Steve Bain

Pareto Efficiency Explained (with a graph)

Pareto efficiency (or Pareto optimality) is a concept in economics named after its inventor Vilfredo Pareto. It examines the allocation of goods and services among individuals and describes a situation where it is impossible to make one person better off without making another person worse off.

This condition occurs where all mutually beneficial trades of goods & services have been made, and all consumers have equalized the marginal rate of substitution of one good for another. Similarly, all producers have equalized theIR marginal rate of transformation such that inputs cannot be reallocated to produce more of one good without reducing production of another. For technical explanations of this, have a look at my articles about:

In simple terms, with all mutually beneficial trades being exhausted, waste has been eliminated. Pareto efficiency, however, tells us nothing about fairness or equity. While it ensures that no more gains can be made from reallocating goods, that does not imply that the outcome is socially desirable, equitable, or just.

Pareto efficiency applies to both consumption of goods & services and their production. In production we achieve efficiency where we cannot reallocate inputs (land, labor, capital and entrepreneurship) in a way that increases production of one good without decreasing production of another.

While Pareto efficiency applies to both consumption and production, some texts tend to explain the concept in terms of consumption alone. One reason for that is because the limitations of Pareto optimality are more obvious in consumption i.e., the lack of accounting for equity and fairness that occurs there.

Pareto Efficiency and the Allocation of Goods & Services

Pareto efficiency is fundamentally concerned with how goods and services (the outputs of the production process) are distributed among individuals. For example, if person A has biscuits but would prefer cheese, and person B has cheese but would prefer biscuits, then there is an opportunity for a mutually beneficial trade that would deliver a Pareto improvement.

If one person holds a large share of the goods while others hold very little, that could still be a Pareto efficient allocation despite the uneven equity. If taking goods from the wealthier individual would make them worse off, even by a small amount, it fails the Pareto principle. This means that Pareto efficiency is about avoiding waste, not about ensuring fairness.

In models like the Edgeworth box, which uses a graph to illustrate how two individuals might trade two goods, the contract curve that arises represents all Pareto efficient allocations. In the graph below, every point on the contract curve shows an allocation where no further improvement can be made without hurting one of the parties involved.

Pareto Efficiency GraphPareto Efficiency illustrated by the Contract Curve in an Edgeworth Box Diagram.

For a full explanation of the graph above, have a look at my articles about:

Importantly, while all points on the contract curve satisfy the Pareto principle, some may be highly unequal, benefiting one person far more than the other. This highlights the key limitation, so just to restate it again: Pareto efficiency ensures that waste is eliminated, but it does not determine the optimal allocation in terms of fairness or equity.

Pareto Efficiency and Equity

Unfortunately, elimination of waste is not a sufficient parameter for achieving optimal standards of living, and while it is necessary to satisfy the Pareto criterion to achieve optimal outcomes, it is not sufficient by itself. A Pareto efficient outcome can still be highly unequal and unfair.

For example, in an economy where one person holds 90% of all goods and the rest are left with scraps, this could still be a Pareto optimum if redistributing the goods would reduce the welfare of the wealthy individual, no matter how small the reduction is.

This disconnect between efficiency and equity highlights why Pareto efficiency, on its own, cannot be the sole standard for evaluating economic outcomes. It does not provide any guidance on whether a Pareto equilibrium allocation is socially desirable or just.

The Role of Welfare Economics and Utility Optimization

To address these concerns about fairness, economists turn to welfare economics, which goes beyond Pareto efficiency to assess the overall economic well-being (utility) generated for all consumers in a society.

Welfare economics introduces the idea of a social welfare function, a tool that aggregates consumers' utility to provide a measure of societal welfare. The goal here is twofold:

  • To satisfy the Pareto criterion regarding the distribution of goods and services.
  • To simultaneously optimize total utility via redistributive policies aimed at achieving greater equity.

While Pareto efficiency simply ensures that no one can be made better off without making someone else worse off, welfare economics often allows for a trade-off between individual consumers’ utilities. For instance, it might justify redistributing goods from wealthier individuals to poorer ones if doing so increases the overall welfare in society, even if it is not Pareto efficient under the strict definition.

We should note that, when making judgements about what is fair or equitable, we are getting into 'normative' economics rather than 'positive' economics. In other words, there is no objective way to determine the correct level of equity, it depends on subjective value judgements rather than objective truths.

For example, if taking some goods from a wealthy person causes a small loss in their utility but results in a large increase in utility for a poorer person, welfare economics would typically view this redistribution as desirable because it creates an improvement in total utility. In contrast, Pareto efficiency would reject this redistribution because it causes harm to the wealthy individual, even if that harm is negligible.

Utility Optimization and the Challenge of Equity

While utility optimization offers a broader perspective than Pareto efficiency, it comes with challenges.

One key difficulty is that utility is very difficult to measure. It varies from person to person and cannot be directly compared like money or goods. Despite this, economists use various forms of social welfare functions to make decisions about how to balance total consumer utility with efficiency in order to improve societal welfare.

Some welfare functions prioritize equity by giving more weight to the well-being of the less fortunate, while others focus more on overall efficiency.

Distinguishing Pareto Efficiency from Other Forms of Efficiency

We should note here that Pareto efficiency is distinct from other types of efficiency discussed in economics:

  • Production efficiency refers to producing goods and services at the lowest possible cost by using resources in the most efficient way. This is about how well an economy uses its inputs (land, labor, capital and entrepreneurship) to generate outputs.
  • Allocative efficiency refers to a situation where goods and services are distributed in an optimal way. A Pareto efficient allocation is one that maximizes allocative efficiency, but there are also an unlimited number of sub-optimal allocations that might exist.
  • Dynamic efficiency is another type of efficiency, referring to an economy’s ability to improve its productive capacity over time, through innovation and technological advancements. Dynamic efficiency is concerned with the long-term growth of the economy and the future ability to produce more goods and services.

Conclusion: Efficiency, Equity, and Welfare

In conclusion, Pareto efficiency is a useful concept for determining when the allocation of goods and services has reached a point where no further gains can be made without causing harm. However, it is limited by its neutrality on the issue of equity.

To address these concerns, economists look to welfare economics and the concept of utility optimization, which allows for trade-offs between different individuals’ utilities in order to achieve greater social welfare.

While Pareto efficiency ensures that waste is eliminated, it is not enough to determine whether an allocation of goods is fair or desirable. Welfare economics brings in the crucial element of equity, helping policymakers assess whether the allocation of goods and services in society leads to a fair distribution of well-being.

By combining Pareto efficiency with the broader insights of welfare economics, societies can aim to achieve not only a relatively more efficient allocation of goods but also outcomes that are deemed more equitable and just.

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