Pareto efficiency is the allocation of resources in the most efficient way, where any change benefiting one party harms another. It is named after Vilfredo Pareto and used in welfare economics. Efficient production, consumption, and resource production structure are necessary for Pareto efficiency. It does not imply fairness and cannot be used as the sole consideration in designing welfare systems.
Pareto efficiency, also known as Pareto optimality and allocative efficiency, refers to a condition where all available resources are allocated in the most efficient way. Therefore, any change that benefits one party will make another party worse. If there is no Pareto efficiency, one party can improve without harming the welfare of another party. Named after the Italian economist Vilfredo Pareto, the concept is often used in welfare economics.
If there are two hypothetical states or social conditions, and everyone thinks the first state is at least as good as the second, with at least one person believing the first is better than the second, then the first is what is known as the “Pareto superior “to the latter. In a set of welfare states, the state that is Pareto superior to all others is Pareto efficient. Often there are more than one Pareto efficient state in a set of states, and switching between them to increase the welfare of one party cannot be done without reducing the welfare of another party. When two states are equally Pareto efficient, they are said to be Pareto incomparable. Except in pathological conditions, any set of welfare states always includes a state with Pareto efficiency.
To achieve Pareto efficiency, one must have efficient production, efficient consumption, and an efficient resource production structure. Efficient production occurs when it is not possible to produce more of one good without reducing the production of another. Efficient consumption is when all goods have been assigned to consumers and there is no way to increase satisfaction without increasing the number of goods available. An efficient production structure refers to a condition in which the production of more of one good reduces the production of another good.
Pareto efficiency theory can rank many states in the economy for purposes of social welfare, because some states are Pareto superior to others in terms of utility, allowing at least one individual to get better off without making anyone worse off. Pareto efficiency, however, does not imply fairness. For example, if resources in a society were distributed among a small minority living in luxury and a large majority living in poverty, the situation would be Pareto efficient because reallocating some of the resources to the poor would hurt the rich. The concept does not provide any means to compare between different Pareto efficient states due to Pareto non-comparability. The concept therefore cannot be used as the sole consideration in the design of welfare systems, and economists have other criteria to help them make decisions about socially preferable alternatives.
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