Thursday, April 12, 2012

Pareto Efficiency

According to definition, a Pareto efficient situation is one at which no party can be better off without making another party worse off. To be more specific, all resources are being used. Similarly, a Pareto inefficient situation is one at which one or more parties can gain something without making anybody else worse off.
These definitions are a little vague, so I will illustration a simple example. Let’s pretend that you and I are walking and we come across a gold mine with five nuggets, and we each take two. This is a Pareto INefficient situation because there is one nugget remaining and either one of us could take it without making the other worse off. Although we were trying to be fair be each only taking two, we are also being inefficient according to the aforementioned theory. Let’s now say that you decide to take the one remaining gold nugget. We are now in a Pareto efficient situation, because all resources are distributed. In addition, neither party can have an additional nugget without steeling from somebody else.

Notice, however, that Pareto efficiency has nothing to do with equality. All resources in the world have to be in use—however, they can be used by one person or by seven billion people.
If, for example, you went ahead of me and got all five nuggets, the situation would still be Pareto efficient. Although I would have zero, it would not matter according to the theory. As you can see in the graph below, there are many Pareto efficient points. They all equality ‘efficient,’ so any one of these points would satisfy efficiency in the same way.

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