Pareto efficiency

Empirical methods Prescriptive and policy In welfare economics, a Pareto improvement formalizes the idea of an outcome being "better in every possible way".

[3] Besides economics, the notion of Pareto efficiency has also been applied to selecting alternatives in engineering and biology.

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.

For instance, excessive use of negative commodities (such as drugs and cigarettes) results in expenses to non-smokers as well as early mortality for smokers.

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.

In the multi-objective optimization setting, various solutions can be "incomparable"[10] as there is no total order relation to facilitate the comparison

Consider the allocation giving all resources to Alice, where the utility profile is (10, 0): A market does not require local nonsatiation to get to a weak Pareto optimum.

[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.

In such a case, a planner who wishes to improve the situation is unlikely to have access to any information that the participants in the markets do not have.

This is in contrast to standard Pareto efficiency, which only considers domination by feasible (discrete) allocations.

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.

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

Due to the fact that it is feasible to improve, market failure implies Pareto inefficiency.

For example, excessive consumption of depreciating items (drugs/tobacco) results in external costs to non-smokers, as well as premature death for smokers who do not quit.

An increase in the price of cigarettes could motivate people to quit smoking while also raising funds for the treatment of smoking-related ailments.

This captures the notion that improvements smaller than (1 + ε) are negligible and should not be considered a breach of efficiency.

Japanese neo-Walrasian economist Takashi Negishi proved[20] that, under certain assumptions, the opposite is also true: for every Pareto-efficient allocation x, there exists a positive vector a such that x maximizes Wa.

[23] Modern microeconomic theory has drawn heavily upon the concept of Pareto efficiency for inspiration.

Pareto and his successors have tended to describe this technical definition of optimal resource allocation in the context of it being an equilibrium that can theoretically be achieved within an abstract model of market competition.

[4] 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.

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.

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".

[24] Analysis of "the problem with redistribution" deals with the observed political question of how income or commodity taxes should be utilized.

[25] In bacteria, genes were shown to be either inexpensive to make (resource-efficient) or easier to read (translation-efficient).

Natural selection acts to push highly expressed genes towards the Pareto frontier for resource use and translational efficiency.

[26] Genes near the Pareto frontier were also shown to evolve more slowly (indicating that they are providing a selective advantage).

[27] 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.

With it implying that capitalism is self-regulated thereof, it is likely that the embedded structural problems such as unemployment would be treated as deviating from the equilibrium or norm, and thus neglected or discounted.

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

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.