When a market is in equilibrium, it is said to be at its most socially efficient point.
This most socially efficient point is called allocative efficiency. At this point, form society’s point of view, the scarce resources have been allocated in the most efficient way. At the equilibrium point, community surplus is maximized. Market equilibrium provides society with the optimal allocation of resources.
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However, there might be an efficient allocation of resources in an economy, but an unfair distribution of wealth. This report will identify the factors that drive allocative efficiency as well as explain the potential policies that can be used to improve end-result equity. Since a market economy cannot provide equal income distribution it means that, if left to the market, a substantial number of the members of society will be unable to earn an income level necessary to meet their basic needs. If this situation is left it would create problems for society. This apart, most people accept that all members of society should be able to meet their basic needs.
As a consequence of this market failure, governments have stepped in to achieve a more equitable distribution of income. A market system might not create an equal distribution but a government can make a market system more equitable. The policies involve an element of redistribution of income i.e.
taking from the richer sections of society and giving it to the poorer sections. Distribution of income refers to how the income of the economy is divided up among the people who live in that economy. ‘Equity’ as a team means ‘fair’ or ‘just’. As a term, it is normative since what is ‘fair’ comes down to an individual opinion. So an ‘equitable’ tax system is one that is considered ‘fair’ to the taxpayers. ‘Equality’ as a term is easier to define in that it means treating people and ideas equally or the same.
For the example in the area of wages, equal pay laws make it illegal to pay men and women doing the same job different wages. Recent laws in the UK have resulted in homosexual couples being treated equally as heterosexual couples in terms of inheritance taxes following the death of one of the partners. In other words, an equal tax system will see all taxpayers treated the same.Equality in the distribution of income means that everyone earns the same income (one of the aims of Central Planning).
Whether this is equitable will depend on one’s viewpoint. If someone believes equality in income distribution is equitable then in this person’s view, equality in income distribution means the same as equity in income distribution. However, if someone else believes that income should be related to the amount of effort and hard work a person does, then this person would regard equal income distribution as inequitable (unfair) since no matter how hard a person works they will still receive the same income. For this person, unequal distribution is a more equitable system since it recognizes and rewards that some people, for whatever reason, work harder than others.
Why does unequal distribution of income occur?Unequal distribution of income occurs because of the market economy and how it functions. The free market certainly possesses advantages as it allocates scarce resources and provides incentives through the pursuit of the self-interest to entrepreneurs and labor to work hard, to be innovative and creative since these incentives are rewarded in the form of higher profits and wages. Furthermore, it provides consumers with choice and a wider array of goods and services and it encourages competition between producers which results in efficiently produced and better quality goods and services.
However, what a market economy does not promote is a greater equality. Indeed, the trade-off for all the benefits the market economy brings is greater inequality which is shown by unequal income distribution. The reason for this is that a market economy, the ownership of the factors of production is in the hands of private individuals (the private sector). The problem of unequal distribution occurs for two reasons. The first reason is that the ownership of the factors of production is highly unequal.
Individuals at the lowest level of ownership own their labor, but the income selling their labor earns will vary due to their level of ability and skill. Other individuals, however, may own land and/or capital and/or entrepreneurial ability which will add to their income. The second reason for unequal distribution is that the prices (rewards) received by selling the factors of production vary. In the free market, the prices received by selling the factors of production vary accordingly to the laws of supply and demand.
Using wages as an example, wage levels vary hugely between different occupations as well as within an occupation. The reasons are to do with the level of skill and ability but also to do with demand and supply. The result is that income distribution in a market economy is and will remain unequal with some receiving far larger shares of income than others. The market economy provides incentives and rewards those individuals who work hard and punishes those who, for whatever reason, are unable to command a high income for the sale of their labor.Governments and Poverty (potential policies)Modern governments have accepted that their intervention is necessary in order to combat and reduce poverty. Poverty can be seen as a consequence of market failure. The market fails to provide income equality. If an unequal distribution of income is the primary cause of poverty and governments wish to reduce poverty, then governments must tackle income inequality and promote greater equity.
The role of governments in the distribution of income is carried out via:1. Taxation2. The direct provision of certain goods and services (Public goods and Merit goods)3. Transfer Payments As income rises, so does the average rate of taxation. This is the key aspect of a progressive tax which means the greater the income, the greater will be the proportion of the tax paid.
The rich will pay more than the poor. Lower-income households will not only pay less in tax but they will also pay a smaller percentage of their income in tax too. Furthermore, a progressive tax is a tax system that brings the greatest equity and if it is combined with an element of transfer payments, it provides greater equality in terms of income distribution. Income distribution when left to the market, results in unequal distribution of income which in turn produces poverty which is inequitable. If it was left to the market, low-income families would be unable to afford education and health care, the consumption of which provides extensive positive externalities for society.
