Pareto Efficiency

Pareto efficiency
From Wikipedia, the free encyclopedia

Pareto efficiency, or Pareto optimality, is a state of allocation of resources in which it is
impossible to make any one individual better off without making at least one individual worse
off. The term is named after Vilfredo Pareto (18481923), an Italian economist who used the
concept in his studies of economic efficiency and income distribution. The concept has
applications in academic fields such as economics, engineering, and the life sciences.
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 is 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 wellbeing of a society.[1][2] The notion of Pareto efficiency can also be applied to the selection of
alternatives in engineering and similar fields. Each option is first assessed under multiple criteria
and then a subset of options is identified with the property that no other option can categorically
outperform any of its members.
Contents
1 Overview
2 Weak Pareto efficiency
3 Use in engineering
o 3.1 Formal representation
3.1.1 Pareto frontier
3.1.2 Relationship to marginal rate of substitution
3.1.3 Computation
4 Criticisms
o 4.1 Sen
5 See also
6 Further reading
7 References
Overview
A production-possibility frontier is an example of a Pareto Efficient Frontier. The connected line

of red points represent Pareto optimal choices of production.
If economic allocation in any system is not Pareto efficient, there is potential for a Pareto
improvementan increase in Pareto efficiency: through reallocation, improvements can be made
to at least one participant's well-being without reducing any other participant's well-being.
It is important to note, however, that a change from an inefficient allocation to an efficient one is
not necessarily a Pareto improvement. Thus, in practice, ensuring that nobody is disadvantaged
by a change aimed at achieving Pareto efficiency may require compensation of one or more
parties. For instance, if a change in economic policy eliminates a monopoly and that market
subsequently becomes competitive and more efficient, the monopolist will be made worse off.
However, the loss to the monopolist will be more than the offset by the gain in efficiency. This
means the monopolist can be compensated for its loss while still leaving a net gain for others in
the economy, a Pareto improvement.
In real-world practice, such compensations have unintended consequences. They can lead to
incentive distortions over time as agents anticipate such compensations and change their actions
accordingly. Under certain idealized conditions, it can be shown that a system of free markets
will lead to a Pareto efficient outcome. This is called the first welfare theorem. It was first
demonstrated mathematically by economists Kenneth Arrow and Grard Debreu. However, the
result only holds under the restrictive assumptions necessary for the proof (markets exist for all
possible goods so there are no externalities, all markets are in full equilibrium, markets are
perfectly competitive, transaction costs are negligible, and market participants have perfect
information). In the absence of perfect information or complete markets, outcomes will
generically be Pareto inefficient, per the GreenwaldStiglitz theorem.[3]
Weak Pareto efficiency

A "weak Pareto optimum" (WPO) is an allocation for which there are no possible alternative
allocations whose realization would cause every individual to gain. Thus an alternative allocation
is considered to be a Pareto improvement only if the alternative allocation is strictly preferred by
all individuals.When contrasted with weak Pareto efficiency, a standard Pareto optimum as
described above may be referred to as a "strong Pareto optimum" (SPO).
Weak Pareto-optimality is "weaker" than strong Pareto-optimality in the sense that any SPO also
qualifies as a WPO, but a WPO allocation is not necessarily an SPO.
Use in engineering
Example of a Pareto frontier. The boxed points represent feasible choices, and smaller values are
preferred to larger ones. Point C is not on the Pareto Frontier because it is dominated by both
point A and point B. Points A and B are not strictly dominated by any other, and hence do lie on
the frontier.
The notion of Pareto efficiency is also useful in engineering. Given a set of choices and a way of
valuing them, the Pareto frontier or Pareto set or Pareto front is the set of choices that are
Pareto efficient. By restricting attention to the set of choices that are Pareto-efficient, a designer
can make tradeoffs within this set, rather than considering the full range of every parameter.
Formal representation
Pareto frontier
For a given system, the Pareto frontier or Pareto set is the set of parameterizations (allocations)
that are all Pareto efficient. Finding Pareto frontiers is particularly useful in engineering. By
yielding all of the potentially optimal solutions, a designer can make focused tradeoffs within
this constrained set of parameters, rather than needing to consider the full ranges of parameters.
The Pareto frontier, P(Y), may be more formally described as follows. Consider a system with
function
, where X is a compact set of feasible decisions in the metric space
and Y is the feasible set of criterion vectors in
, such that
.
We assume that the preferred directions of criteria values are known. A point
preferred to (strictly dominating) another point
frontier is thus written as:
, written as
is
. The Pareto
.
Relationship to marginal rate of substitution
An important fact about the Pareto frontier in economics is that at a Pareto efficient allocation,
the marginal rate of substitution is the same for all consumers. A formal statement can be derived
by considering a system with m consumers and n goods, and a utility function of each consumer
as
where
constraint is written
multipliers are used:
is the vector of goods, both for all i. The supply

