Pareto Efficiency

Reviewed by Komal | Updated on Aug 27, 2020

What is Pareto Efficiency?

Pareto efficiency, or Pareto optimality, is an economic situation where resources cannot be redistributed to make one person better without making one person worse. Pareto efficiency means the allocation of resources in the most economically efficient way but does not indicate fairness or justice.

Pareto optimum state for an economy implies where no economic changes can make one person happier without making at least another person worse off.

Pareto efficiency is a major pillar of welfare economics, named after the Italian economist and political scientist Vilfredo Pareto (1848-1923).

Understanding Pareto Efficiency

Hypothetically, if perfect competition existed and resources were used to optimise their productive ability, then each would be at their highest standard of living or Pareto efficiency. Theoretically, economists Kenneth Arrow and Gerard Debreu have shown that under the assumption of perfect competition, and where all goods and services are tradable in competitive markets with zero transaction costs, an economy will tend towards Pareto efficiency.

Pareto Improvement

In any case other than Pareto efficiency, certain changes can be made to resource distribution in an economy, so that at least one individual benefits and no individual loses from the adjustment. Only improvements in resource allocation that satisfy this criterion are considered steps towards Pareto efficiency. Such a move is considered a Pareto improvement.

A Pareto improvement happens when no one is affected by a shift in allocation and benefits at least one person, given the initial allocation of products for a set of people. The theory says that Pareto improvements will continue to increase an economy's value until it reaches a Pareto equilibrium, where changes to Pareto are no longer possible. Conversely, any adjustment to resource allocation would make at least one person worse off when an economy is at Pareto efficiency.

The principle of Pareto improvements can be discovered in many scientific fields where trade-offs are simulated and analysed to determine the amount and type of resource variable reallocation required to achieve Pareto efficiency.

In the corporate world, factory managers will perform Pareto improvement tests in which they re-allocate labour resources to try, without telling, and increase the efficiency of manufacturing employees, raising the productivity of packaging and shipping workers.