Pareto Efficiency / Pareto Optimality

Optional read for Operations Management

Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that
makes one individual better off without making another worse off. The concept is named after
Vilfredo Pareto (1848–1923), Italian civil engineer and economist, who used the concept in his
studies of economic efficiency and income distribution. The following three concepts are closely
related:

• Given an initial situation, a Pareto improvement is a new situation where some agents will
gain, and no agents will lose.

• A situation is called Pareto-dominated if there exists a possible Pareto improvement.

• A situation is called Pareto-optimal or Pareto-efficient if no change could lead to improved

satisfaction for some agent without some other agent losing or, equivalently, if there is no scope for
further Pareto improvement.

The Pareto front (also called Pareto frontier or Pareto set) is the set of all Pareto-efficient situations.

Pareto originally used the word "optimal" for the concept, but as it describes a situation where a
limited number of people will be made better off under finite resources, and it does not take
equality or social well-being into account, it is in effect a definition of and better captured by
"efficiency".[3]

In addition to the context of efficiency in allocation, the concept of Pareto efficiency also arises in
the context of efficiency in production vs. x-inefficiency: a set of outputs of goods is Pareto-efficient
if there is no feasible re-allocation of productive inputs such that output of one product increases
while the outputs of all other goods either increase or remain the same.[4]

Pareto efficiency is measured along the production possibility frontier (PPF), which is a graphical
representation of all the possible options of output for two products that can be produced using all
factors of production.

Besides economics, the notion of Pareto efficiency has been applied to the selection of alternatives
in engineering and biology. Each option is first assessed, under multiple criteria, and then a subset of
options is ostensibly identified with the property that no other option can categorically outperform
the specified option. It is a statement of impossibility of improving one variable without harming
other variables in the subject of multi-objective optimization (also termed Pareto optimization).

Formally, a state is Pareto-optimal if there is no alternative state where improvements can be made
to at least one participant's well-being without reducing any other participant's well-being. If there is
a state change that satisfies this condition, the new state is called a "Pareto improvement". When no
Pareto improvements are possible, the state is a "Pareto optimum".

In other words, Pareto efficiency is when it is impossible to make one party better off without
making another party worse off. This state indicates that resources can no longer be allocated in a
way that makes one party better off without harming other parties. In a state of Pareto Efficiency,
resources are allocated in the most efficient way possible.
Pareto efficiency is mathematically represented when there is no other strategy profile s' such that
ui (s') ≥ ui (s) for every player i and uj (s') > uj (s) for some player j. In this equation s represents the
strategy profile, u represents the utility or benefit, and j represents the player.

Efficiency is an important criterion for judging behavior in a game. In a notable and often analyzed
game known as Prisoner's Dilemma, depicted below as a normal form game, this concept of
efficiency can be observed, in that the strategy profile (Cooperate, Cooperate) is more efficient than
(Defect, Defect).[6]

Prisoner's Dilemma Game

Cooperate Defect

Cooperate 2, 2 0, 3

Defect 3, 0 1, 1

Using the definition listed above, u(Ci) ≥ u(Di) for i ∈ {1, 2}, thus yielding this strategy as a Pareto
efficient strategy. In other words, both players receive an increase in payoff by selecting Cooperate
over Defect.

In zero-sum games, every outcome is Pareto-efficient.

A special case of a state is an allocation of resources. The formal presentation of the concept in an
economy is the following: Consider an economy with agents and goods. Then an allocation ,
where for all i, is Pareto-optimal if there is no other feasible allocation where, for utility function
for each agent , for all with for some .[7] Here, in this simple economy, "feasibility" refers to an
allocation where the total amount of each good that is allocated sums to no more than the total
amount of the good in the economy. In a more complex economy with production, an allocation
would consist both of consumption vectors and production vectors, and feasibility would require
that the total amount of each consumed good is no greater than the initial endowment plus the
amount produced.

Under the assumptions of the first welfare theorem, a competitive market leads to a Pareto-efficient
outcome. This result was first demonstrated mathematically by economists Kenneth Arrow and
Gérard Debreu.[8] However, the result only holds under the assumptions of the theorem: markets
exist for all possible goods, there are no externalities, markets are perfectly competitive, and market
participants have perfect information.

In the absence of perfect information or complete markets, outcomes will generally be Pareto-
inefficient, per the Greenwald–Stiglitz theorem.[9]

The second welfare theorem is essentially the reverse of the first welfare theorem. It states that
under similar, ideal assumptions, any Pareto optimum can be obtained by some competitive
equilibrium, or free market system, although it may also require a lump-sum transfer of wealth.[7]

Pareto efficiency and market failure An ineffective distribution of resources in a free market is
known as market failure. Given that there is room for improvement, market failure implies Pareto
inefficiency.
For instance, excessive use of negative commodities (such as drugs and cigarettes) results in
expenses to non-smokers as well as early mortality for smokers. Cigarette taxes may help individuals
stop smoking while also raising money to address ailments brought on by smoking.

