Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.
Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made.
Pareto efficiency is a minimal notion of efficiency and does not necessarily result in a socially desirable distribution of resources, as it makes no statement about equality or the overall well-being of a society.
Pareto efficiency in short
An economic system that is not Pareto efficient implies that a certain change in allocation of goods (for example) may result in some individuals being made "better off" with no individual being made worse off, and therefore can be made more Pareto efficient through a Pareto improvement. Here 'better off' is often interpreted as "put in a preferred position." It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an important criterion for evaluating economic systems and public policies.
If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements to at least one participant's well-being can be made without reducing any other participant's well-being.
In the real world ensuring that nobody is disadvantaged by a change aimed at improving economic efficiency may require compensation of one or more parties. For instance, if a change in economic policy dictates that a legally protected monopoly ceases to exist and that market subsequently becomes competitive and more efficient, the monopolist will be made worse off. However, the loss to the monopolist will be more than offset by the gain in efficiency. This means the monopolist can be compensated for its loss while still leaving an efficiency gain to be realized by others in the economy. Thus, the requirement of nobody being made worse off for a gain to others is met. In real-world practice compensations have substantial frictional costs. They can also lead to incentive distortions over time since most real-world policy changes occur with players who are not atomistic, rather who have considerable market power (or political power) over time and may use it in a game theoretic manner. Compensation attempts may therefore lead to substantial practical problems of misrepresentation and moral hazard and considerable inefficiency as players behave opportunistically and with guile.
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