Economics Terms A-Z
Pareto efficiency (or also Pareto optimality) is an important efficiency concept in economics used to evaluate or compare different allocations of resources, names after Italian economist Vilfredo Pareto (1848–1923). An allocation of resources is Pareto efficient if it cannot be modified to increase the wellbeing of one individual without diminishing the wellbeing of any other individual. If it is possible to reallocate resources and improve the welfare of one person without harming anyone else, this reallocation is an efficiency improvement and consequently the initial allocation was not Pareto efficient.
Sometimes we distinguish between Pareto efficiency in the allocation of resources and pareto efficiency in the production of goods and services. The concepts are very similar. Pareto efficiency in consumption (i.e., in the allocation of resources) means that no one can be made better off without making someone else worse off. Pareto efficiency in production implies that we cannot increase the production of one good (or service) without decreasing the production of another good or service.
Let’s look at an example to better understand what a Pareto efficient allocation is: suppose you’re walking together with a friend along a beach when you suddenly discover two beautiful seashells laying on the beach. You decide to pick them up and keep one for yourself and give the other to your friend so that each of you has one seashell. Is this allocation Pareto efficient? To answer this question let us consider whether we can reallocate resources to improve the welfare of one of you without harming the other. If we want to increase your welfare, we have to give you the seashell of your friend. But this means that we have to take away the seashell from them and their wellbeing will decrease. Taking away your friends´ seashell is not a Pareto improvement. Similarly, it is not a Pareto improvement if we take your seashell to give it to your friend. Given that we can not reallocate the resources (in this example seashells) without making someone worse off, the initial allocation was Pareto efficient.
What if instead of picking up both shells, you only pick up one and leave the other on the beach? Is this Pareto efficient? For simplicity, let us assume that no one else would come to pick up the seashell and also no cancer or other living being would use it. Can we reallocate the resources and improve efficiency? In this case the answer is clearly yes. If instead of leaving the seashell on the beach you pick it up and give it to your friend, his or her wellbeing will increase without reducing the wellbeing of anyone else. This means that the initial allocation was not Pareto efficient.
Pareto efficiency does not tell us anything about the equality of the distribution of resources. For example, suppose the entire wealth of a country, all that it owns and produces, is given to one single person (so this person is incredibly rich), while all the other citizens do not obtain anything. Is this allocation of resources Pareto efficient? Yes, it is. Why? In order to see that, think about whether it is possible to reassign the resources in a way that the wellbeing of one of the poor individuals increases. Is this possible without harming the rich person? Obviously not. If we want to give something to the poor, we have to take it from the rich. That is, in order to increase the welfare of a poor individual, we have to reallocate it from the rich person and this means that the initial distribution was Pareto efficient. Coming back to our seashell example, an allocation in which for example you decide to keep both seashells that you found is Pareto efficient as well.
Sometimes the analogy of a cake is used to explain the difference between equality (or equity) and efficiency. The size of the cake is what can be measured by efficiency. If we can increase the size of the cake and people can have more cake this clearly is an efficiency improvement. The size of the cake however does not tell us anything about how the cake is being distributed. To decide who should get what is difficult as this usually involves some judgement about what is fair or just. What would be a fair way to split the cake? Should everyone receive a piece of equal size? Should the person who made the cake get a larger piece? Should we give a smaller person a smaller piece? As you can see, there are many considerations that have to be taken into account when deciding on how to distribute the cake and asking three different people you might get three different opinions. Yet, if someone comes with a new technology that can convert the same amount of ingredients into a larger and equally tasty cake, then no one would object in doing so. As you can see, (Pareto) efficiency is a concept that is way less controversial than fairness or equality. What seems fair or just to one person does not necessarily seem fair to another person. For these reasons economists usually focus their analyses on efficiency.
In the seashell example used above we said that an allocation in which you keep both seashells and your friend has none is Pareto efficient. The question is what happens if your friend gets jealous of you having two seashells while they don’t have any. Beckman, Formby, Smith and Zheng (“Envy, malice and Pareto efficiency: An experimental examination”, Social choice and welfare, 2000) used an experimental approach to analyze the role that envy and malice play in economic decisions. The authors found that envy and malice are strong motivations that can lead to reduced support for Pareto efficient outcomes.
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What would Pareto have to say about Robin Hood, who stole from the rich to give it to the poor? He clearly would disapprove of such a reallocation of resources based on efficiency considerations. To increase the welfare of the poor, Robin Hood is willing to decrease the welfare of the rich, which means that the reallocation is not a Pareto improvement. Of course, Robin Hood would probably not use efficiency as an argument to justify his deeds.
In capital markets, capital is exchanged between investors (who supply it from their assets) and investees (who need it to fund projects and ventures). The investment horizon is usually at least one year.
Standing in contrast to macroeconomics, microeconomics looks at the choices made by economic actors - be they people, firms, or whole industries - and how they affect the allocation of scarce resources. Primarily, this involves investigation into why goods and services assume different values and understanding how changing economic conditions can alter the decision-making of economic actors.
A market is in equilibrium if at the market price the quantity demanded is equal to the quantity supplied. The price at which the quantity demanded is equal to the quantity supplied is called the equilibrium price or market clearing price and the corresponding quantity is the equilibrium quantity.