Overview

How do you know if an economy is “perfect”? Vilfredo Pareto said: “It’s perfect if you can’t make anyone happier without making someone else sadder.” If I have 10 apples and you have 0, giving you 1 apple makes you happier but me sadder. So the original state was Pareto Efficient. It doesn’t mean it’s fair; it just means it’s efficient.

Core Idea

The core idea is No Waste. If there is a way to make someone better off without hurting anyone else (a “Pareto Improvement”), then we should do it. If we have done all those things, we are at the Pareto Frontier.

Formal Definition

A state of allocation of resources where it is impossible to make any one individual better off without making at least one individual worse off.

Intuition

  • Pizza: We have a pizza.
    • Scenario A: I eat the whole pizza. You starve. (Pareto Efficient. To give you a slice, I have to lose a slice).
    • Scenario B: We throw the pizza in the trash. (Inefficient. We could both be happier if we ate it).
    • Scenario C: We split it 50/50. (Pareto Efficient).
    • Lesson: Efficiency says “Don’t waste the pizza.” It doesn’t say “Share the pizza.”

Examples

  • Trade: If I trade my apple for your orange, we are both happier. That is a Pareto Improvement. We keep trading until we can’t improve anymore.
  • Traffic: If a road is empty, letting one more car on it helps the driver and hurts no one. If the road is jammed, letting one more car on it slows everyone down.

Common Misconceptions

  • Efficient = Good: No. A dictator owning everything is Pareto Efficient. Economics separates “Efficiency” (size of the pie) from “Equity” (how the pie is sliced).
  • Pareto Principle (80/20 Rule): 80% of the wealth is owned by 20% of the people. 80% of the work is done by 20% of the team. (Named after the same guy, but a different concept).
  • Kaldor-Hicks Efficiency: A more realistic version. A change is good if the winners could compensate the losers and still be better off (even if they don’t actually pay them).

Applications

  • Game Theory: Finding the Nash Equilibrium often involves looking for Pareto Efficiency.

Criticism / Limitations

  • Status Quo Bias: Pareto Efficiency protects the rich. It says we can’t tax the rich to feed the poor because that would make the rich “worse off.”

Further Reading

  • Pareto, Vilfredo. Manual of Political Economy.