Earn your certification as a Financial Modeling & Valuation Analyst (FMVA)®. Register today!

Pareto Efficiency

An economic situation wherein it is impossible to make one party better without making another party worse

What is Pareto Efficiency?

Pareto Efficiency, a concept commonly used in economics, is an economic situation in which it is impossible to make one party better off without making another party worse off.

 

Pareto Efficiency

 

Understanding Pareto Efficiency

To clearly understand the concept of Pareto Efficiency, it is important to introduce the concept of Pareto Improvement.

Pareto Improvement: A resource allocation is Pareto improved if there exists another allocation in which one person is better off, and no person is worse off.

Pareto Efficiency: A resource allocation is Pareto efficient if no Pareto improvement is possible.

Therefore, Pareto Efficiency indicates that resources can no longer be allocated in a way that makes a party better off without harming other parties. In Pareto Efficiency, resources are allocated in the most efficient way possible.

 

Pareto Efficiency and the Production Possibility Frontier

The concept of Pareto Efficiency can be applied to the production-possibility frontier. Consider the following diagram of an economy with outputs of Good A on the x-axis and Good B on the y-axis:

 

Pareto Efficiency - Graph

 

Consider points A, B, C, D above – which are Pareto efficient?

Recall that resource allocation is Pareto efficient if no Pareto improvement is possible.

  • Points A and B are Pareto inefficient because there is a possibility of increasing output of both goods A and B. It would be a Pareto improvement as the total output in the economy increases.
  • Points C and D are Pareto efficient because there is no Pareto improvement possible. Increasing the output of one good would decrease the output of the other good.

Therefore, every point on the PPF frontier is Pareto efficient.

 

Simple Example of Pareto Efficiency

Consider the following background information for an allocation problem:

  • Two types of goods: Apples and oranges
  • Two individuals: Colin and John

 

Consider the preferences for each individual:

  • Colin does not have a preference for apples or oranges
  • John has a preference for apples over oranges

 

Consider the following allocation:

  • Apples are all allocated to Colin
  • Oranges are all allocated to John

 

Is the allocation above Pareto efficient?

To determine whether an allocation is a Pareto efficiency, it is important to determine if a Pareto improvement is possible. As in, is there a way to make an individual better off without making someone else worse off?

In the example above, a Pareto improvement is possible. If the allocation of oranges went to John and the allocation of apples went to Colin, both individuals would be better off while no one would be worse off. John has a preference for apples while Colin does not have a preference for apples or oranges.

Therefore, the current allocation of apples to Colin and oranges to John is Pareto inefficient. For the allocation to be Pareto efficient, apples should be allocated to John and oranges should be allocated to Colin.

 

Intermediate Example of Pareto Efficiency and Equality

Consider the following background information for an allocation problem:

  • One type of good: A chocolate bar
  • Two individuals: Colin and John

 

Consider the preferences for each individual:

  • Colin prefers as much of the chocolate bar as possible
  • John prefers as much of the chocolate bar as possible

 

Consider three potential allocations:

  • A chocolate bar is all allocated to Colin
  • A chocolate bar is all allocated to John
  • A chocolate bar is half allocated to Colin and half allocated to John

 

Is each allocation above Pareto efficient?

To determine whether an allocation is a Pareto efficiency, it is important to determine if a Pareto improvement is possible. As in, is there a way to make an individual better off without making someone else worse off? Since each individual prefers as much of the chocolate bar as possible, there is not an allocation that makes an individual better off without making someone else worse off. Therefore:

  • Is Pareto efficient
  • Is Pareto efficient
  • Is Pareto efficient

 

The example illustrates an important aspect of Pareto efficiency. That is, Pareto efficiency does not equate to fairness or equality. Allocations in the first and third allocation illustrate that even though the opposing individual does not have any chocolate bar, it is Pareto efficient because allocating a portion of the chocolate bar to the individual who does not have any would make the person who is losing that portion of the chocolate bar worse off.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Invisible Hand
  • Law of Supply
  • Nash Equilibrium
  • Normative Economics

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!