pareto efficiency

 

  • [2] Pareto originally used the word “optimal” for the concept, but as it describes a situation where a limited number of people will be made better off under finite resources,
    and it does not take equality or social well-being into account, it is in effect a definition of and better captured by “efficiency”.

  • Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off.

  • It states that under similar, ideal assumptions, any Pareto optimum can be obtained by some competitive equilibrium, or free market system, although it may also require a
    lump-sum transfer of wealth.

  • Pareto efficiency and market failure In order to fully understand market failure, one must first comprehend market success, which is defined as the ability of a set of idealized
    competitive markets to achieve an equilibrium allocation of resources that is Pareto-optimal in terms of resource allocation.

  • Consider the allocation giving all resources to Alice, where the utility profile is (10, 0): • It is a weak PO, since no other allocation is strictly better to both agents
    (there are no strong Pareto improvements).

  • Because of this, most of the literature is focused on finding solutions where given there is a tax structure, how can the tax structure prescribe a situation where no person
    could be made better off by a change in available taxes.

  • Approximate Pareto efficiency[edit] Given some, an outcome is called ε-Pareto-efficient if no other outcome gives all agents at least the same utility, and one agent a utility
    at least higher.

  • It is impossible to raise the output of products without decreasing the output of services when an economy is functioning on a basic production potential frontier, such as
    at point A, B, or C. Pareto order If multiple sub-goals (with ) exist, combined into a vector-valued objective function , generally, finding a unique optimum becomes challenging.

  • However, the assignment of, say, a half section to each of two individuals and none to the third is also Pareto-optimal despite not being equitable, because none of the recipients
    could be made better off without decreasing someone else’s share; and there are many other such distribution examples.

  • Consider the allocation giving the first item to Alice and the second to George, where the utility profile is (3, 1): • It is Pareto-efficient, since any other discrete allocation
    (without splitting items) makes someone worse-off.

  • Overview Formally, a state is Pareto-optimal if there is no alternative state where improvements can be made to at least one participant’s well-being without reducing any
    other participant’s well-being.

  • By restricting attention to the set of choices that are Pareto-efficient, a designer can make trade-offs within this set, rather than considering the full range of every parameter.

  • [12] Formally, a strong Pareto improvement is defined as a situation in which all agents are strictly better-off (in contrast to just “Pareto improvement”, which requires
    that one agent is strictly better-off and the other agents are at least as good).

  • [3] However, because the Pareto-efficient outcome is difficult to assess in the real world when issues including asymmetric information, signalling, adverse selection, and
    moral hazard are introduced, most people do not take the theorems of welfare economics as accurate descriptions of the real world.

  • [14] An example is of a setting where individuals have private information (for example, a labor market where the worker’s own productivity is known to the worker but not
    to a potential employer, or a used-car market where the quality of a car is known to the seller but not to the buyer) which results in moral hazard or an adverse selection and a sub-optimal outcome.

  • Despite the fact that it is frequently used in conjunction with the idea of Pareto optimality, the term “efficiency” refers to the process of increasing societal productivity.

  • According to the definition of market failure, it is a circumstance in which the conclusion of the first fundamental theorem of welfare is erroneous; that is, when the allocations
    made through markets are not efficient.

  • [13] Constrained Pareto efficiency [edit] Constrained Pareto efficiency is a weakening of Pareto optimality, accounting for the fact that a potential planner (e.g., the government)
    may not be able to improve upon a decentralized market outcome, even if that outcome is inefficient.

  • The following three concepts are closely related: • Given an initial situation, a Pareto improvement is a new situation where some agents will gain, and no agents will lose.

  • [29] An example would be the interpretation of one school district with low property tax revenue versus another with much higher revenue as a sign that more equal distribution
    occurs with the help of government redistribution.

  • More considerations should be considered while making decisions, including social efficiency, overall wellbeing, and problems like declining marginal utility of money.

  • • A situation is called Pareto-optimal or Pareto-efficient if no change could lead to improved satisfaction for some agent without some other agent losing or, equivalently,
    if there is no scope for further Pareto improvement (in other words, the situation is not Pareto-dominated).

  • If there exists no allowed rule that can successfully improve upon the market outcome, then that outcome is said to be “constrained Pareto-optimal”.

