Pareto Improvement and Pareto Efficiency - Example

PARETO EFFICIENCY INTRODUCTION Welfare improvement in regard to Pareto efficiency refers to a situation whereby an economic change is preferred if in the new condition at least one person’ wellbeing is better off and no other person’s situation is made worse off than before. This means that in an economy, such welfare improvement is preferred as long as some individual’s situation improves and other people are not harmed even if there is no equity. This can be an advantage to those people whose conditions are improved; but of course it can also be a disadvantage because in essence, few economic policies lead to social implications of this kind (Dinwiddy & Teal, 1996, p. 60). Against this backdrop, this paper seeks to discuss the concept of Pareto efficiency and how it applies as a guide in economic policy. The paper also refers to other economic concepts such as Pareto improvement to illustrate clearly the meaning of Pareto efficiency. PARETO IMPROVEMENT AND PARETO EFFICIENCY Pareto improvement Pareto improvement and Pareto efficiency are terms coined after an Italian, Vilfredo Pareto. Pareto efficiency is best understood by first grasping what Pareto improvement means. Pareto improvement is a situation that results when there is a change in the distribution of resources which makes one person better off but does not make any other person’s condition worse off (EconGuru, no date). For example, if three people share 10 apples, each will get three and they will be left with one apple. Since each of the three people is satisfied that they have three apples, they can decide to give the remaining apple to one of them. This means that one person will have an extra apple, but the other two people’s condition is not worsened because each one of them is left with the three apples that they have. In the same way, if two people, A and B enter a restaurant and person A orders a fizzy drink while person B orders fresh squeezed juice, both will be seeking to satisfy their thirsts. However, person A can change her mind and desire the fresh juice. If person B has no problem taking the fizzy drink, he will allow a swap and let person A drink his juice. In this case person A’s condition is improved because she had new desire, while person B’s condition is not made worse because he had no problem taking any of the drinks in the first place. These two scenarios illustrate how Pareto improvement occurs. In the case of people sharing apples above, there is a Pareto improvement as long as the allocation of the extra apple does not occur at the expense of one of the other three people’s apples. Similarly, the swap of drinks as illustrated is a Pareto improvement if person B in the case is not dissatisfied with taking the fizzy drink. Pareto efficiency Now, turning to Pareto efficiency, the situation occurs when no other improvements can be made in the distribution of resources to one person without it resulting into a loss to other individuals. That is, Pareto efficiency is a condition that results when it is not possible to improve one person’s condition without it resulting into other people’s conditions to be worse off (EconGuru, no date; Osborne, 1997; Zerbe, 2011, p. 3). This means that Pareto efficiency is therefore a situation in which Pareto improvements are impossible. Thus, as defined by (Schäfer & Ott, 2004, p. 23), Pareto efficiency is a social state whereby if we attempt to make one person better off, then at least one other person is made worse off. Pareto efficiency may be thought to be implying equity but this is not true. An example can be given of a group of people in which one person has then pairs of shoes while the rest of the people have one pair of shoes each. The situation is Pareto efficient if it is not possible for the individual with ten pairs of shoes to acquire another pair without making the other people poorer. PARETO EFFICIENCY VERSUS PRODUCTION AND CONSUMPTION Pareto efficiency is also applied in production, where a decision can be made regarding the production of two goods X and Y. If production of one of the two goods is Pareto efficient while production of the other good is not, it is worth asking if we should prefer the Pareto efficient state over the other. But this requires delving a little more into the concept of Pareto efficiency. Thus, there is need to look at some fundamentals that help to understand the conditions that fulfil the Pareto concept. According to Schäfer and Ott (2004, p. 23), it is important to evaluate the basic conditions of the society by looking at three factors: the initial endowment of goods, the technology available, and the society’s preferences. These factors are described below: a) Initial endowments of goods: It is important to know the initial allocation of resources. b) Technology: The state of technology is important as it determines the relationship between resources and their use in production. c) Preferences: It is important to know the different bundles of goods as ranked by members of the society. In relation to point a) above, a Pareto-efficient condition deals only with the amount of productive resources as well as the preferences of the members of the society, and the distribution of these resources. This is because it is quite possible that there is another initial distribution