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 efficient manner, but does not imply equality or fairness.
BREAKING DOWN Pareto Efficiency
Pareto efficiency, named after the Italian economist and political scientist Vilfredo Pareto (1848-1923), is used in neoclassical economics alongside the theoretical construct of perfect competition, as benchmarks to judge the efficiency of real markets — though neither outcome is experienced outside of economic theory. Hypothetically, if there were perfect competition and resources were used to their maximum efficient capacity, then everyone would be at their highest standard of living, or Pareto efficiency.
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 the concept of Pareto improvement has found a wider use in economics. 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.
Because Pareto-efficiency is not necessarily equitable, and does not address issues of welfare among different groups of people, welfare economics suggests a Pareto-efficient allocation can be achieved as a competitive market equilibrium through wealth transfers. A state of affairs x is inefficient if there is some alternative state of affairs y such that, in y, there is a set of possible lump-sum transfers of wealth from those who are better off under y to those who are worse off, such that, with those transfers, everyone is at least as well-off under y as under x.
Pareto in Practice
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 say, decreasing the productivity of the packing and shipping workers.