Pareto Efficiency Examples and Production Possibility Frontier

What Is Pareto Efficiency?

Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off. Pareto efficiency implies that resources are allocated in the most economically efficient manner, but does not imply equality or fairness. An economy is said to be in a Pareto optimum state when no economic changes can make one individual better off without making at least one other individual worse off.

Pareto efficiency, named after the Italian economist and political scientist Vilfredo Pareto (1848-1923), is a major pillar of welfare economics. Neoclassical economics, alongside the theoretical construct of perfect competition, is used as a benchmark to judge the efficiency of real markets—though neither perfectly efficient nor perfectly competitive markets occur outside of economic theory.

Understanding Pareto Efficiency

Hypothetically, if there were perfect competition and resources were used to maximum efficient capacity, then everyone would be at their highest standard of living or Pareto efficiency. Economists Kenneth Arrow and Gerard Debreu demonstrated, theoretically, that under the assumption of perfect competition and where all goods and services are tradeable in competitive markets with zero transaction costs, an economy will tend toward Pareto efficiency.

In any situation other than Pareto efficiency, some changes to the allocation of resources in an economy can be made, such that at least one individual gains and no individuals lose from the change. Only changes in the allocation of resources that meet this condition are considered moves toward Pareto efficiency. Such a change is called a Pareto improvement.

A Pareto improvement occurs when a change in allocation harms no one and helps at least one person, given an initial allocation of goods for a set of persons. The theory suggests that Pareto improvements will keep enhancing the value of an economy until it achieves a Pareto equilibrium, where no more Pareto improvements can be made. Conversely, when an economy is at Pareto efficiency, any change to the allocation of resources will make at least one individual worse off.

Pareto Efficiency in Practice

In practice, it is almost impossible to take any social action, such as a change in economic policy, without making at least one person worse off, which is why other criteria of economic efficiency have found wider use in economics. This includes:

• The Buchanan unanimity criterion under which a change is efficient if all members of society unanimously consent to it.
• The Kaldor-Hicks efficiency under which a change is efficient if the gains to the winners of any change in allocation outweigh the damage to the losers.
• The Coase Theorem which states that individuals can bargain over the gains and losses to reach an economically efficient outcome under competitive markets with no transaction cost.

These alternative criteria for economic efficiency all to some extent relax the strict requirements of pure Pareto efficiency in the pragmatic interest of real-world policy and decision-making.

Aside from applications in economics, the concept of Pareto improvements can be found in many scientific fields, where trade-offs are simulated and studied to determine the number and type of reallocation of resource variables necessary to achieve Pareto efficiency.

In the business world, factory managers may run Pareto improvement trials, in which they reallocate labor resources to try to boost the productivity of assembly workers without, for example, decreasing the productivity of the packing and shipping workers.

Pareto Efficiency and Market Failure

Market failure occurs when internal and external factors prevent an economy from reaching Pareto efficiency. It is aptly named because, in these situations, the market has failed to allocate optimally or efficiently.

Consider an example of a free public good such as a public park. The provider of the park may not be able to exclude individuals who do not contribute tax dollars, donations, or volunteer hours to the park. Therefore, the public good creates an opportunity for individuals to "free ride".

In addition, the consumption of the public good by one individual often does not compete with or reduce the benefit consumed by another individual. Therefore, public goods are often market inefficient because an increase in one person's consumption often does not result in a decrease of value to another.

In another example, consider a monopoly where a single producer sets the market price. In this monopoly, the market price is often set higher than the marginal cost of the product. Because price and marginal cost are not the same, market efficiency is not achieved and the optimal output is present.

Pareto Efficiency and Production Possibility Frontier

Pareto efficiency can be graphically depicted to more easily demonstrate the production possibility frontier. The production possibility frontier is all of the possible combinations of resources that yield market efficiency. Combinations that do not reside on the production possibility frontier are inefficient because additional resources can be allocated.

The graph below demonstrates the visualization of the production possibility frontier in a fictional economy that can only produce wine and cotton.

The quantity of wine produced resides along the y-axis, and the quantity of cotton produced resides along the x-axis. The blue curve with a solid line represents the production possibility frontier where the maximum number of resources are being utilized. There are three different instances outlined in the graph above:

• Point X: Because X does not reside along the production possibility frontier, it is inefficient. The market has unspent resources it could be using to further produce either wine or cotton.
• Points A, B, or C: All three points reside on the production possibility frontier. All three combinations use the maximum amount of market resources; therefore, Pareto efficiency is achieved at any of the three points.
• Point Y: Because Y does not reside along the production possibility frontier, it is not efficient. This point exceeds the resources available in a market; the economy simply can't produce these quantities based on available resources. In order for Point Y to become Pareto efficient, the production possibility must shift outward by having expanded capabilities/resources.