that can lead to a different efficient allocation. Therefore, Pareto efficiency can be broken down into three aspects: efficient production, efficient consumption, and efficient structure of production (Schäfer & Ott, 2004, p. 24). Efficient production If the available factors of production and the level of technology that a given economy possesses are known, it is possible to show which goods and in which volume can be produced. A good illustration is an economy that produces only two goods, X and Y. Supposing that all factors of production are used solely to produce good X, if there is no waste in the production process, then the maximum output of O-A of X can be achieved as shown in figure 1. However, if the society decides to produce only good B, then the maximum output becomes O-B. The curve A-B shows all the possible combinations of X and Y that can be produced given the existing resources and technology and represents the production possibility frontier. Figure 1: Production possibility frontier Source: Schäfer and Ott (2004, p. 24) All points on the production possibility frontier are efficient, while any point under the curve, such as point C, is inefficient. The efficiency is reflected by the fact that it is possible to produce more of all the goods using the same quantity of resources. On the contrary, efficient production refers to that point where it is no longer possible to produce more of one good without lowering the output of another good. In figure 1, a move from point D to point E is only possible if the quantity of good X is lowered by ∆X; that is, it is possible to produce ∆Y more of Y only if the output of X has been reduced by ∆X. This is a condition where one has to shift resources from the creation of one good to another. It is important however to note that efficient production is not the same as Pareto efficiency. Optimality in production can be represented by considering the production functions of two firms X1 and X2. An Edgeworth box can be used to represent the production isoquants of the two firms, with the origin of X1 in the lower left-hand corner and the origin of X2 in the upper right-hand corner. Figure 2 below shows the possible allocations of the fixed quantities of the factors of production (labour and capital) between the two firms. The Pareto efficiency allocation of the factors of production between the two firms will lie on the contract curve that joins the points of tangency between the isoquants of X1 and X2. The gradient of the isoquants determines the marginal rate of substitution between the two factors in the production process. Figure 2: Efficiency in production and the Pareto allocation points Source: Dinwiddy and Teal (1996, p. 63). In figure 2, an assumption is made that neither firm suffers from technical inefficiency in its production processes. The two sets of isoquants represent the maximum output that is achievable with the given output without having to increase the level of factor inputs. Efficient consumption Efficient consumption is attained when, on the margin, no one is willing to forgo more of good Y for good X than is any other individual (Hirshleifer, Glazer & Hirshleifer, 2005, p. 506). That is, if this condition fails to hold between any two individuals, they could both gain by the trade-off. For instance, if Mary from her allocation of goods, is willing to sacrifice five apples for one more quart of milk; and suppose Tom is willing to forgo one quart of milk for three apples, then the two individuals will both benefit from the trade-off. Efficient consumption is that state when it is no longer feasible to increase satisfaction by further exchanges of two good or services. This implies that it is not simply the allotment of entitlements with particular rights and the availability of goods that establish the degree of satisfaction that can be derived by a society. The welfare of the society can also increase even without a rise in production provided that efficient consumption has not been attained, and this point is arrived at when the marginal utility of all goods for each member of the society is equalised (Schäfer & Ott, 2004, p. 23). With respect to consumption, Pareto efficiency conditions can be represented in a schema by considering the utility of functions as well as the production functions that underpin the construction of the two-consumer general equilibrium. The representation can be done using an Edgeworth box (a way of distributing resources). It can be assumed that a given quantity of good 1 which is measured on the horizontal axis in figure 3, and a given quantity of good 2, measured on the vertical plane, are to be distributed between two consumers A and B. Figure 3 shows the indifference curves of A and B; those of A are drawn from a starting point in the lower left-hand corner of the Edgeworth box while those of B begin from the upper right-hand corner. In the figure, the Pareto efficient points are those where the indifference curves of A are tangential to the indifference curves of B. This can straightforwardly be seen by considering any point that is away from the contract curve drawn on figure 3 to link all the tangency points. At any other point within the Edgeworth box in figure 3, the satisfaction of one consumer would be increased without reducing the utility of the other – implying