Pareto Efficiency

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What is 'Pareto Efficiency'

Pareto efficiency, also known as "Pareto optimality," is an economic state where resources are allocated in the most efficient manner, and it is obtained when a distribution strategy exists where one party's situation cannot be improved without making another party's situation worse. Pareto efficiency does not imply equality or fairness.

BREAKING DOWN 'Pareto Efficiency'

Pareto efficiency has broad implications in economics, particularly in game theory. Unlike the predicted logical outcome of a prisoner's dilemma (participants choose selfishly and do not achieve the best possible outcome), if an economic state is Pareto efficient, individuals are maximizing their utility. The final allocation decision cannot be improved upon, given a limited amount of resources, without causing harm to one of the participants.

Pareto efficiency does allow for a party to experience improvement, a process known as Pareto improvement, but it must not come at the expense of any other party. For example, if a company produces three products as part of its normal business operations, the addition of an employee on one production line may result in higher outputs of that product without any negative impact on the other two.

In contrast, if the company move one employee from one production line to another, there may be an increase in productivity in one line. This may be offset by the decrease in the other and, therefore, is not an example of Pareto efficiency since a negative outcome occurred.

Using Pareto Improvements to Reach Pareto Efficiency

A primary focus is on productive efficiency, where the production of goods has been optimized for maximum output with optimal input and limited waste. As processes improve internally, resulting in no external deficit, productive efficiency has increased. Once all areas within a system have completed all of the Pareto improvements available, the system is said to be an example of Pareto efficiency. Even when efficiency has been reached, that does not mean that all participants in the system are achieving the same levels of production, only that no other improvements can be made without a detriment to another.

Understanding Production Resources

When discussing the allocation of resources in the attempt to reach Pareto efficiency, many items may be included as any restructuring that can lead to process improvement may be considered a reallocation of resources. It can include tangible production materials as well as any associated real estate, tools or equipment. Employees can also qualify as resources when attempting to arrange an optimal balance. Further, distribution channels and shipping methods can also be adjusted to reach peak efficiency.