Importance of Pareto Efficiency

The importance of Pareto efficiency lies in its ability to serve as a benchmark for evaluating the efficiency of resource allocation in an economy. A Pareto-efficient allocation ensures that resources are allocated in the most efficient manner possible. This ensures that resources, especially scarce commodities, are allocated in the "best" way.

Pareto efficiency also helps to identify situations where resources are being wasted or underutilized. Using Pareto efficiency tables, analysts or decision-makers can seek to improve the overall efficiency of an economy. This is done by not only looking at how to allocate resources but by analyzing where existing resources may be getting sent and whether there is true benefit with existing allocations.

In this manner, Pareto efficiency is a useful tool for analyzing the distribution of resources in society. Often, as tax revenue is a limited resource, policymakers must take steps to address issues. However, there is also often controversy across departments. For example, should a fire department already be receiving a majority of funds from a city's department, some may feel it inequitable for the department to receive special one-time funds. On the other hand, Pareto efficiency incorporates the value generated by each city entity. Thus, Pareto efficiency is important in balancing equity and value.

Limitations of Pareto Efficiency

Even with its usefulness and strengths, there are limitations to Pareto efficiency. Below are some of the primary drawbacks of the tool.

• Distribution Analysis: Pareto efficiency curves can be used to analyze equity, but they themselves do not automatically consider implications of fairness. Because this concept requires human intervention and analysis, the Pareto efficiency curve on its own does not consider moral distributions or equality across resource recipients.
• Perfect Competition: Pareto efficiency assumes that markets are perfectly competitive, meaning that all buyers and sellers have equal market power and perfect information. In reality, however, markets are often imperfectly competitive. Some beings simply have more power than others.
• Externalities: Pareto efficiency only considers the benefits and costs that accrue to the parties directly involved in a transaction, without taking into account any external effects on third parties. This means that Pareto-efficient allocations could still result in negative externalities. For example, consider externalities and resource allocations that cause pollution.
• Transaction Costs: Pareto efficiency assumes that all transactions can be completed at zero cost, which is not always the case. Transaction costs such as the cost of negotiating contracts or the cost of enforcing property rights can affect the efficiency of resource allocation.
• Difficult Comparisons: Pareto efficiency requires comparison of different individuals which can be difficult to do in practice. Not only may this be impossible due to the complexity of human nature, but it also requires potential moral or philosophical distinctions that are difficult to quantify. As such, Pareto efficiency may sometimes turn into a contentious issue in economics.

Variations of Pareto Efficiency

There are general variations of Pareto efficiency that dictate how efficient a decision or resource allocation may be. The most strict situation is a strongly Pareto allocation. A resource allocation is considered strongly Pareto efficient if it is not possible to make at least one individual better off without making any other individual worse off. This is a stricter condition than standard Pareto efficiency which only requires that no individual can be made better off without making someone else worse off.

On the other hand, a weakly Pareto allocation is an opposite variant. This is a less strict condition than standard Pareto efficiency, which only requires that there is no potential Pareto improvement. A weakly Pareto allocation is often associated with an allocation in which everyone is better off in a situation, though nobody is worse off.

A restricted Pareto efficiency takes into account additional constraints or preferences that may exist in a given situation. For example, a resource allocation may be considered Pareto efficient under certain environmental or social constraints. In these cases, even if it is not Pareto efficient under the standard definition, it may be under these special circumstances. Similar to a constrained Pareto, this concept may take into account that some resources may not be fully utilized due to institutional or legal constraints, and these barriers may be temporary.

Example of Pareto Efficiency

Consider a government official reviewing two new programs: a transportation program and a housing stimulus program. The official has $1 million of unallocated public funding to distribute to the programs. Its top choices are:

• $1 million to the transportation program, $0 to the housing program
• $500,000 to the transportation program, $500,000 to the housing program
• $0 to the transportation program, $1,000,000 to the housing program

In this example, all three choices are Pareto efficient. Because the funds are currently unallocated, there is no allocation that makes one program better off without making the other program worse off. Be mindful that Pareto efficiency does not equate fairness or equity in the allocation.

Consider the two additional options:

1. $750,000 to the transportation program, $500,000 to the housing program
2. $1,000,000 to the transportation program, but it only ends up spending $600,000

The first additional option is not Pareto efficient because only $1,000,000 of capital is available. In order to award this amount to each of the programs, the official will have to make another program worse off (take funds from that program) to award.

The second additional option is also not Pareto efficient because resources are not utilized. The unspent $400,000 could have been allocated to the housing program; instead, it was not used.

The Bottom Line

Pareto efficiency occurs when an economy is most efficiently allocating its goods. At this point, no further changes to the economy can be made without one party benefiting and one party becoming worse off. Often used to evaluate outcomes of public policy or decisions that impact larger groups of individuals, Pareto efficiency is heavily used in economics to determine competitive equilibrium.