that a Pareto improvement would be achieved. This emphasises the fact that Pareto efficiency is the opposite of Pareto improvement since Pareto efficiency in the diagram is only possible along the curve joining the tangential points formed by indifference curves A and B. Figure 3: Efficiency in consumption: illustration of the Pareto efficiency points Efficient structure of production Efficient production and efficient consumption are essential but not sufficient conditions for allocative efficiency. Since in a society there will be goods that have a high level of satisfaction, but are either produced in too small amount or none at all, this means that productive efficiency is possible. Efficient consumption is also feasible, because once goods have been manufactured, the utility that they produce can be improved by exchange. Additionally, it may still be possible to increase utility of the society if the structure of production can be altered. An efficient production structure is achieved at a point where creating a marginal unit of one good or service (X) results in a decline in the production of another good (Y), such that the individuals in the society are not willing to forgo some of the production of good Y so as to create an extra unit of good X. If all the conditions above, that is, efficient production, efficient consumption, and efficient structure of production are fulfilled, then a condition of Pareto efficiency is created. Along this line, a very vital economic result is that postulated by Gerrard Debreu and Kenneth Arrow, who proved that under perfect competition, a situation is reached in which no one can be made better off without worsening the condition of another person, i.e. Pareto efficiency is attained (Schäfer & Ott, 2004, p. 26; Young, 2004, p. 983; Mandal, 2009, p. 218). PARETO EFFICIENCY AS A GUIDE TO ECONOMIC POLICY Pareto efficiency is an important concept in economics with wide-ranging applications in game theory, social sciences and engineering. An economic system that is Pareto inefficient (that is one that is not Pareto efficient) means that a certain alteration in allocation of goods or services may result in some people being made better off with no person’s condition being worsened, and can therefore be made more Pareto efficient by a Pareto improvement. Generally, it is accepted that situations that are not Pareto efficient need top be avoided; hence Pareto efficiency is a vital decisive factor for assessing economic systems as well as public policies (Taylor & Weerapana, 2009, p. 185) An economic system that is not Pareto efficient necessitates a Pareto improvement. As such, policy decisions can be made to reallocate resources, such that at least one participant’s situation can be improved without deteriorating the situation of another (Pinstrup-Andersen, Watson & Frandsen, 2011, p. 312). The conditions that must be fulfilled for Pareto efficiency to occur are that (1) the marginal benefit of the last food that is produced must be equal to its marginal cost; (2) the marginal cost of production for all manufacturers must be matching; and (3) the marginal benefit for all consumers must be matching (Taylor & Weerapana, 2009, p. 188). If marginal benefit surpasses marginal cost, this implies that too little of the good is being produced, while if marginal cost exceeds marginal benefit, then a surplus of the good is being manufactured. In both cases, it is necessary to make an economic decision that would adjust the quantity being produced so as to enhance efficiency. CONCLUSION Pareto efficiency is a situation that arises when it is not possible to improve one individual’s condition without worsening the condition other individual. It occurs in terms of both production and consumption and if a condition of one party is improved, it results into the condition of another individual or individuals being made worse off. An economic situation that is not Pareto efficient is deemed to be undesirable, and hence necessitates Pareto improvement. To achieve this, it is necessary to make policy decisions that adjust production so that some level of efficiency is achieved in the economy. REFERENCES Dinwiddy, C L & Teal, F 1996, Principles of Cost-Benefit Analysis for Developing Countries, Cambridge University Press, Cambridge. EconGuru, no date, ‘What is Pareto efficiency?’ viewed 18 May 2012 Hirshleifer, J, Glazer, A & Hirshleifer, D 2005, Price Theory And Applications: Decisions, Markets, and Information, 7th edn, Cambridge University Press, Cambridge. Mandal, B N 2009, Global Encyclopaedia of Welfare Economics, Global Vision Publishing House, New Delhi. Osborne, M J 1997, ‘Pareto efficiency’, viewed 18 May 2012 Pinstrup-Andersen, P, Watson, D D & Frandsen, S E 2011, Food Policy for Developing Countries: The Role of Government in Global, National, and Local Food Systems, 2nd edn, Cornell University Press, Ithaca, New York. Schäfer, H & Ott, C 2004, The Economic Analysis of Civil Law, Elgar Publishing, New York. Taylor, J & Weerapana, A 2009, Principles of Microeconomics: Global Financial Crisis, 6th edn, Cengage Learning, New York. Young, M W 2004, Malinowski: Odyssey of an Anthropologist, 1884–1920, Yale University Press, New Haven, CT, viewed 18 May 2012 Zerbe, R O, 2011, Economic Efficiency in Law and Economics, Edward Elgar Publishing, New York. Read More