Pareto efficiency

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Pareto efficiency, or Pareto optimality, is a central theory in economics with broad applications in game theory, engineering and the social sciences. Given a set of alternative allocations and a set of individuals, a movement from one alternative allocation to another that can make at least one individual better off, without making any other individual worse off is called a Pareto improvement or Pareto optimization. An allocation of resources is Pareto efficient or Pareto optimal when no further Pareto improvements can be made.

The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.

If an economic system is Pareto efficient, then it is the case that no individual can be made better off without another being made worse off. It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an important criterion for evaluating economic systems and political policies.

In particular, it can be shown that, under certain idealised conditions, a system of free markets will lead to a Pareto efficient outcome. This was first demonstrated mathematically by economists Kenneth Arrow and Gerard Debreu, although the result may not necessarily reflect the workings of real economies because of the restrictive assumptions necessary for the proof (markets exist for all possible goods, markets are perfectly competitive, and transaction costs are negligible). This is called the first welfare theorem.

A strongly Pareto optimal (SPO) allocation is one such that the allocation is strictly preferred by one person, and no other allocation would be as good for everyone. A weakly Pareto optimal (WPO) allocation is one where a feasible reallocation would be strictly preferred by all agents.

A key drawback of Pareto optimality is its localization. In an economic system with millions of variables there can be very many Local optimum points. The Pareto improvement criterion does not even define any Global optimum. Under a reasonable criterion, many Pareto-optimal solutions may be far inferior to the global solution.

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Criticisms

Many undesirable systems are Pareto efficient. For example, a dictatorship where the dictator gets every resource is Pareto efficient because any redistribution would decrease the wealth of the dictator.

Another problem with Pareto efficiency is that it only considers private property and private income but does not consider the Commons, Natural Environment, and effects of some Externalities.

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References

Fudenberg, D. and Tirole, J. (1993) Game Theory MIT Press. (see Chapter 1, sect 2.4)
Osborne, M.J. and Rubenstein, A. (1994) A Course in Game Theory MIT Press (see p7)

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