for
. To optimize this problem, Lagrange
where and are

multipliers.
Taking the partial derivative of the Lagrangian with respect to one good, i, and then taking the
partial derivative of the Lagrangian with respect to another good, j, gives the following system of
equations:
where
for j=1,...,n.
for i = 2,...,m and j=1,...,n,
is the marginal utility on f' of x (the partial derivative of f with respect to x).
Rearranging these to eliminate the multipliers gives the wanted result:
for i,k=1,...,m and j,s=1,...,n.

Computation
Algorithms for computing the Pareto frontier of a finite set of alternatives have been studied in
computer science, power engineering,[4] sometimes referred to as the maximum vector problem
or the skyline query.[5][6]
Criticisms
Pareto efficiency does not require an equitable distribution of wealth. An economy in which the
wealthy hold the vast majority of resources can be Pareto efficient. This possibility is inherent in
the definition of Pareto efficiency; by requiring that an allocation leave no participant worse off,
Pareto efficiency tends to favor outcomes that do not depart radically from the status quo.
Sen
Amartya Sen has elaborated a mathematical basis for this criticism, pointing out that under
relatively plausible starting conditions, systems of social choice will converge to Pareto efficient,
but inequitable, distributions.[7] A simple example is the distribution of a pie among three people.
The most equitable distribution would assign one third to each person. However the assignment
of, say, a half section to each of two individuals and none to the third is also Pareto optimal
despite not being equitable, because none of the recipients is left worse off than before, and there
are many other such distributions. An example of a Pareto inefficient distribution of the pie
would be allocation of a quarter of the pie to each of the three, with the remainder discarded. The
origin of the pie is conceived as immaterial in these examples. In such cases, in which a
"windfall" that none of the potential distributees actually produced is to be allocated (e.g., land,
inherited wealth, a portion of the broadcast spectrum, or some other resource), the criterion of
Pareto efficiency does not determine a unique optimal allocation.
See also
Admissible decision rule, analog in decision theory
Arrow's impossibility theorem
Bayesian efficiency
Fundamental theorems of welfare economics
Constrained Pareto efficiency
Deadweight loss
Efficiency (economics)
Game theory
KaldorHicks efficiency
Market failure, when a market result is not Pareto optimal
Maximal element, concept in order theory
Multiobjective optimization
Nash equilibrium
Robinson Crusoe economy
Social Choice and Individual Values for the '(weak) Pareto principle'
Welfare economics

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Pareto efficiency

From Wikipedia, the free encyclopedia

2 Weak Pareto efficiency

3.1.1 Pareto frontier

3.1.2 Relationship to marginal rate of substitution

A production-possibility frontier is an example of a Pareto Efficient Frontier. The connected line

Weak Pareto efficiency

is the vector of goods, both for all i. The supply

. To optimize this problem, Lagrange

where and are

Rearranging these to eliminate the multipliers gives the wanted result:

for i,k=1,...,m and j,s=1,...,n.

Admissible decision rule, analog in decision theory

Arrow's impossibility theorem

Fundamental theorems of welfare economics

Constrained Pareto efficiency

Market failure, when a market result is not Pareto optimal

Maximal element, concept in order theory

Robinson Crusoe economy

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