What is Pareto Efficiency?

Defining Pareto efficiency

The underlying objective of the study of economics is to achieve efficiency, which is defined as the optimal allocation of resources such that social welfare is maximised. Indeed, Alfred Marshall, considered the father of microeconomics and welfare economics, opens his most renowned work Principles of Economics by specifying exactly this: 

As the field of economics evolved, different definitions of “efficiency” emerged, each addressing different aspects of optimal resource allocation across different contexts. More specifically, there are three main definitions for efficiency; this study guide focuses on Pareto efficiency, named after Italian economist Vilfredo Pareto. This type of efficiency focuses on the optimal allocation of resources in markets, looking at the most desirable output levels across markets to prevent scarcity and surpluses, allowing them to interact and co-exist harmoniously. For example, Pareto efficiency principles can be used to explain why a city might choose to transform an underused public park into a community garden. Suppose the park is rarely visited by citizens, but demand for local, fresh produce is high. Reallocating those land resources to grow food can benefit the entire community by providing fresh produce without negatively impacting those who rarely use the park, thereby achieving Pareto efficiency.

In The Economics of Collective Choice, Joe B. Stevens writes,

This study guide explains Pareto efficiency in depth, using the production possibility frontier (PPF) model to illustrate what this type of efficiency looks like in practice through real-life examples. 

Pareto efficiency and the PPF model 

How much does it take to make someone better off without making someone else worse off? Do several Pareto efficiency outcomes exist? Or is there a single one? These are some of the questions that may arise in the reader's mind when first introduced to such a concept. Economists typically respond by visualising the answers using graphical representations. Pareto came up with a model referred to as a production possibility frontier (PPF), where he depicts the workings of Pareto efficiency; the model “shows all the combinations of two outputs that can be produced by a society in a given time period” (Goodwin et al., Microeconomics in Context, 2018).

These graphical representations are best understood with an example (see Figure 1). Suppose you have a garden where you can grow a certain amount of flowers (y-axis) or vegetables (x-axis) to sell at the weekend’s farmer's market. The PPF (or Pareto Curve) is a curve that shows all the different combinations of flowers and vegetables you can grow using all your resources (time, space, water, etc.) efficiently. Each point on this curve (e.g., points A or B) represents a different mix of the two products you can achieve at full efficiency. 

The outcomes in this curve are Pareto efficient because resources have been used in such a way that you can’t choose more flowers without getting fewer vegetables and vice versa.  Indeed, if you're at a point on the PPF curve, you're at Pareto efficiency because any change to produce more of one good necessarily means producing less of the other, assuming your garden's resources are fully and efficiently used. For example, say that you wanted to produce a lot more flowers than vegetables at Point C. You wouldn’t be able to do so unless you gave up on the production of vegetables, making their production worse off and resulting in Pareto inefficiency.

Equally, if you're producing at a point inside the curve (Point D), this is Pareto inefficient because it means there's still room to grow more flowers or vegetables (or both) without sacrificing anything. In other words, there is a potential Pareto improvement, as described by Stevens: 

Being on the curve indicates that your garden is being used in such a balanced way that you can't improve the yield of one product without hurting the other, showing the trade-off between the two goods. 

Even though this was a simplified version of Pareto efficiency and the PPF, the workings can be extrapolated to markets and industries with competing resources to understand where the optimal share of resources lies. For example, economies may apply Pareto logic to decide on the distribution split of water available in a country between manufacturing and agriculture. Under the assumption of perfect competition and where all goods and services are tradeable in competitive markets with zero transaction costs, all markets in an economy will tend toward Pareto efficiency. A practical example of this is the allocation of water resources in Israel, which employs advanced water management technologies and policies to distribute water between agricultural, industrial, and residential uses. By using technologies like drip irrigation and water recycling, the utility of its limited water supply is maximised, ensuring that the allocation of this resource is managed in a way that no further reallocation would improve the situation of one sector without harming another, thus aiming for a Pareto efficient outcome.

Alternative approaches to efficiency

As described in the introduction, Pareto efficiency is not the only way of thinking about efficiency, and there are several definitions for it depending on the context and who the benefactor of these efficiency gains are. In Principles of Economics 2e, Stephen A. Greenlaw, Timothy Taylor, and David Shapiro briefly explain the difference between the three main types of efficiency: productive, allocative, and Pareto: 

Indeed, allocative efficiency focuses on achieving the production of an optimal mix of goods and services that align with the preferences, needs, and wants of entire populations, benefiting whole societies and economies. On the other hand, productive efficiency is all about optimising production for firms, looking at how they can produce goods and services at their lowest possible cost. Firms often achieve productive efficiency by using the fewest resources possible or the least expensive combination of resources for production. Pareto efficiency focuses on optimising resource allocation across individual markets to eliminate scarcity or surplus, ensuring a fair and equitable distribution of resources throughout industries according to their respective demand and supply curves. 