  • In other words, Pareto efficiency is when it is impossible to make one party better off without making another party worse off.

  • [8] However, the result only holds under the assumptions of the theorem: markets exist for all possible goods, there are no externalities, markets are perfectly competitive,
    and market participants have perfect information.

  • [5] This state indicates that resources can no longer be allocated in a way that makes one party better off without harming other parties.

  • [3] Pareto efficiency does not require a totally equitable distribution of wealth, which is another aspect that draws in criticism.

  • [4] Pareto efficiency is measured along the production possibility frontier (PPF), which is a graphical representation of all the possible options of output for two products
    that can be produced using all factors of production.

  • • But it is not a strong PO, since the allocation in which George gets the second resource is strictly better for George and weakly better for Alice (it is a weak Pareto improvement)
    – its utility profile is (10, 5).

  • [7] Pareto efficiency and market failure[edit] An ineffective distribution of resources in a free market is known as market failure.

  • The third person does not lose out (even if he does not partake in the pie), hence splitting it in half and giving it to two individuals would be considered Pareto efficient.

  • [27] Common misconceptions It would be incorrect to treat Pareto efficiency as equivalent to societal optimization,[28] as the latter is a normative concept, which is a matter
    of interpretation that typically would account for the consequence of degrees of inequality of distribution.

  • Under the assumptions of the first welfare theorem, a competitive market leads to a Pareto-efficient outcome.

  • The opposite is not true; for example, consider a resource allocation problem with two resources, which Alice values at , and George values at.

  • [3] In addition to the context of efficiency in allocation, the concept of Pareto efficiency also arises in the context of efficiency in production vs. x-inefficiency: a set
    of outputs of goods is Pareto-efficient if there is no feasible re-allocation of productive inputs such that output of one product increases while the outputs of all other goods either increase or remain the same.

  • That framework is that the welfare economics theorems allow the political economy to be studied in the following two situations: “market failure” and “the problem of redistribution”.

  • In this case, various solutions can be “incomparable”[10] as there is no total order relation to facilitate the comparison .

  • When comparing the “real” economy to the complete contingent markets economy (which is considered efficient), the inefficiencies become clear.

  • • However, it is not fractionally Pareto-efficient, since it is Pareto-dominated by the allocation giving to Alice 1/2 of the first item and the whole second item, and the
    other 1/2 of the first item to George – its utility profile is (3.5, 2).

  • When making judgments, it is critical to consider a variety of aspects, including social efficiency, overall welfare, and issues such as diminishing marginal value.

  • However, if the pie is divided in half and shared between two people, it is considered Pareto efficient – meaning that the third person does not lose out (despite the fact
    that he does not receive a piece of the pie).

  • In a more complex economy with production, an allocation would consist both of consumption vectors and production vectors, and feasibility would require that the total amount
    of each consumed good is no greater than the initial endowment plus the amount produced.

  • In a notable and often analyzed game known as Prisoner’s Dilemma, depicted below as a normal-form game, this concept of efficiency can be observed, in that the strategy profile
    (Cooperate, Cooperate) is more efficient than (Defect, Defect).

  • As Wharton School professor Ben Lockwood argues, one possible reason is that any other efficiency criteria established in the neoclassical domain will reduce to Pareto efficiency
    at the end.

  • Therefore, the significance of the two welfare theorems of economics is in their ability to generate a framework that has dominated neoclassical thinking about public policy.

  • Ex-ante Pareto efficiency[edit] When the decision process is random, such as in fair random assignment or random social choice or fractional approval voting, there is a difference
    between ex-post and ex-ante Pareto efficiency: • Ex-post Pareto efficiency means that any outcome of the random process is Pareto-efficient.

  • [6] Using the definition listed above, thus yielding this strategy as a Pareto efficient strategy.

  • The most equitable distribution would assign one third to each person.

  • Hence, the planner cannot implement allocation rules which are based on the idiosyncratic characteristics of individuals; for example, “if a person is of type A, they pay
    price p1, but if of type B, they pay price p2” (see Lindahl prices).

 

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Photo credit: https://www.flickr.com/photos/aigle_dore/5952223760/’]