Economic System: Efficiency And Equality

A good economic system has two features: efficiency and equality. How to achieve this?

From Hal Varian's 'Microeconomics' (2010):

The Second Theorem of Welfare Economics asserts that under certain conditions, every Pareto efficient allocation can be achieved as a competitive equilibrium.

What is the meaning of this result? The Second Welfare Theorem implies that the problems of distribution and efficiency can be separated. Whatever Pareto efficient allocation you want can be supported by the market mechanism. The market mechanism is distributionally neutral. Whatever your criteria for a good or a just distribution of welfare, you can use competitive markets to achieve it.

Prices play two roles in the market system: an allocative role and a distributive role. The allocative role of prices is to indicate relative scarcity; the distributive role is to determine how much of different goods different agents can purchase. The Second Welfare Theorem says that these two roles can be separated: we can redistribute endowments of goods to determine how much wealth agents have, and then use prices to indicate relative scarcity.

Policy discussions often become confused on this point. One often hears arguments for intervening in pricing decisions on grounds of distributional equity. However, such intervention is typically misguided. As we have seen above, a convenient way to achieve efficient allocations is for each agent to face the true social costs of his/her actions and to make choices that reflect those costs. Thus in a perfectly competitive market, the marginal decision of whether to consume more or less of some good will depend on the price – which measures how everyone else values this good on the margin. The considerations of efficiency are inherently marginal decisions – each person should face the correct marginal tradeoff in making his/her consumption decisions.

The decision about how much different agents should consume is a totally different issue. In a competitive market, this is determined by the value of the resources that a person has to sell. From the viewpoint of the pure theory, there is no reason why the state can't transfer purchasing power (endowments) among consumers in any way that is seen fit. But the message of the Second Welfare Theorem is important. Prices should be used to reflect scarcity. Lump-sum transfers of wealth should be used to adjust for distributional goals. To a large degree, these two policy decisions can be separated.

People's concern about the distribution of welfare can lead them to advocate various forms of manipulation of prices. It has been argued, for example, that senior citizens should have access to less expensive telephone service, or that small users of electricity should pay lower rates than large users. These are basically attempts to redistribute income through the price system by offering some people lower prices than others. When you think about it, this is a terribly inefficient way to redistribute income. If you want to redistribute income, why don't you simply redistribute income? If you give a person an extra dollar to spend, then he can choose to consume more of any of the goods that he wants to consume – not necessarily just the good being subsidised.