What Is Pareto Efficiency?
Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off. Pareto efficiency implies that resources are allocated in the most economically efficient manner, but does not imply equality or fairness. An economy is said to be in a Pareto optimum state when no economic changes can make one individual better off without making at least one other individual worse off.
Pareto efficiency, named after the Italian economist and political scientist Vilfredo Pareto (1848-1923), is a major pillar of welfare economics. Neoclassical economics, alongside the theoretical construct of perfect competition, is used as a benchmark to judge the efficiency of real markets—though neither perfectly efficient nor perfectly competitive markets occur outside of economic theory.
- Pareto efficiency is when an economy has its resources and goods allocated to the maximum level of efficiency, and no change can be made without making someone worse off.
- Pure Pareto efficiency exists only in theory, though the economy can move toward Pareto efficiency.
- Alternative criteria for economic efficiency based on Pareto efficiency are often used to make economic policy, as it is very difficult to make any change that will not make any one individual worse off.
- Pareto efficiency is measured along the production possibility frontier; when graphically depicted, combinations on the PFF representation efficient markets.
- Market failure occurs when inefficiency is not achieved either by leaving an individual worse off or by resources being unspent.
Understanding Pareto Efficiency
Hypothetically, if there were perfect competition and resources were used to maximum efficient capacity, then everyone would be at their highest standard of living, or Pareto efficiency. Economists Kenneth Arrow and Gerard Debreu demonstrated, theoretically, that under the assumption of perfect competition and where all goods and services are tradeable in competitive markets with zero transaction costs, an economy will tend toward Pareto efficiency.
In any situation other than Pareto efficiency, some changes to the allocation of resources in an economy can be made, such that at least one individual gains and no individuals lose from the change. Only changes in allocation of resources that meet this condition are considered moves toward Pareto efficiency. Such a change is called a Pareto improvement.
A Pareto improvement occurs when a change in allocation harms no one and helps at least one person, given an initial allocation of goods for a set of persons. The theory suggests that Pareto improvements will keep enhancing value to an economy until it achieves a Pareto equilibrium, where no more Pareto improvements can be made. Conversely, when an economy is at Pareto efficiency, any change to the allocation of resources will make at least one individual worse off.
Pareto efficiency only deals in absolutes. An allocation of resources is either Pareto efficient or it isn't; there is no degree of efficiency when performing Pareto analysis.
Pareto Efficiency in Practice
In practice, it is almost impossible to take any social action, such as a change in economic policy, without making at least one person worse off, which is why other criteria of economic efficiency have found a wider use in economics. This includes:
- the Buchanan unanimity criterion under which a change is efficient if all members of society unanimously consent to it.
- the Kaldor-Hicks efficiency under which a change is efficient if the gains to the winners of any change in allocation outweigh the damage to the losers.
- the Coase Theorem which states that individuals can bargain over the gains and losses to reach an economically efficient outcome under competitive markets with no transaction cost.
These alternative criteria for economic efficiency all to some extent relax the strict requirements of pure Pareto efficiency in the pragmatic interest of real world policy and decision making.
Aside from applications in economics, the concept of Pareto improvements can be found in many scientific fields, where trade-offs are simulated and studied to determine the number and type of reallocation of resource variables necessary to achieve Pareto efficiency.
In the business world, factory managers may run Pareto improvement trials, in which they reallocate labor resources to try to boost the productivity of assembly workers without, for example, decreasing the productivity of the packing and shipping workers.
Pareto Efficiency and Market Failure
Market failure occurs when internal and external factors prevent an economy from reaching Pareto efficiency. It is aptly named because in these situations, the market has failed to allocates optimally or efficiently.
Consider an example of a free public good such as a public park. The provider of the park may not be able to exclude individuals who do not contribute tax dollars, donations, or volunteer hours to the park. Therefore, the public good creates an opportunity for individuals to "free ride".
In addition, the consumption of the public good by one individual often does not compete or reduce the benefit consumed by another individual. Therefore, public goods are often market inefficient because an increase in one person's consumption often does not result in a decrease of value to other.
