THE PARETO-OPTIMALITY CRITERION

This criterion refers to economic efficiency which can be objectively measured. It is

called Pareto criterion after the famous Italian economist Vilfredo Pareto (1848-
1923). According to this criterion any change that makes at least one individual
better-off and no one worse-off is an improvement in social welfare.

Conversely, a change that makes no one better-off and at least one worse-off is a
decrease in social welfare. The criterion can be stated in a somewhat different way:
a situation in which it is impossible to make anyone better-off without making
someone worse-off is said to be Pareto-optimal or Paretoefficient.

For the attainment of a Pareto-efficient situation in an economy three marginal

conditions must be satisfied:

(a) Efficiency of distribution of commodities among consumers (efficiency in

exchange);

(b) Efficiency of the allocation of factors among firms (efficiency of production);

(c) Efficiency in the allocation of factors among commodities (efficiency in the

product-mix, or composition of output).

Before examining these marginal conditions we discuss briefly the main weaknesses
of the Pareto criterion. The Pareto criterion cannot evaluate a change that makes
some individuals better- off and others worse-off. Since most government policies
involve changes that benefit some and harm others it is obvious that the strict Pareto
criterion is of limited applicability in real-world situations. Furthermore, a Pareto-
optimal situation does not guarantee the maximisation of the social welfare. For
example, we know that any point on the production possibility curve represents a
Pareto efficient situation.

To decide which of these points yields maximum social welfare we need an

interpersonal comparison of the individual consumer's utility. In a subsequent section
we will show that the Pareto-optimal state is a necessary but not sufficient condition
for maximum social welfare. Let us examine now the three marginal conditions that
must be satisfied in order to attain a Paretoefficient situation in the economy.

(a) Efficiency of distribution of commodities among consumers

Applying the Pareto optimality criterion to the case of distribution of commodities Y

and X, we can say that a distribution of the given commodities X and Y between the
two consumers is efficient if it is impossible by a redistribution of these goods to
increase the utility of one individual without reducing the utility of the other. In the
above figure, we show the Edgeworth box for the given commodities X and Y. We
know that only points on the Edgeworth contract curve satisfy the Paretooptimality
condition.
Any other distribution off the contract curve is inefficient. For example, point z is
inefficient, since a redistribution of the commodities such as to reach any point
between a and b increases the utility of both consumers. A movement to a increases
the utility of B without reducing the utility of A. Similarly, the distribution implied by b
increases the utility of A without reducing the utility of B. Thus all the points from a to
b represent improvements in social welfare compared with the distribution at z. By
reversing the argument it can be seen that a movement from a point on the contract
curve to a point off it results in a decrease in social welfare

Thus the contract curve shows the locus of Pareto-optimal or efficient distribution of
goods between consumers. This curve is formed from the points of tangency of the
two consumers indifference curves, that is, points where the slopes of the
indifference curves are equal. In other words, the MRSx,y between any two goods
be equal for all consumeers.

Therefore we may state the marginal condition for a Pareto- efficient distribution of
given commodities as follows:

The marginal condition for a Pareto-optimal or -efficient distribution of commodities

among consumers requires that the MRS between two goods be equal for all
consumers.

(b) Efficiency of allocation of factors among firm-producers

To derive the marginal condition for a Pareto-optimal allocation of factors among
producers we use an argument closely analogous to the one used for the derivation
of the marginal condition for optimal distribution of commodities among consumers.
In the case of allocation of given resources K and L we use the Edgeworth box of
production shown in figure. Only points s' on the contract curve of production are
Pareto-efficient. Point H is inefficient, since a reallocation of the given K and L
between the producers of X and Y such as to reach any point from c to d inclusive
results in the increase of at least one commodity without a reduction in the other.