Pareto efficiency and equity A Pareto improvement may be seen, but this does not always imply that
the result is desirable or equitable. After a Pareto improvement, inequality could still exist.

A society may be Pareto efficient but have significant levels of inequality. The most equitable course
of action would be to split the pie into three equal portions if there were three persons and a pie.
The third person doesn't lose out (even if he doesn't partake in the pie), hence splitting it in half and
giving it to two individuals would be considered Pareto efficient.

More considerations should be considered while making decisions, including social efficiency, overall
wellbeing, and problems like declining marginal utility of money.

Practical implication of pareto efficiency It is believed that Pareto efficiency arises when it is
impossible to benefit one party without harming another.

When no one suffers a loss and at least one person benefits, this is known as a Pareto improvement.

On a frontier of production possibilities, Pareto efficiency will happen. It is impossible to raise the
output of products without decreasing the output of services when an economy is functioning on a
basic production potential frontier, such as at point A, B, or C.

According to Pareto efficiency, a decision is efficient if it benefits some individuals while harming
none of them. Vilfredo Pareto, an Italian economist and sociologist renowned for his use of
mathematics in economic analysis, especially in his Manual of Political Economy (1906), is credited
with creating the idea. By analyzing "ophelimity," Pareto utilized this study to create his theory of
pure economics.

Variants[edit]

Weak Pareto efficiency[edit]

Weak Pareto efficiency is a situation that cannot be strictly improved for every individual.[10]

Formally, a strong Pareto improvement is defined as a situation in which all agents are strictly
better-off (in contrast to just "Pareto improvement", which requires that one agent is strictly better-
off and the other agents are at least as good). A situation is weak Pareto-efficient if it has no strong
Pareto improvements.

Any strong Pareto improvement is also a weak Pareto improvement. The opposite is not true; for
example, consider a resource allocation problem with two resources, which Alice values at {10, 0},
and George values at {5, 5}. Consider the allocation giving all resources to Alice, where the utility
profile is (10, 0):

• It is a weak PO, since no other allocation is strictly better to both agents (there are no strong
Pareto improvements).

• But it is not a strong PO, since the allocation in which George gets the second resource is
strictly better for George and weakly better for Alice (it is a weak Pareto improvement) – its utility
profile is (10, 5).
A market doesn't require local nonsatiation to get to a weak Pareto optimum.[11]

Constrained Pareto efficiency [edit]

Constrained Pareto efficiency is a weakening of Pareto optimality, accounting for the fact that a
potential planner (e.g., the government) may not be able to improve upon a decentralized market
outcome, even if that outcome is inefficient. This will occur if it is limited by the same informational
or institutional constraints as are individual agents.[12]

An example is of a setting where individuals have private information (for example, a labor market
where the worker's own productivity is known to the worker but not to a potential employer, or a
used-car market where the quality of a car is known to the seller but not to the buyer) which results
in moral hazard or an adverse selection and a sub-optimal outcome. In such a case, a planner who
wishes to improve the situation is unlikely to have access to any information that the participants in
the markets do not have. Hence, the planner cannot implement allocation rules which are based on
the idiosyncratic characteristics of individuals; for example, "if a person is of type A, they pay price
p1, but if of type B, they pay price p2" (see Lindahl prices). Essentially, only anonymous rules are
allowed (of the sort "Everyone pays price p") or rules based on observable behavior; "if any person
chooses x at price px, then they get a subsidy of ten dollars, and nothing otherwise". If there exists
no allowed rule that can successfully improve upon the market outcome, then that outcome is said
to be "constrained Pareto-optimal".

Fractional Pareto efficiency[edit]

Main article: Fractional Pareto efficiency

Fractional Pareto efficiency is a strengthening of Pareto efficiency in the context of fair item
allocation. An allocation of indivisible items is fractionally Pareto-efficient (fPE or fPO) if it is not
Pareto-dominated even by an allocation in which some items are split between agents. This is in
contrast to standard Pareto efficiency, which only considers domination by feasible (discrete)
allocations.[13][14]

As an example, consider an item allocation problem with two items, which Alice values at {3, 2} and
George values at {4, 1}. Consider the allocation giving the first item to Alice and the second to
George, where the utility profile is (3, 1):

• It is Pareto-efficient, since any other discrete allocation (without splitting items) makes
someone worse-off.

