Meaning of Pareto optimality
Pareto optimality occurs when it is impossible to reallocate resources so that one person becomes better off without making another worse off.
Figure 1: A PPC showing Pareto Optimality
On the Production Possibility Curve (PPC), a movement from one point to another is Pareto optimal or Pareto efficient – the quantity of one good increases, while the quantity of the other good decreases. In Figure 1 above, the movement from Point A to Point B on the PPC is Pareto optimal.
This concept, also referred to as Pareto efficiency, was introduced by Vilfredo Pareto, an Italian economist.
Pareto Improvement
There is Pareto improvement if resources can be reallocated in such a way that at least one person is better off without making anyone worse off. The welfare improvement experienced by one person is not at the expense of any other person.
A movement from one point to another within the PPC that increases the quantity of one good without reducing the quantity of the other represents Pareto improvement. It is either that both goods are increasing in quantity or the quantity of one increases while the quantity of the other is the same. But when they are on the PPC, no such improvement is possible – some quantity of one good must be given up to increase the quantity of another. That is when Pareto optimality is attained. For example, a government project that is beneficial to everyone represents Pareto improvement. When it gets to the point that some individuals would be harmed, Pareto optimality is achieved.
Pareto optimality and fairness
Pareto optimality is more about efficiency, not equity. Resources may be concentrated in the hands of a few people, but it is Pareto optimal. For example, the construction of a major road reduces the welfare of some people while harming others. It is Pareto optimal but not fair.
Usefulness of Pareto optimality
Welfare improvement of policies
It is used to evaluate government policies to ascertain whether they can improve people’s welfare or create equity. The government would normally combine efficiency with other criteria to ensure that welfare and equity are attained.
Efficiency
It provides a clear standard for analysing whether resources are used efficiently. Efficiency is achieved when the economy is at any point on the PPC.
Determining the environmental impact of activities
It helps in ensuring that resources are used in a sustainable manner. It evaluates the impacts of economic activities on the environment.
Limitations of Pareto optimality
It ignores equity
Allocation can be Pareto efficient without a fair or equitable distribution of resources. One person might have much more than others, but a reallocation of resources will make him worse off. One person may even own all the wealth.
It is unrealistic
Pareto optimality is possible in a perfectly competitive market. However, a perfectly competitive market is unrealistic due to the dominance of one major seller, sellers having control over prices and imperfect knowledge about the market. Pareto optimality is not attainable in a world of imperfection.
Short-term in nature
Pareto optimality ignores dynamic efficiency. It evaluates efficiency at a point in time (static efficiency), without necessarily considering the fact that efficiency can change over a long time due to innovation, investment in technology or Research and Development (R&D).