The contract curve is the locus of points of tangency of the isoquants of the two firms
which produce X and Y, that is, points where the slopes of the isoquants are equal.
Thus at each point of the contract curve the following condition holds

MRTSX LK = MRTSY LK

Therefore we may state the marginal condition for a Pareto- optimal allocation of
factors among firms as follows:

The marginal condition for a Pareto-optimal allocation of factors (inputs) requires that
the MRTS between labour and capital be equal for all commodities produced by
different firms

(c) Efficiency in the composition of output (product-mix)

The third possible way of increasing social welfare is a change in the product-mix. To
define the third marginal condition recall that the slope of the PPC is called the
'marginal rate of (product) transformation' (MRPTxy), and it shows the amount of Y
that must be sacrificed in order to obtain an additional unit of X. In other words the
MRPT is the rate at which a good can be transformed into another. The marginal
condition for a Pareto-optimal or efficient composition of output requires that the
MRPT between any two commodities be equal to the MRS between the same two
goods:

MRPTx,y = MRS XY of A= MRS XY of B

Since the MRPT shows the rate at which a good can be transformed into another (on
the production side), and the MRS shows the rate at which consumers are willing to
exchange a good for another, the rates must be equal for a Pareto-optimal situation
to be attained. Suppose that these rates are unequal.

For example assume that,

MRPTx,y=2Y/1X

MRSx,y=1Y/1X

MRPTx,y>MRSx,y

The above inequality shows that the economy can produce two units of Y by
sacrificing one unit of X, while the consumers are willing to exchange one unit of Y
for one unit of X. Clearly the economy produces too much of X and too little of Y
relatively to the tastes of consumers. Therefore, welfare can be increased by
increasing the production of Y and decreasing the production of X.

A Pareto-optimal state in the economy can be attained if the following three marginal
conditions are fulfilled:

• The MRSx,y between any two goods be equal for all consumers.

• The MRTSLKbetween any two inputs be equal in the production of all commodities.

• The MRPTx,y be equal to the MRSx,y for any two goods.

PARETO OPTIMUM AND MARKET FAILURE IN THE PRESENCE OF

EXTERNALITIES

This efficiency criterion was developed by Vilfredo Pareto in his book "Manual of
Political Economy", 1906. An allocation of goods is Pareto optimal when there is no
possibility of redistribution in a way where at least one individual would be better off
while no other individual ends up worse off.
Pareto optimality describes a situation where no further improvements to society's
well being can be made through a reallocation of resources that makes at least one
person better off in without making someone else worse off.

A definition can also be made in two steps:

a change from situation A to B is a Pareto improvement if at least one individual is

better off without making other individuals worse off

B is Pareto optimal if there is no possible Pareto improvement.

This can be easily understood using an Edgeworth box.

Starting from point C, two Pareto improvements can be made:

From C to D: individual I would increase its utility, since a further indifference curve would
be reached, while individual 2 will remain with the same utility

From C to E: individual 2 would maintain its utility while individual 2 increases theirs. Once
we are at point either D or E, no further Pareto improvements can be made.

Therefore, D and E are Pareto optimal.

Following the same steps for every indifference curve, we can say that every point in which
indifference curves from different of individuals are tangent is Pareto optimal. The curve that
links these infinite Pareto optima is called the contract curve.

Market Failure of Pareto Optimality:

In the real world, there is non-attainment of Pareto optimality (or optimum welfare) due to a
number of constraints in the working be of perfect competition. These lead to market failure.
Market failure refers to the circumstances under which markets fail to allocate resources
efficiently.

They are discussed as under:

1. Monopoly or Imperfect Markets:

Whenever markets are imperfect, as under monopoly, monopolistic competition or oligopoly,

the perfect market will fail to achieve the Paretion optimum conditions. The main condition
for Pereto optimality under perfect competition is the equality of marginal rate of substitution
(MRS) and marginal rate of transformation (MRT) between two products X and Y and their
price ratios Px/Py. But under monopoly, MRSXY will not equal MRSXY and both will not
equal the ratio of their prices (PX/PY).

2. Externalities:

The presence of externalities in consumption and production also lead to market failure.
Externalities are market imperfections where the market offers no price for service or
disservice. These externalities lead to mal-allocation of resources and cause consumption or
production to fall short of Pareto optimality. