APPLIED FINANCIAL MANAGEMENT

Applied Financial Management

Applied Financial Management

How should we understand the economic efficiency in conjunction with equity?

Economics is concerned with the allocation of scarce resources among competing uses. There are two aspects to the allocation of scarce resources for achieving value: efficiency and equity. Efficiency is concerned with producing the greatest total social value (as determined subjectively by individuals and as measured by economists either in markets or by using non-market methods) for the least possible social cost. Efficiency is achieved when all resources are in their most productive use (production efficiency), (Rappaport, 1986) no mutually beneficial trades of goods and services are possible (exchange efficiency), and net value is maximized. No reallocation of resources or consumption can result in an increase in total value net of cost.

Equity is concerned with the relative distribution of value and resources among individuals and groups in society according to notions of fairness and justice and interpersonal comparisons of utility. Both efficiency and equity matter to policy makers, so in the public policy arena, tradeoffs are frequently made between solutions involving more efficient uses of resources and those producing more equitable ones. Related to the notions of efficiency and equity is that of social welfare and a concept called Pareto efficiency, named for the Italian economist Vilfredo Pareto (1848-1923). If no reallocation of resources or trade of goods and service can be made that increases value to some individual without anyone else being made worse off, the situation is Pareto efficient. However, a Pareto-efficient solution may be seen as inequitable (not increasing social welfare) because of an unfair initial distribution of resources or some other reason, so Pareto-efficiency is a necessary but not sufficient condition for maximum social welfare. Economists use different types of analyses to measure efficiency and equity. (Rappaport, 1986)

Social benefits, often measured through benefit-cost analysis (BCA) and/or cost-effectiveness analysis (see Approaches for Conducting Analysis of Natural Resource Values), are concepts related to the efficiency of policies and actions. BCA and cost-effectiveness analysis are methods designed to help determine whether social value and social welfare is increased in a Pareto-efficiency sense by a given action. BCA, for example, estimates the increase in value to society (measured in markets or by non-market methods) produced by some action, such as restoration of a wetland, net of the costs necessary to achieve the restoration. As noted in the page on this Web site dealing with the methods for measuring natural resource values over time, the primary objective of BCA is to determine whether society as a whole would benefit as a result of implementing an environmental policy or action. To answer this question, BCA weighs the social benefits and costs of an environmental action and determines whether the gains outweigh the losses. BCA is, therefore, primarily concerned with determining the most economically efficient option. (Prahalad, 1994)

Among the resources appearing on the cost side of the ledger are factors of production, such as the capital and labor, used in restoration ...