In another example, consider a monopoly where a single producer sets the market price. In this monopoly, the market price is often set higher than the marginal cost of the product. Because price and marginal cost are not the same, market efficient is not achieved and the optimal output is present.
If any resources are not utilized, Pareto efficiency has not been achieved as the market could have incurred additional units or benefit to some party.
Pareto Efficiency and Production Possibility Frontier
Pareto efficiency can be graphically depicted to more easily demonstrate the production possibility frontier. The production possibility frontier is all of the possible combinations of resources that yield market efficiency. Combinations that do not reside on the production possibility frontier are inefficient because additional resources can be allocated.
The graph below demonstrates the visualization of the production possibility frontier in a fictional economy that can only produce wine and cotton.
The quantity of wine produced resides along the y-axis, and the quantity of cotton produced resides along the x-axis. The blue curve with a sold line represents the production possibility frontier where the maximum number of resources are being utilized. There are three different instances outlined in the graph above:
- Point X: Because X does not reside along the production possibility frontier, it is inefficient. The market has unspent resources it could be using to further produce either wine or cotton.
- Points A, B, or C: All three points reside on the production possibility frontier. All three combinations use the maximum amount of market resources; therefore, Pareto efficiency is achieved at any of the three points.
- Point Y: Because Y does not reside along the production possibility frontier, it is not efficient. This point exceeds the resources available in a market; the economy simply can't produce these quantities based on available resources. In order for Point Y to become Pareto efficient, the production possibility must shift outward by having expanded capabilities/resources.
Example of Pareto Efficiency
Consider a government official reviewing two new programs: a transportation program and a housing stimulus program. The official has $1 million of unallocated public funding to distribute to the programs. It's top choices are:
- $1 million to the transportation program, $0 to the housing program
- $500,000 to the transportation program, $500,000 to the housing program
- $200,000 to the transportation program, $200,000 to the housing program
- $0 to the transportation program, $1,000,000 to the housing program
In this example, all four choices are Pareto efficient. Because the funds are currently unallocated, there is no allocation that makes one program better off without making the other program worse off. Be mindful that Pareto efficiency does not equate fairness or equity in the allocation.
Consider the two additional options:
- $750,000 to the transportation program, $500,000 to the housing program
- $1,000,000 to the transportation program, but it only ends up spending $600,000
The first additional option is not Pareto efficient because only $1,000,000 of capital is available. In order to award this amount of each of the programs, the official will have to make another program worse off (take funds from that program) to award.
The second additional option is also not Pareto efficient because resources are not utilized. The unspent $400,000 could have been allocated to the housing program; instead, it was not used.
What Are the 3 Conditions of Pareto Efficiency?
Three criteria must be met for market equilibrium to occur. There much be exchange efficiency, production efficiency, and output efficiency. Without all three occurring, market efficient will be occur.
What Is the Downside to Pareto Efficiency?
Pareto efficiency considers the overall distribution efficiency. However, it does not reflect the equity or distribution of resources among parties. Though the distribution of a resource may be efficient, it may not maximize overall social welfare or leave certain negatively impacted parties feeling worse off.
Is Pareto Efficiency Supported by Perfect or Imperfect Competition?
Pareto efficiency is supported by perfect competition. This is often in contrast to imperfect competition where there is often a greater opportunity for higher returns and better distribution when considering the prospective innovation and growth of the market size.
Why Is Pareto Efficiency Important?
Pareto efficiency is commonly used to compare various economic outcomes of proposed policies. Though the Pareto test has limitations as to which one to choose, it can be an indicator to inform analyzes which option is most efficient and allocates resources with the least amount of waste. It is also an important psychological concept that helps decision-makers realize which individuals will be better off and which will be worse off based on market efficiency.
The Bottom Line
Pareto efficiency occurs when an economy is most efficiently allocating its good. At this point, no further changes to the economy can be made without one party benefiting and one party becoming worse off. Often used to evaluate outcomes of public policy or decisions that impact larger groups of individuals, Pareto efficiency is heavily used in economics to determine competitive equilibrium.