaluate systems of resource allocation are economic efficiency and equity.

Economic efficiency occurs when a society obtains the largest possible amount of output from its limited resources. Each country in the world has labor, capital, and natural resources. Countries differ, however, in the sizes of their population (and thus their labor force) and the types and quantities of capital and natural resources. Regardless of its resource endowment, however, a society can produce some maximum quantity of output if it uses its resources wisely. This output is composed of goods and services. A good is a tangible commodity or piece of merchandise that is produced for sale, such as a car, a sweater, or a book. A service is useful labor that does not create a tangible commodity or piece of merchandise. Examples of services are haircuts, financial and legal advice, and many forms of entertainment. To illustrate the difference between goods and services, consider a vacation trip to Walt Disney World in Florida. Admission tickets to theme parks are services because they provide access to the entertainment within the park. Souvenirs, such as stuffed animals, clothing, and jewelry, are goods. Restaurants also illustrate the difference between goods and services. The reason meals cost more in restaurants than when you prepare them at home is that part of the cost of the meal is for the service of having the food prepared for you. A general name for an output is a product. A product is the output of human labor and can be either a good or a service.

Economic efficiency is an important consideration for societies that desire more goods and services. Being efficient with resources allows a society to satisfy more needs and wants than if the resources are allocated inefficiently. Economic efficiency is not the only consideration, however.

Equity occurs if a society distributes its economic resources fairly among its people. Different opinions about fairness, however, cause people to debate how resources should be allocated and are a primary determinant of political affiliation. People who think markets provide a generally fair distribution of output among the population tend to oppose government intervention in the marketplace. This is the position of most traditional conservatives, who usually favor a very limited government role in the economy. People who think markets create an unfair distribution of output tend to favor a larger role for government in the redistribution of wealth. Traditional liberals tend to favor this position.

Some systems of resource allocation may be efficient without being fair. Other systems may be fair without being efficient. Societies choose different types of political and economic systems based in large part on different perceptions and valuations of efficiency and equity.

When a society chooses to have a government, then citizens pay taxes to generate revenue for the provision of government services. Efficiency and equity are also the two primary criteria used to evaluate tax systems. This is discussed in greater detail in Chapter 10 (Fiscal Policy).