The idea of Pareto Efficiency is named after the Italian Economist Vilfredo Pareto. For a given set of consumer tastes, resources and technology, an allocation is Pareto-efficient if there is no other feasible allocation that makes some people better off and nobody worse off.
The diagram shows an economy with only two people, John and Karen. The initial allocation at Z gives John QJ goods and Karen QK goods. Provided people assess their own utility by the quantity of what they themselves receive, Y is a better allocation than Z, which in turn is a better allocation than T. But a comparison of Z with points such as U, V or W, requires us to adopt a value judgment about the relative importance to us of John’s and Karen’s utility. It is important to note from the figure the following:
- If you move from Z to Y or Z to X it is a Pareto gain – Z to Y both Karen and John are better off. Z to X Karen is better off, John no worse off.
- If point Y or X is feasible, then point Z is Pareto-inefficient – more goods can be consumed
- A move from Z to V makes John better off and Karen worse off. However, we need to make a judgment about the relative value of John’s and Karen’s utility before we can comprehensively state that John is better off. Therefore the Pareto principle is limited in comparing allocations on efficiency – it only allows us to evaluate moves to the north-east and south-west
Therefore, we need look at the economy as a whole and how many goods it can produce. On the diagram the frontier AD shows the maximum quantity of goods that the economy can produce for one person given the quantity of goods being produced for the other person. All points on the frontier are Pareto-efficient. John can only be made better off by making Karen worse off and vice versa. The distribution of goods between John and Karen is much more equal at point C than at points A or B. Note that:
- Anywhere inside the frontier is Pareto-inefficient – some can be made better off without making the other worse off.
- Moving from a point E to C is Pareto gain – both John and Karen gain output.
- Moving from point B to C is Pareto-efficient – John gains more goods but Karen loses goods.
The economy should never choose an inefficient allocation inside the frontier. Which of the efficient points on the frontier (A, B, C or D) is the most desirable will depend on the value judgment about the relative value of John’s and Karen’s utility.