What is Pareto Efficiency?

Pareto efficiency, also known as Pareto optimality and allocative efficiency, refers to a condition in which all available resources are allocated in the most efficient manner. As such, any changes that benefit any one party will make another party worse off. If there is no Pareto efficiency, a party can become better off without harming another party's well-being. Named after the Italian economist Vilfredo Pareto, the concept is used often in welfare economics.

If there are two hypothetical social states or conditions, and everyone thinks the former state is at least as good as the latter, with at least one person finding the former to be better than the latter, then the former is what is known as "Pareto superior" to the latter. In a set of social states, the state that is Pareto superior to all of the others is Pareto efficient. There often are more than one Pareto efficient state in a set of states, and moving from one to another in order to increase one party's well-being cannot be done without reducing another party's well-being. When two states are similarly Pareto efficient, they are said to be Pareto non-comparable. Except under pathological conditions, any set of social states always includes a state with Pareto efficiency.

To achieve Pareto efficiency, there needs to be efficient production, efficient consumption and an efficient production structure of resources. Efficient production occurs when there is no possibility to produce more of one good without reducing the output of another. Efficient consumption is when all goods have been allocated to consumers and there is no way to increase satisfaction without increasing the number of goods available. Efficient production structure refers to a condition in which producing more of one good reduces the production of another good.

The Pareto efficiency theory can rank many states of the economy for social welfare purposes, because some states are Pareto superior to others in utility terms, allowing at least one individual to be better off while making nobody worse off. Pareto efficiency, however, does not imply equity. For example, if resources in a society are distributed between a small minority that lives in luxury and a large majority that lives in poverty, the situation would be Pareto efficient because reassigning some of the resources to the poor would harm the rich. The concept provides no tool to compare between several Pareto efficient states because of Pareto non-comparability. The concept, therefore, cannot be used as the sole consideration in designing welfare systems, and economists have other criteria to help them make decisions regarding socially preferable alternatives.