This means that low-income families would remain trapped in poverty and lead to the continuation of the income gap between rich and poor. Therefore, the government must step in to correct these market failures and ensure full provision at a price which is affordable to even the lowest income groups. In reality, this can only be achieved if the government itself directly provides education and health care. Such merit goods are often provided at zero price in the case of education and health care (depending on the country) or at a very low price. As important as the direct provision of merit goods is the provision of basic infrastructure which will help people to meet their basic needs. Governments will have to undertake the provision of sanitation (clean drinking water and effective sewage collection and disposal) as well as effective power supplies and good communications. Again subsidized provision will be necessary. The provision of universal health care, education, and basic infrastructure aids the goal of reduced income inequality.
By educating low-income families, it provides an increased chance that such families can escape from poverty. Better health will permit greater productivity. As a consequence, not only do low-income families benefit but so does the rest of society. A healthier, better-educated workforce means potential economic growth, higher living standards, and further economic development. It permits an escape from the poverty cycle. INSERT POVERTY CYCLETransfer payments are payments made by the government to individuals for the purpose of redistributing income away from certain groups and towards other groups. Usually, the intention is to aid the more vulnerable members of society by providing them with financial assistance. The Role of Foreign Direct Investment (FDI)The limited income of the people means that there is little saving.
Without the saving, there is less money available to be borrowed by business to finance capital investment and without the capital investment, it is difficult for the economy to grow and develop and therefore income remains low. Another possible way of breaking this vicious cycle is to encourage foreign firms to carry out the domestic investment. There are both, advantages as well as disadvantages of FDI for developing economies.
The advantages of FDI are that it will increase employment in the country; MNC’s will hire local workers. This will increase local employment levels thus increasing local incomes (and local tax revenues). Another advantage will be the increased government revenue that will be generated. The government will have the opportunity to tax the MNC’s.
with greater tax revenue, there will be more money to finance projects that aid development. On the other hand, others may argue that FDI does not increase employment. MNC’s may prefer to bring the expertise to manage and use the technology. The result will be that the local human capital will not develop or be used as desired.
As a result, the jobs that are created locally may be low skilled and consequently low paid. Indicator of Income Equality/Inequality – The Gini Coefficient The Gini Coefficient is the ratio of the area between a country’s Lorenz Curve and the line of perfect income equality (marked A on the diagram) to the total area under the line of perfect income equality (marked A and B on the diagram).The Gini Coefficient has a value between 0 and 1. If there was perfect income equality the coefficient equals zero since the Lorenz curve would lay along the line of perfect income equality.
Each household in the economy would enjoy an equal share of the national income. If the coefficient reads 1, it would simply mean a single household receives all the income and the area under the line of perfect income equality would equal the area of the Lorenz Curve. In terms of Belarus and Bolivia, the Gini coefficient numbers show that Belarus has a relatively better income distribution than Bolivia. The Relationship between Equity and Efficiency – An Evaluation Although one might believe that government intervention in support of greater equity and greater equality of income distribution cannot be questioned, this is in fact not the case.
There are arguments for and against government intervention of redistributing income. Some argue that greater equality in income increases efficiency because it helps reduce poverty levels and allows people to escape from the poverty trap. Also, as the quality of human capital improves, it becomes more productive and efficient and aids potential economic growth. However, others may argue that greater equality in income distribution increases inefficiency. Greater income equality can only be achieved with a progressive tax system. However, high-income taxes act as a distinctive to work hard.
High-income earners are penalized for working hard and may choose to work less. Furthermore, taxes may worsen the allocation of resources. In a free market, price acts as a signal and allocates the resources to their best use. indirect taxes affect prices and distort them, which means that resource allocation is hindered and that inefficiency will occur as a result. The conclusion as to whether governments should aim for a more equitable system of taxation in order to obtain a greater equality in income distribution is a normative one. An economy that employs an equitable system of taxes and government spending will achieve an equal distribution of its income, reduce poverty and improve productivity.
On the other hand, a tax system that is so progressive that it punishes innovation, incentives and productivity should be avoided. In reality, governments opt for a tax system that combines progressive income taxes with regressive indirect taxes. Such a system means that both, rich and poor contribute to the tax burden.
However, the wealthier section of society pays the larger burden while the poorer sections benefit from government provision of public goods, merit goods, and transfer payments. Therefore, inequalities are reduced but not eliminated and market failures are addressed but not solved.