Pareto Efficiency
One of the founders of economics as a modern science, Vilfredo Pareto's work deals with the concept of utility, more specifically, marginal utility and the collective maximization of such; thus his work is of great interest to the theory and study of welfare economics.[1] Pareto's work spans a variety of studies from welfare economics to political economy to legal economics and others.
There are two main theories within his works collectively referred to as Pareto Principles:
- Pareto Improvement
- Pareto Efficiency or Pareto Optimization
Pareto Efficiency
Pareto efficiency refers to an allocation of goods in an economy whereby goods cannot be reallocated without making at least one individual worse off. It is used to evaluate social welfare.[2] A Pareto efficient equilibrium does not need to be equitable as long as the marginal utilities of individuals are met, it doesn't matter how goods are distributed. Essentially, as long as everyone is just as "satisfied" it doesn't matter how the goods are allocated. When in a Pareto efficient equilibrium any change will result in at least one person becoming less "happy" or "satisfied" with their good(s).
| Individual | Initial Allocation | Initial Utility Level | New Allocation | New Utility Level |
|---|---|---|---|---|
| Person 1 | Good A | x | Good C | x +1 |
| Person 2 | Good B | x | Good A | x |
| Person 3 | Good C | x | Good B | x-1 |
All three individuals started at the same level of utility, x, after the re-allocation the utility of Person 1 increased to x+1 but the utility of Person 3 decreased to x-1. But that is only one configuration, if the goods are reallocated again from the original allocation so that each person gets a new good:
| Individual | Initial Allocation | Initial Utility Level | New Allocation | New Utility Level |
|---|---|---|---|---|
| Person 1 | Good A | x | Good B | x +1 |
| Person 2 | Good B | x | Good C | x-1 |
| Person 3 | Good C | x | Good A | x |
In this allocation of goods, Person 1 is still better off and while Person 3 is back at their original utility and is neither better or worse off, Person 2 is worse off as their utility has fallen to x-1. The initial allocation is said to be Pareto efficient because there is no allocation where one can be made better off without another being worse off.
Pareto Optimization
There is not always one single allocation that is Pareto efficient however, optimization means that there are a number of efficient outcomes in a market that can be chosen without disrupting the efficiency. This is known as a production possibility frontier (PPF).[4]
At any one of the red points (A,B,C,D,E,F,G,H) the allocation is Pareto efficient. At any one of the grey points (K,N), the allocation is not efficient and there is room for Pareto improvement to get a place on the PPF. As stated above, the allocation does not need to be equal, at Points A and H there is a large quantity of one good and a small quantity of another but both are considered optimal distributions because they yield the same amount of "satisfaction".
This is a condition of a social state whereby there is no other social state that is preferred to the current one, basically everyone is "happy." To avoid confusion, when in a Pareto efficient state, the allocation of goods is the most satisfying to people, but the things that go into making the goods can change.
If we put the PPF in an energy context and assume that Item 1 is electricity produced from hydroelectric dams and Item 2 is electricity is produced from coal-fired power plants then we can see how a society values its electricity production. At Point A, a province such as Alberta can use coal-fired plants to produce the vast quantity of its electricity while the hydroelectric production makes up the remainder. As an alternative, Albertans could choose to operate at Point D where the majority is still coal but there is more of an equal use of both sources of electricity. Both of these scenarios deliver the same amount of utility to Albertans. If the Albertan market ends up at Point N it could because the use of coal creates a negative externality and thus diminishes its utility to Albertans, to get to an efficient point, the Pareto improving move of using more hydroelectric than coal will push Point N to Point E on the PPF thus making the market efficient.[5]
References
- ↑ R. Marchionatti and F. Mornati, ed. Considerations on the Fundamental Principles of Pure Political Economy. New York: Routledge, 2007, pp. xi.
- ↑ A. Goolsbee, S. Levitt and C. Syverson. ‘’Microeconomics’’. New York: Worth Publishers, 2013, pp. 580.
- ↑ Wikimedia Commons [Online], Available: https://commons.wikimedia.org/wiki/File:PareoEfficientFrontier1024x1024.png
- ↑ A. Goolsbee, S. Levitt and C. Syverson. ‘’Microeconomics’’. New York: Worth Publishers, 2013, pp. 591.
- ↑ J.Black, N. Hashimzade, and G. Myles. (2009) "Production Possibility Frontier." [Online], Available: http://www.oxfordreference.com/view/10.1093/acref/9780199237043.001.0001/acref-9780199237043-e-2462?rskey=XZLl4A&result=1, 2009 [June 1, 2016]