• However, it is not fractionally Pareto-efficient, since it is Pareto-dominated by the allocation

giving to Alice 1/2 of the first item and the whole second item, and the other 1/2 of the first item to
George – its utility profile is (3.5, 2).

Ex-ante Pareto efficiency[edit]

When the decision process is random, such as in fair random assignment or random social choice or
fractional approval voting, there is a difference between ex-post and ex-ante Pareto efficiency:

• Ex-post Pareto efficiency means that any outcome of the random process is Pareto-efficient.

• Ex-ante Pareto efficiency means that the lottery determined by the process is Pareto-
efficient with respect to the expected utilities. That is: no other lottery gives a higher expected utility
to one agent and at least as high expected utility to all agents.
If some lottery L is ex-ante PE, then it is also ex-post PE. Proof: suppose that one of the ex-post
outcomes x of L is Pareto-dominated by some other outcome y. Then, by moving some probability
mass from x to y, one attains another lottery L' that ex-ante Pareto-dominates L.

The opposite is not true: ex-ante PE is stronger that ex-post PE. For example, suppose there are two
objects – a car and a house. Alice values the car at 2 and the house at 3; George values the car at 2
and the house at 9. Consider the following two lotteries:

1. With probability 1/2, give car to Alice and house to George; otherwise, give car to George
and house to Alice. The expected utility is (2/2 + 3/2) = 2.5 for Alice and (2/2 + 9/2) = 5.5 for George.
Both allocations are ex-post PE, since the one who got the car cannot be made better-off without
harming the one who got the house.

2. With probability 1, give car to Alice, then with probability 1/3 give the house to Alice,
otherwise give it to George. The expected utility is (2 + 3/3) = 3 for Alice and (9 × 2/3) = 6 for George.
Again, both allocations are ex-post PE.

While both lotteries are ex-post PE, the lottery 1 is not ex-ante PE, since it is Pareto-dominated by
lottery 2.

Another example involves dichotomous preferences.[15] There are 5 possible outcomes (a, b, c, d, e)
and 6 voters. The voters' approval sets are (ac, ad, ae, bc, bd, be). All five outcomes are PE, so every
lottery is ex-post PE. But the lottery selecting c, d, e with probability 1/3 each is not ex-ante PE, since
it gives an expected utility of 1/3 to each voter, while the lottery selecting a, b with probability 1/2
each gives an expected utility of 1/2 to each voter.

Bayesian Pareto efficiency[edit]

Main article: Bayesian efficiency

Bayesian efficiency is an adaptation of Pareto efficiency to settings in which players have incomplete
information regarding the types of other players.

Ordinal Pareto efficiency[edit]

Main article: Ordinal Pareto efficiency

Ordinal Pareto efficiency is an adaptation of Pareto efficiency to settings in which players report only
rankings on individual items, and we do not know for sure how they rank entire bundles.

Pareto efficiency and equity[edit]

Although an outcome may be considered a Pareto improvement, this does not imply that the
outcome is satisfying or equitable. It is possible that inequality persists even after a Pareto
improvement. Despite the fact that it is frequently used in conjunction with the idea of Pareto
optimality, the term "efficiency" refers to the process of increasing societal productivity.[16] It is
possible for a society to have Pareto efficiency while also have high levels of inequality. Consider the
following scenario: there is a pie and three persons; the most equitable way would be to divide the
pie into three equal portions. However, if the pie is divided in half and shared between two people,
it is considered Pareto efficient – meaning that the third person does not lose out (despite the fact
that he does not receive a piece of the pie). When making judgments, it is critical to consider a
variety of aspects, including social efficiency, overall welfare, and issues such as diminishing marginal
value.
Pareto efficiency and market failure[edit]

In order to fully understand market failure, one must first comprehend market success, which is
defined as the ability of a set of idealized competitive markets to achieve an equilibrium allocation of
resources that is Pareto-optimal in terms of resource allocation. According to the definition of
market failure, it is a circumstance in which the conclusion of the first fundamental theorem of
welfare is erroneous; that is, when the allocations made through markets are not efficient.[17] In a
free market, market failure is defined as an inefficient allocation of resources. Due to the fact that it
is feasible to improve, market failure implies Pareto inefficiency. For example, excessive
consumption of depreciating items (drugs/tobacco) results in external costs to non-smokers, as well
as premature death for smokers who do not quit. An increase in the price of cigarettes could
motivate people to quit smoking while also raising funds for the treatment of smoking-related
ailments.

