Pareto efficiency is the allocation of resources in the most efficient way, where any changes that benefit one party will harm the other. Efficient production, consumption, and structure are needed. Pareto efficiency does not imply equity and cannot be used as the sole consideration in welfare system design.
Pareto efficiency, also known as Pareto optimization and allocative efficiency, refers to a condition in which all available resources are allocated in the most efficient way. As such, any changes that benefit one party will make the other party worse. If there is no Pareto efficiency, one party can improve without harming the well-being 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 that the first state is at least as good as the last, with at least one person thinking that the first is better than the last, then the first is what is known as “Pareto superior” to the latter. In a set of social states, the state that is Pareto superior to all others is Pareto efficient. There is often more than one Pareto efficient state in a set of states, and switching from one to another 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 non-comparable. Except under pathological conditions, any set of social states always includes a Pareto efficient state.
To achieve Pareto efficiency, there needs to be efficient production, efficient consumption and a resource efficient production structure. Efficient production occurs when there is no possibility of producing more of one good without reducing the production of another. Efficient consumption is when all goods have been allocated to consumers and there is no way to increase satisfaction without increasing the number of goods available. Efficient production structure refers to a condition in which producing more of one good reduces the production of another good.
Pareto efficiency theory can rank many states of the economy for social welfare purposes, because some states are Pareto superior to others in terms of utility, allowing at least one individual to be better and not harming anyone. Pareto efficiency, however, does not imply equity. For example, if a society’s resources are distributed between a small minority living in luxury and a large majority living in poverty, the situation would be Pareto efficient, as reallocating some of the resources to the poor would harm the rich. The concept does not provide any tool to compare between several 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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