Pareto efficiency or Pareto optimality is a situation where no individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engineer and economist, who used the concept in his studies of economic efficiency and income distribution. The following three concepts are closely related:
Pareto originally used the word "optimal" for the concept, but as it describes a situation where a limited number of people will be made better off under finite resources, and it does not take equality or social well-being into account, it is in effect a definition of and better captured by "efficiency".
In addition to the context of efficiency in allocation, the concept of Pareto efficiency also arises in the context of efficiency in production vs. x-inefficiency: a set of outputs of goods is Pareto efficient if there is no feasible re-allocation of productive inputs such that output of one product increases while the outputs of all other goods either increase or remain the same.: 459
Besides economics, the notion of Pareto efficiency has been applied to the selection of alternatives in engineering and biology. Each option is first assessed, under multiple criteria, and then a subset of options is ostensibly identified with the property that no other option can categorically outperform the specified option. It is a statement of impossibility of improving one variable without harming other variables in the subject of multi-objective optimization (also termed Pareto optimization).
Formally, a state is Pareto optimal if there is no alternative state where improvements can be made to at least one participant's well-being without reducing any other participant's well-being. If there is a state-change that satisfies this condition, the new state is called a "Pareto improvement". When no Pareto improvements are possible, the state is a "Pareto optimum".
A special case of a state is an allocation of resources. The formal presentation of the concept in an economy is the following: Consider an economy with agents and goods. Then an allocation , where for all i, is Pareto optimal if there is no other feasible allocation where, for utility function for each agent , for all with for some . Here, in this simple economy, "feasibility" refers to an allocation where the total amount of each good that is allocated sums to no more than the total amount of the good in the economy. In a more complex economy with production, an allocation would consist both of consumption vectors and production vectors, and feasibility would require that the total amount of each consumed good is no greater than the initial endowment plus the amount produced.
Under the assumptions of the first welfare theorem, a competitive market leads to a Pareto-efficient outcome. This result was first demonstrated mathematically by economists Kenneth Arrow and Gérard Debreu. However, the result only holds under the assumptions of the theorem: markets exist for all possible goods, there are no externalities; markets are perfectly competitive; and market participants have perfect information.
The second welfare theorem is essentially the reverse of the first welfare-theorem. It states that under similar, ideal assumptions, any Pareto optimum can be obtained by some competitive equilibrium, or free market system, although it may also require a lump-sum transfer of wealth.
Weak Pareto efficiency is a situation that cannot be strictly improved for every individual.
Formally, a strong Pareto improvement is defined as a situation in which all agents are strictly better-off (in contrast to just "Pareto improvement", which requires that one agent is strictly better-off and the other agents are at least as good). A situation is weak Pareto-efficient if it has no strong Pareto-improvements.
Any strong Pareto-improvement is also a weak Pareto-improvement. The opposite is not true; for example, consider a resource allocation problem with two resources, which Alice values at 10, 0 and George values at 5, 5. Consider the allocation giving all resources to Alice, where the utility profile is (10,0):
Constrained Pareto efficiency is a weakening of Pareto-optimality, accounting for the fact that a potential planner (e.g., the government) may not be able to improve upon a decentralized market outcome, even if that outcome is inefficient. This will occur if it is limited by the same informational or institutional constraints as are individual agents.: 104
An example is of a setting where individuals have private information (for example, a labor market where the worker's own productivity is known to the worker but not to a potential employer, or a used-car market where the quality of a car is known to the seller but not to the buyer) which results in moral hazard or an adverse selection and a sub-optimal outcome. In such a case, a planner who wishes to improve the situation is unlikely to have access to any information that the participants in the markets do not have. Hence, the planner cannot implement allocation rules which are based on the idiosyncratic characteristics of individuals; for example, "if a person is of type A, they pay price p1, but if of type B, they pay price p2" (see Lindahl prices). Essentially, only anonymous rules are allowed (of the sort "Everyone pays price p") or rules based on observable behavior; "if any person chooses x at price px, then they get a subsidy of ten dollars, and nothing otherwise". If there exists no allowed rule that can successfully improve upon the market outcome, then that outcome is said to be "constrained Pareto-optimal".
