PARETO OPTIMALITY

Pareto efficiency or Pareto optimality is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto (1848–1923), an Italian economist who used the concept in his studies of economic efficiency and income distribution. In a Pareto efficient economic system no allocation of given goods can be made without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement.

An allocation can be defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made. Pareto efficiency is a minimal notion of efficiency and does not necessarily result in a socially desirable distribution of resources: it makes no statement about equality, or the overall well-being of a society.

Pareto rejected the notion of cardinal utility and its additive nature. He detached the welfare economics from the interpersonal comparison of utilities. Pareto’s concept of maximum social welfare is based upon ordinal utility and also free from value judgments. Pareto optimum is a position where it is impossible to make anyone better off without making someone worse off by any reallocation of resources or inputs and outputs.

According to Pareto optimum the welfare of an individual of the society cannot be increased without decreasing welfare of another member. Pareto’s concept of Pareto optimum is based upon Pareto’s criterion of social welfare. Pareto’s criterion of social welfare states that if any reorganization of economic resources does not harm anybody and makes someone better off, it indicates that an increase in social welfare.

Marginal conditions of Pareto optimality

assumptions

1. Each individual has his own ordinal utility function and possess a definite amount of each product and factor.

2.  Production function of every firm and the state of the technology is given and remain constant.

3.  Goods are perfectly divisible.

4.   A producer tries to produce a given output with least cost combination of factors.

5.   Every individual want to maximize his satisfaction.

6.   Every individuals purchase some quantity of all goods.

7.  All factors of production are perfectly mobile.

The first order conditions of Pareto optimum are required for the achievement of Pareto optimum or maximum social welfare are follows.

A.  The optimum distribution of products among the consumers (efficiency in exchange)

B. Marginal rate of substitution of one good for another is the amount of one good necessary to compensate for the marginal unit of another to maintain constant level of satisfaction.

C. The marginal rate of substitution between any two goods must be the same for every individual who consumes them both.

D. The marginal rate of substitution between two goods is not equal in case of any two consumers, when they entering in to the exchange will increase satisfaction of the both consumers or increase ones satisfaction without affecting the satisfaction of the other.

E. The available factors of production should be utilized in the production of different goods, so it is impossible to increase the output of one good without decreasing out of another good. Or it is impossible to the output of both goods by reallocating the factors of production.

F. The situation would be achieved if the marginal rate of substitution between any pair of factors must be the same for any firms producing two different products and using both the factors to produce the products.

G. The efficiency in production is related to the technical conditions of production and the state of consumer’s preference.

H. Fulfillment of this condition determines the optimum quantities different commodities to be produced with given factor endowments.

I. According to this view, the economic efficiency or maximum social welfare can be achieved in accordance with the consumer preference.

J. The optimum degree of specialization is the necessary condition for determining the optimum level of output of every product by every firm, to obtain Pareto optimum the marginal rate of transformation between any two products must be the same for any two firms that produce both.

K.  This condition states that marginal product of any factor in producing a particular product must be the same in all firms producing that product.

L. Optimum allocation of factor’s time states that, in case of labour the marginal rate of transformation between leisure and work for money income must be equal to the marginal rate of transformation between labour time and the product.

M. Marginal rate of substitution between money funds at any pairs of times must be the same for every pairs of individuals or firms.

PARETO’S CRITERION WITH THE HELP OF UTILITY POSSIBILITY CURVE

A.  Suppose there are two individuals sharing a given bundle of goods X, A’s utility is represented on the horizontal axis and B’s utility on the vertical axis. 

B. Thus BA represents the utility possibility curve of all combinations of individual utilities.

C. Pareto’s criterion of social welfare shows that any change which causes a movement from C to F on the production possibility curve means that there is an increase in social welfare because it makes both individual better off their by maximizing social welfare.

D.  An improvement on the BA curve like C to D or E makes at least one person better off without making others worse off. 

E. But any point outside the segment DE is not a Pareto improvement. I.e. C to H improves B’s welfare but offsets A’s welfare.

CRITICISM ON PARETO’S VIEW 

A. Pareto’ criterion is not free from value judgments, Pareto’s criterion discussed that a policy change is making someone better off without making others worse off, which means that an increase in social welfare, itself a value judgment. 

B. Pareto’s criterion cannot be applied to judge the social desirability of those policy proposals which benefits someone and harms others, because policy changes helping very rarely so which may harm at least one individual in the society. 

C. Pareto evaluates only unambiguous changes in welfare.