Limitations of Pareto efficiency

Pareto efficiency provides a solid foundation and framework for economists to understand how to allocate resources across industries, ensuring they are adequately distributed. However, like most static economic models, there are many things that this model fails to account for, which creates skepticism around its effectiveness as a way of modeling efficiency.

Firstly, Pareto efficiency fails to take into account that economies are dynamic and ever-changing, with different markets facing different conditions at different points in time. Indeed, as Roger L. Martin describes in When More is Not Better, Pareto efficiency models markets and economies in their entirety as if they were “machines” that can be easily tweaked to yield optimal outcomes:

The book emphasises the importance of recognising economies as dynamic ecosystems rather than mechanisms for economists to optimise, highlighting the need for inclusive participation and shared responsibility in promoting economic wellbeing. 

In New Essays on Pareto’s Economic Theory (2009), Luigino Bruni and Aldo Montesano develop Martin's discussion on the flaws of Parento efficiency. Martin hinted that it is important to ensure individuals across economies have equal and accessible opportunities to contribute to efficiency. Bruni and Montesano take this critique one step further, arguing that Pareto efficiency often fails to account for the differences in starting points and initial allocations of different markets and individuals across economies: 

They suggest that for the Pareto model to work effectively, it must consider the different initial distributions of the variables it models, which is an aspect it currently overlooks. 

The last notable limitation of Pareto efficiency, which is growing louder as economies strive to become more sustainable, is related to externalities. Indeed, as Stevens points out in The Economics of Collective Choice (2018), the model fails to account for the external spillover effects — both positive and negative — that production processes impose on third parties not directly involved in production processes. These unaccounted spillover effects lead to inefficiencies within economies. For instance, an example of a negative externality would be pollution generated from manufacturing, affecting non-participating individuals’ health and wellbeing. On the other hand, an example of a positive externality would be the supply of vaccination, which not only benefits its primary users (i.e., those receiving the vaccination) but also significantly improves the quality of life for surrounding communities by avoiding the spread of specific illnesses. 

The effects of these negative and positive externalities are not captured in traditional Pareto efficiency analysis. Stevens provides an updated view of the model, explaining how these effects can be accounted for in a PPF:

Closing thoughts

Overall, Pareto efficiency looks at how resources can be optimally distributed across markets such that no one in the economy can be made better off, without making someone else worse off. Economists tend to represent this type of efficiency using a production possibility frontier (PPF) graph, where all production combinations on the PPF curve are Pareto efficient. It's important for readers to understand that efficiency can be viewed through different lenses; allocative and productive efficiency offer alternative perspectives, each with its own context and beneficiaries of the efficiency gains. Equally important is to understand and accept the limitations of such models. In Pareto efficiency modeling, limitations include its static nature and inability to account for initial distributions of resources and externalities. However, by embracing the complexity of these models, economists have improved them over time to better navigate the intricacies of economic efficiency, fostering a more nuanced understanding of how resources can be most effectively allocated for the greater good.

Further reading on Perlego

How Efficiency Changes the Game: Developing Lean Operations for Competitive Advantage (2021) by Ray Hodge

Social Choice and Individual Values (2012) by Kenneth J. Arrow and Eric S. Maskin

The Economics of Welfare (2017) by Arthur Cecil Pigou

Bibliography

Bruni, L. and Montesano, A. (2009) New Essays on Pareto’s Economic Theory. Routledge. Available at: https://www.perlego.com/book/714609/new-essays-on-paretos-economic-theory-pdf 

Goodwin, N. et al. (2018) Microeconomics in Context. 4th edn. Routledge. Available at: https://www.perlego.com/book/2193491/microeconomics-in-context-pdf 

Greenlaw, S., Taylor, T., and Shapiro, D. (2017) Principles of Economics 2e. OpenStax. Available at: https://www.perlego.com/book/695160/principles-of-economics-2e-pdf 

Marshall, A. (2021) Principles of Economics. Illustrated. Strelbytskyy Multimedia Publishing. Available at: https://www.perlego.com/book/3041868/principles-of-economics-illustrated-pdf 

Martin, R. (2020) When More Is Not Better: Overcoming America’s Obsession with Economic Efficiency Harvard Business Review Press. Available at: https://www.perlego.com/book/1351529/when-more-is-not-better-overcoming-americas-obsession-with-economic-efficiency-pdf 

Organisation for Economic Co-operation and Development (OECD) Israel's sustainable water management plans. OECD. Available at: https://www.oecd.org/climate-action/ipac/practices/israel-s-sustainable-water-management-plans-d81db5f5/

Stevens, J. B. (2018) The Economics Of Collective Choice. Routledge. Available at: https://www.perlego.com/book/1597020/the-economics-of-collective-choice-pdf