Pareto Efficiency

One of the hardiest and most widely cited results in all of economics, Pareto efficiency, was developed by Vilfredo Pareto in “The Maximum of Utility Given by Free Competition,” an article published in Giornale degli Economisti in 1894, and his Manuale d'economia politica, first published in 1906 and revised and translated into French in 1909. Pareto proposed that an allocation or distribution of goods was efficient or optimal if, once attained, any move away from it could not make anyone better off without at the same time making at least one other person worse off. Allocations that are not Pareto optimal allow for redistributions that make at least one person better off while making no one else worse off.

Consideration of Pareto efficiency, the Pareto process, and other associated terms and concepts constitutes a large part of modern welfare economics, the branch of economics devoted to the study of the distribution and allocation of goods and services.

Pareto developed his approach in response to the utilitarian Benthamite “calculus,” which was premised on the view that utility was cardinally measurable and comparable across individuals. The view that utility is both cardinally and interpersonally measurable implies, among other things, that social policies can be designed for redistribution of goods leading to the utilitarian goal or ethic of the “greatest good for the greatest number.” According to this view, policy makers may calculate the net aggregate utility increase or decrease of any policy change, with policy changes leading to greater increases in net utility being preferred even though some individuals may be absolutely worse off after the change.

Considering the possibility that policy changes would cause some to sacrifice for others led to a focus on the equity or fairness of such changes. For example, who decides who gains and who loses and how much each person or group gains or loses? This requires some socially accepted ethical rule beyond Bentham's “greatest good for the greatest number.” This new rule itself—whatever it might be—represents a change in policy and thus is subject to the same focus on equity. Solving this requires a socially acceptable metarule on rule changes, and the infinite regress nature of the problem reveals itself.

Also, from the 1880s onward, it was noted that for the “felicific calculus” of Bentham to work, everyone would have to have identical utility functions in income, which is a special and limiting assumption. Identical utility functions in income imply that the social optimum is one of uniform, or equal, income distribution, where each individual assigns the same utility value to his or her last dollar's worth of income. It is not the equal distribution outcome that is being criticized but the restrictive assumption on utility that produces it.

Once cardinal utility was abandoned, the search was on for a new criterion for judging the efficiency of policies. The inability to make interpersonal utility comparisons means that a simple summing up of individual utilities into one number is impossible. Yet without knowing by how much “losers” lose relative to how much “winners” gain from any policy change, measuring the impact of a policy and hence finding a social optimum (or utility optimum optimorum) becomes extremely challenging.

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