Pareto Efficient and Pareto Optimal Tutorial

pareto optimal

The main tenant of economics is that resources are scarce. Due to scarcity, that means that not everyone can have some of everything, leading to competition. By these means, a transaction that makes one better off means that someone else is worse off. This concept is known as an Pareto efficient economic allocation.

Pareto Efficiency

Named for an Italian economist who specialized in resource and income allocation, Pareto Efficiency goes hand in hand with the Pareto Optimal concept. Given one set of initial allocation of resources, other allocation alternatives exist. When a change in the initial allocation that makes one individual better off while not making another worse off is called a Pareto Improvement.  When all of the other alternate allocation options have been exhausted, or where all of the Pareto Improvements have been made, the allocation is deemed as Pareto Optimal or Pareto Efficient.

 

Through making Pareto Improvements, overall social utility can be increased, by seeking to make allocation decisions that minimize decreased utility for other individuals in the efforts to increase one individual’s utility. This concept can be looked at through examples of eminent domain. If a house resides on land that would best serve society through being converted to a high way, the land could be taken. Initially individuals are made worse off as they lose their home as other individuals are made better off as they gain land that will speed up transportation and decrease commute time bringing benefits. A Pareto Improvement alternative would be compensating the homeowners for the land, where those who will now benefit from the highway are made better off, but the individuals losing their home will not be made worse off.

What is Pareto Optimality

 

pareto optimal

Looking at a standard production possibilities frontier, all points that lie under the curve are inefficient allocations. Point A is an inefficient allocation between guns and butter. A decision to move from point A to to point D would be a Pareto Improvement. It improves those that want guns and those that want butter, without making anyone else worse off. The move from point A to point D increases both gun and butter production. This move would be a Pareto Improvement and be Pareto Optimal. A move from Point A to point B would not be a Pareto Improvement. This move is not an improvement because it increases gun production by decreasing butter production, thus making one side better off by making another worse off.

 

Pareto Optimality is used heavily in political economics as a means to distribute resources in a more efficient manner to increase overall social utility. As it is the stated goal to promote the general interest of the public, Pareto Improvements are desirable to government officials seeking to act in the name of the electorate. Another practical uses include managers seeking to make decisions for investors, the company and consumers that serves everyone’s interests.  Pareto Optimality has even been used in the engineering field in recent years.