Economic Security and the Myth of the Efficiency/equity Tradeoff

By Zalewski, David A. | Journal of Economic Issues, June 2005 | Go to article overview

Economic Security and the Myth of the Efficiency/equity Tradeoff


Zalewski, David A., Journal of Economic Issues


I think the one special thing about a Harvard education is that it allows you options.

--Ted Donato

Confronted with an uncertain future driven by heightened global competition, rapid technological change, and volatile energy prices, a growing number of managers have responded by becoming more flexible in their use of resources. For example, their firms have increased the use of temporary employees, adopted just-in-time production systems, and grouped people into work teams that can be reorganized rapidly as business conditions change. What these strategies have in common is the conversion of fixed into variable costs, which helps insulate profits against unforeseen disruptions in business conditions.

This preference for flexibility is even stronger for financing and investment decisions. For example, because most financial transactions occur in an environment characterized by asymmetric information, investors prefer liquid securities and engage in practices such as the sequential financing of venture capital deals. Moreover, many executives have begun to treat capital project proposals as a series of real options, enabling them to gauge how improvements in the timing of investment expenditures can increase the firm's value. The way these practices reduce uncertainty is by shortening the investment time horizon, which is crucial for companies that must invest in long-term, often irreversible assets.

Neoclassical economists support this quest for flexibility on the presumption that it improves allocative efficiency, despite the fact that it usually increases wage and employment insecurity. However, as Glen Atkinson noted, the tradeoff between equity and efficiency is often more complex than the one postulated by mainstream economic theory (1995). This paper presents a situation that illustrates what Atkinson called a "false dichotomy" between these two goals. Focusing on college students, it argues that the specter of employment insecurity--often the byproduct of efforts by the owners of capital to secure their returns--complicates an already difficult decision concerning the choice of major. In response, students have increasingly opted for vocationally oriented programs that have the best job prospects at present and, in the process, risk becoming overspecialized. If this occurs, they will be less able to adapt to the inevitable changes in economic conditions. Not only will this limit their incomes but the waste of their talents will also prevent the economy from reaching its potential. To avoid this, the paper concludes with a suggestion for higher education curriculum reform that requires a government guaranty of economic security to be successful.

Uncertainty, Investment, and Time

The current period of economic uncertainty began with the onset of higher rates of inflation in the mid 1960s, which eventually led to the demise of the Bretton Woods system in 1971. Since this time, the United States has regularly experienced episodes of interest-rate and exchange-rate volatility, which when combined with the dismantling of trade barriers and rapid technological change has made it more difficult for managers to plan and to make investment decisions. Because uncertainty increases with the length of time between making a decision and its ultimate outcome, both executives and shareholders attempt to manage this problem by shrinking this interval.

One technique for accomplishing this is to view capital investment decisions as a series of real options. Unlike traditional discounted-cash-flow analysis in which managers compare the cost of a project with the present value of all estimated pecuniary benefits, this approach considers the investment process as a sequence of shorter-term decisions. This permits the valuation of responses to uncertainty such as delaying or modifying the project. Despite its intuitive appeal, Tom Copeland and Peter Tufano reported some disappointment among practitioners--largely because of the difficulty in valuing real options and from the lack of specific decision rules governing their exercise (2004). …

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