Fractional Pareto efficiency is a strengthening of Pareto-efficiency in the context of fair item allocation. An allocation of indivisible items is fractionally Pareto-efficient (fPE or fPO) if it is not Pareto-dominated even by an allocation in which some items are split between agents. This is in contrast to standard Pareto-efficiency, which only considers domination by feasible (discrete) allocations.
As an example, consider an item allocation problem with two items, which Alice values at 3, 2 and George values at 4, 1. Consider the allocation giving the first item to Alice and the second to George, where the utility profile is (3,1):
If some lottery L is ex-ante PE, then it is also ex-post PE. Proof: suppose that one of the ex-post outcomes x of L is Pareto-dominated by some other outcome y. Then, by moving some probability mass from x to y, one attains another lottery L' which ex-ante Pareto-dominates L.
The opposite is not true: ex-ante PE is stronger that ex-post PE. For example, suppose there are two objects - a car and a house. Alice values the car at 2 and the house at 3; George values the car at 2 and the house at 9. Consider the following two lotteries:
While both lotteries are ex-post PE, the lottery 1 is not ex-ante PE, since it is Pareto-dominated by lottery 2.
Another example involves dichotomous preferences. There are 5 possible outcomes (a,b,c,d,e) and 6 voters. The voters' approval sets are (ac, ad, ae, bc, bd, be). All five outcomes are PE, so every lottery is ex-post PE. But the lottery selecting c,d,e with probability 1/3 each is not ex-ante PE, since it gives an expected utility of 1/3 to each voter, while the lottery selecting a,b with probability 1/2 each gives an expected utility of 1/2 to each voter.
Although an outcome may be considered a Pareto improvement, this does not imply that the outcome is satisfying or equitable. It is possible that inequality persists even after a Pareto improvement. Despite the fact that it is frequently used in conjunction with the idea of Pareto optimality, the term "efficiency" refers to the process of increasing societal productivity. It is possible for a society to have Pareto efficiency while also have high levels of inequality. Consider the following scenario: there is a pie and three persons; the most equitable way would be to divide the pie into three equal portions. However, if the pie is divided in half and shared between two people, it is considered Pareto efficient - meaning that the third person does not lose out (despite the fact that he does not receive a piece of the pie). When making judgments, it is critical to consider a variety of aspects, including social efficiency, overall welfare, and issues such as diminishing marginal value.
In order to fully understand market failure, one must first comprehend market success, which is defined as the ability of a set of idealized competitive markets to achieve an equilibrium allocation of resources that is Pareto optimal in terms of resource allocation. According to the definition of market failure, it is a circumstance in which the conclusion of the First Fundamental Theorem of Welfare is erroneous; that is, when the allocations made through markets are not efficient. In a free market, market failure is defined as an inefficient allocation of resources. Due to the fact that it is feasible to improve, market failure implies Pareto inefficiency. For example, excessive consumption of depreciating items (drugs/tobacco) results in external costs to non-smokers as well as premature death for smokers who do not quit. An increase in the price of cigarettes could motivate people to quit smoking while also raising funds for the treatment of smoking-related ailments.
Given some ε>0, an outcome is called ε-Pareto-efficient if no other outcome gives all agents at least the same utility, and one agent a utility at least (1+ε) higher. This captures the notion that improvements smaller than (1+ε) are negligible and should not be considered a breach of efficiency.
Suppose each agent i is assigned a positive weight ai. For every allocation x, define the welfare of x as the weighted sum of utilities of all agents in x, i.e.:
Let xa be an allocation that maximizes the welfare over all allocations, i.e.:
It is easy to show that the allocation xa is Pareto-efficient: since all weights are positive, any Pareto-improvement would increase the sum, contradicting the definition of xa.
