- When no more adjustments in the economy can make one individual better off without making another worse off, the economy is said to be in a Pareto Optimal state. This can be explicitly studied in terms of three conditions that must be met in order for a market equilibrium to result in Pareto Optimality. Exchange efficiency, production efficiency, and output efficiency are all things that should be considered.
- Exchange efficiency
When it is impossible to redistribute goods in such a way that the utility (welfare) of one consumer is increased without diminishing the utility (welfare) of another, exchange efficiency exists. A simple illustration of this is two people, one with a loaf of bread and the other with a block of cheese. By substituting cheese for bread, both can benefit. A well-functioning exchange system will allow bread and cheese to be exchanged until neither party is better off without the other becoming worse off.
Exchange in a multi-product, multi-consumer economy is significantly more complicated, and it often entails the use of money to assist it. The concept, though, remains the same. From the viewpoint of exchange efficiency, the economy is operating sub-optimally as long as products may be reallocated to make one person better off without making another worse off. Exchange will take place in a perfectly competitive market unless this requirement is met.
Pareto Optimality is not always the product of exchange efficiency. This is due to the fact that it only applies to a restricted set of commodities. By modifying the bundle of products generated in the economy, it may be feasible to make one or more individuals even better off – without making anyone else worse off. This could entail increasing the total amount of commodities produced or changing the mix of items produced.
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Production efficiency
When the available production factors are assigned amongst goods in such a way that it is impossible to reallocate the production factors in order to increase the output of one product without diminishing the output of another, production efficiency is achieved.
At the company level, this is similar to technical or production efficiency. What is being emphasised here is that there are many scenarios in which an economy’s total output can be increased at no additional cost by simply reallocating factors of production. This is due to the fact that some factors of production are more productive than others.
Producers bid for factors of production in a competitive economy until they are reassigned to their most productive use.
For example, if the agricultural sector employs a lot of unproductive, low-wage labour and there are labour shortages in the industrial sector, where labour productivity is potentially high, factory owners will bid up the price of labour and recruit workers from the agricultural sector. This could result in a considerable increase in industrial output without having a negative impact on agricultural output. The economy is operating inefficiently in terms of production efficiency as long as factors of production can be transferred in a way that raises the output of one product without decreasing the output of others.
- Output efficiency
When the combination of products actually produced is such that there is no other combination of products that will enhance one consumer’s welfare without lowering the welfare of another, this is known as output efficiency.
To meet this requirement, both the trade efficiency and production efficiency criteria must be met. The economy operates with production efficiency because the combination of outputs generated according to this requirement is dispersed among customers according to the exchange efficiency criterion.
In a perfectly competitive economy, Pareto Optimality is the result of rational economic behaviour on the part of producers, consumers, and owners of sources of production. Although we don’t have the time or space to look into the underlying theory, it can be demonstrated that Pareto Optimality is obtained when all markets are fully competitive and in balance.
It is crucial to remember that while Pareto Optimality is the result of an economy meeting all three efficiency requirements given above, it doesn’t mean there’s only one ‘optimal’ resource allocation. In a Pareto efficient economy, the aggregate economic welfare is maximized for a given income distribution and set of consumer preferences. Individual consumer incomes are affected by changes in income distribution. Their preferences will shift to the left or right when their earnings fluctuate, as will their demand curves for various things. As a result, the many markets that make up the economy will reach a different equilibrium point. A separate Pareto Optimum characterises each alternative income distribution or set of preferences. Therefore, because there are an endless number of alternative methods to divide income, there are an infinite number of different Pareto Optimal equilibriums.
- The first fundamental theorem of welfare economics or the “Invisible Hand Theorem”:
Any competitive equilibrium results in a Pareto optimal resource allocation. The key idea is that markets lead to the social ideal. As a result, no government interference is required, and only “laissez faire” policies should be implemented. Those in favour of government action, on the other hand, argue that the assumptions required for this theorem to function are rarely seen in practice.
- The Samuelson condition:
The conditions for an economy with n consumers are as follows:
MRSi=MRTi
MBi=MC
MRSi refers to individual i’s marginal rate of substitution and MRT refers to the marginal rate of transformation between the public good and an arbitrarily determined private good in the economy.
The Samuelson condition can be re-written as follows only if the private good is a numeraire good:
MBi=MC
The marginal benefit of consuming one extra unit of the public good to each person is MBi, and the marginal cost of supplying that good is MC. To put it another way, the public good should be provided as long as the overall benefits to consumers outweigh the cost of delivering it. (Keep in mind that public goods are non-rivalrous, meaning that they can be enjoyed by a large number of people at the same time).