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 or B) 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; point C is currently impossible without the PPF curve shifting to the right)
Examples of Pareto efficiency
To build a new airport may lead to a greater increase in social benefit than social cost. Therefore, there is a net gain to society. However, those people living near the new airport will lose out. Therefore this is not a Pareto improvement. However, if the people living nearby were compensated for extra noise, then it is possible to have a Pareto improvement.
In practise, there are often practical difficulties and high frictional costs in compensating losers from a particular project.
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.