Pareto efficiency

Pareto efficiency

Pareto efficiency – definition

Pareto efficiency means that an economy is making the best use of its scarce resources by employing all its resources to make goods and services in the least-cost way.

A specific combination of scarce resources is said to be ‘Pareto efficient’ (or ‘Pareto optimal’) if it is impossible to make an individual or group of individuals ‘better off’ without reallocating resources from other individuals or groups thereby making them worse off. A combination of scarce resources is said to be ‘Pareto inefficient’ if it is possible to make someone better off without making someone else worse off.

For example, if a football stadium is full up, with no spare seats, the use of the stadium would be Pareto efficient or optimal. In this case, the only way to allow another spectator into the stadium to watch the match (or game) is to remove an existing spectator, and allocate their seat to the new spectator. Conversely, the stadium is used inefficiently when there are still spare seats.

Pareto efficiency can be explained using production possibility frontiers (PPFs). Operating on the edge of a PPF is considered to be Pareto efficient, given that trying to increase the output of one good must mean the sacrifice of another good.

In the above diagram, both A and B are Pareto efficient – it is not possible to increase K, by moving from point B to point A, without losing a quantity of C (C1 to C2). However, point X is Pareto inefficient because it is possible to increase K goods (and move from X to A), and increase C goods at the same time. Hence, any point inside a PPF is Pareto inefficient