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 investopedia zoe hansenunderstanding pareto efficiencyhypothetically 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 1in 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 only deals in absolutes an allocation of resources is either pareto efficient or it isn t there is no degree of efficiency when performing pareto analysis pareto efficiency in practicein 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 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 failuremarket 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 if any resources are not utilized pareto efficiency has not been achieved as the market could have incurred additional units or benefit to some party pareto efficiency and production possibility frontierpareto 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 image by sabrina jiang investopedia 2020the 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 importance of pareto efficiencythe 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 efficiencyeven with its usefulness and strengths there are limitations to pareto efficiency below are some of the primary drawbacks of the tool variations of pareto efficiencythere 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 2on 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 trying to prepare dinner for your family having a decision between varying food preferences is an exercise related to pareto efficiency as resources must be allocated in the most efficient beneficial way example of pareto efficiencyconsider 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 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 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 