Japanese neo-Walrasian economist Takashi Negishi proved that, under certain assumptions, the opposite is also true: for every Pareto-efficient allocation x, there exists a positive vector a such that x maximizes Wa. A shorter proof is provided by Hal Varian.
The notion of Pareto efficiency has been used in engineering.: 111–148 Given a set of choices and a way of valuing them, the Pareto front (or Pareto set or Pareto frontier) is the set of choices that are Pareto efficient. By restricting attention to the set of choices that are Pareto-efficient, a designer can make tradeoffs within this set, rather than considering the full range of every parameter.: 63–65
Modern microeconomic theory has drawn heavily upon the concept of Pareto efficiency for inspiration. Pareto and his successors have tended to describe this technical definition of optimum resource allocation in the context of it being an equilibrium that can theoretically be achieved within an abstract model of market competition. It has therefore very often been treated as a corroboration of Adam Smith's "invisible hand" notion. More specifically, it motivated the debate over "market socialism" in the 1930s.
However, because the Pareto-efficient outcome is difficult to assess in the real world when issues including asymmetric information, signalling, adverse selection, and moral hazard are introduced, most people do not take the theorems of welfare economics as accurate descriptions of the real world. Therefore, the significance of the two welfare theorems of economics is in their ability to generate a framework that has dominated neoclassical thinking about public policy. That framework is that the welfare economics theorems allow the political economy to be studied in the following two situations: 'market failure,' and 'the problem of redistribution.'
Analysis of 'market failure' can be understood by the literature surrounding externalities. When comparing the 'real' economy to the complete contingent markets economy (which is considered efficient), the inefficiencies become clear. These inefficiencies, or externalities, are then able to be addressed by mechanisms, including property rights, and corrective taxes.
Analysis of 'the problem with redistribution' deals with the observed political question of how income or commodity taxes should be utilized. The theorem tells us that no taxation is Pareto-efficient and taxation with redistribution is Pareto-inefficient. Because of this, most of the literature is focused on finding solutions where given there is a tax structure, how can the tax structure prescribe a situation where no person could be made better off by a change in available taxes.
Pareto optimisation has also been studied in biological processes.: 87–102 In bacteria, genes were shown to be either inexpensive to make (resource efficient) or easier to read (translation efficient). Natural selection acts to push highly expressed genes towards the Pareto frontier for resource use and translational efficiency.: 166–169 Genes near the Pareto frontier were also shown to evolve more slowly (indicating that they are providing a selective advantage).
It would be incorrect to treat Pareto efficiency as equivalent to societal optimization,: 358–364 as the latter is a normative concept that is a matter of interpretation that typically would account for the consequence of degrees of inequality of distribution.: 10–15 An example would be the interpretation of one school district with low property tax revenue versus another with much higher revenue as a sign that more equal distribution occurs with the help of government redistribution.: 95–132
Some commentators contest that Pareto efficiency could potentially serve as an ideological tool. With it implying that capitalism is self-regulated thereof, it is likely that the embedded structural problems such as unemployment would be treated as deviating from the equilibrium or norm, and thus neglected or discounted.
Pareto efficiency does not require a totally equitable distribution of wealth, which is another aspect that draws in criticism.: 222 An economy in which a wealthy few hold the vast majority of resources can be Pareto efficient. A simple example is the distribution of a pie among three people. The most equitable distribution would assign one third to each person. However the assignment of, say, a half section to each of two individuals and none to the third is also Pareto optimal despite not being equitable, because none of the recipients could be made better off without decreasing someone else's share; and there are many other such distribution examples. An example of a Pareto inefficient distribution of the pie would be allocation of a quarter of the pie to each of the three, with the remainder discarded.: 18
The liberal paradox elaborated by Amartya Sen shows that when people have preferences about what other people do, the goal of Pareto efficiency can come into conflict with the goal of individual liberty.: 92–94
Lastly, it is proposed that Pareto efficiency to some extent inhibited discussion of other possible criteria of efficiency. As the scholar Lockhood argues, one possible reason is that any other efficiency criteria established in the neoclassical domain will reduce to Pareto efficiency at the end.