Approximate Pareto efficiency[edit]

Given some ε > 0, an outcome is called ε-Pareto-efficient if no other outcome gives all agents at least
the same utility, and one agent a utility at least (1 + ε) higher. This captures the notion that
improvements smaller than (1 + ε) are negligible and should not be considered a breach of
efficiency.

Pareto-efficiency and welfare-maximization[edit]

See also: Pareto-efficient envy-free division

Suppose each agent i is assigned a positive weight ai. For every allocation x, define the welfare of x
as the weighted sum of utilities of all agents in x:

Let xa be an allocation that maximizes the welfare over all allocations:

It is easy to show that the allocation xa is Pareto-efficient: since all weights are positive, any Pareto
improvement would increase the sum, contradicting the definition of xa.

Japanese neo-Walrasian economist Takashi Negishi proved[18] that, under certain assumptions, the
opposite is also true: for every Pareto-efficient allocation x, there exists a positive vector a such that
x maximizes Wa. A shorter proof is provided by Hal Varian.[19]

Use in engineering[edit]

The notion of Pareto efficiency has been used in engineering.[20] Given a set of choices and a way of
valuing them, the Pareto front (or Pareto set or Pareto frontier) 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
trade-offs within this set, rather than considering the full range of every parameter.[21]

Use in public policy[edit]

Modern microeconomic theory has drawn heavily upon the concept of Pareto efficiency for
inspiration. Pareto and his successors have tended to describe this technical definition of optimal
resource allocation in the context of it being an equilibrium that can theoretically be achieved within
an abstract model of market competition. It has therefore very often been treated as a
corroboration of Adam Smith's "invisible hand" notion. More specifically, it motivated the debate
over "market socialism" in the 1930s.[3]

However, because the Pareto-efficient outcome is difficult to assess in the real world when issues
including asymmetric information, signalling, adverse selection, and moral hazard are introduced,
most people do not take the theorems of welfare economics as accurate descriptions of the real
world. Therefore, the significance of the two welfare theorems of economics is in their ability to
generate a framework that has dominated neoclassical thinking about public policy. That framework
is that the welfare economics theorems allow the political economy to be studied in the following
two situations: "market failure" and "the problem of redistribution".[22]

Analysis of "market failure" can be understood by the literature surrounding externalities. When
comparing the "real" economy to the complete contingent markets economy (which is considered
efficient), the inefficiencies become clear. These inefficiencies, or externalities, are then able to be
addressed by mechanisms, including property rights and corrective taxes.[22]

Analysis of "the problem with redistribution" deals with the observed political question of how
income or commodity taxes should be utilized. The theorem tells us that no taxation is Pareto-
efficient and that taxation with redistribution is Pareto-inefficient. Because of this, most of the
literature is focused on finding solutions where given there is a tax structure, how can the tax
structure prescribe a situation where no person could be made better off by a change in available
taxes.[22]

Use in biology[edit]

Pareto optimisation has also been studied in biological processes.[23] In bacteria, genes were shown
to be either inexpensive to make (resource-efficient) or easier to read (translation-efficient). Natural
selection acts to push highly expressed genes towards the Pareto frontier for resource use and
translational efficiency.[24] Genes near the Pareto frontier were also shown to evolve more slowly
(indicating that they are providing a selective advantage).[25]

Common misconceptions[edit]

It would be incorrect to treat Pareto efficiency as equivalent to societal optimization,[26] as the

latter is a normative concept, which is a matter of interpretation that typically would account for the
consequence of degrees of inequality of distribution.[27] An example would be the interpretation of
one school district with low property tax revenue versus another with much higher revenue as a sign
that more equal distribution occurs with the help of government redistribution.[28]

Criticism[edit]

Some commentators contest that Pareto efficiency could potentially serve as an ideological tool.
With it implying that capitalism is self-regulated thereof, it is likely that the embedded structural
problems such as unemployment would be treated as deviating from the equilibrium or norm, and
thus neglected or discounted.[3]

Pareto efficiency does not require a totally equitable distribution of wealth, which is another aspect
that draws in criticism.[29] An economy in which a wealthy few hold the vast majority of resources
can be Pareto-efficient. 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 could be made better off without decreasing someone
else's share; and there are many other such distribution examples. 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.[30]

The liberal paradox elaborated by Amartya Sen shows that when people have preferences about
what other people do, the goal of Pareto efficiency can come into conflict with the goal of individual
liberty.[31]

Lastly, it is proposed that Pareto efficiency to some extent inhibited discussion of other possible
criteria of efficiency. As Wharton School professor Ben Lockwood argues, one possible reason is that
any other efficiency criteria established in the neoclassical domain will reduce to Pareto efficiency at
the end.[3]