Definition of Pareto efficiency
Pareto efficiency is said to occur when it is impossible to make one party better off without making someone worse off.
A Pareto improvement is said to occur when at least one individual becomes better off without anyone becoming worse off.
Pareto efficiency will occur on a production possibility frontier. When an economy is operating on a simple production possibility frontier, (e.g. at point A, B or C) it is not possible to increase output of goods without reducing output of services
However, at Point D (16 goods and 17 services) It is possible to increase either without leading to a decline in the output of the other. Thus to be at point D would be classed as Pareto inefficient, and this is generally considered to be bad for the economy.
Pareto efficiency is related to the concept of productive efficiency. Productive efficiency is concerned with the optimal production of goods which occurs at the lowest point on the short run average cost curve and occurs on a PPF.
Pareto efficiency is also concerned with allocative efficiency. To be Pareto efficient the distribution of resources needs to be at a point where it is impossible to make someone better off without making someone worse off.
(Note; it is not possible to produce at a point beyond the PPF)
Examples of Pareto efficiency
If we were building a new airport – let us assume there are winners and losers
- The private and external benefits are estimated at £20bn
- The cost of building airport is £13bn
- Residents living nearby see a loss in personal welfare of £1bn (due to pollution and congestion)
- The net benefit to society is £20bn- £14bn. A clear gain of £6bn
- However, using principles of Pareto efficiency – this is not a Pareto improvement because those living nearby lose out.
What should we do? The scheme has a net welfare gain – but some lose out.
- One option is to make the airport company compensate local residents for the inconvenience of losing out.
- In this way, the airport goes ahead, and the company make a profit, but local residents are compensated for losing out.
However, in practice, there are often practical difficulties and high frictional costs in compensating losers from a particular project.
Pareto efficiency and Market failure
Market failure is an inefficient allocation of resources in a free market. Market failure implies Pareto inefficiency – because it is possible to improve.
For example, the over-consumption of demerit goods (drugs/tobacco) leads to external costs to non-smokers and also early death for smokers. A tax on cigarettes could encourage people to quit smoking, and raise revenue for treating smoking-related diseases.
Pareto efficiency and equity
An outcome may be seen as a Pareto improvement, but, it doesn’t mean this is a satisfactory outcome or fair. There could still be inequality after a Pareto improvement.
A society could have Pareto efficiency but large degrees of inequality. Suppose there is a pie and three people; the most equitable solution would be to divide into three equal parts. But, if it was cut in half and shared amongst two people, it would be seen as Pareto efficient – because the third person doesn’t lose out – (even though he doesn’t share in the pie).
When making decisions, it is important to take into more factors, such as social efficiency, total welfare and issues like diminishing marginal utility of money.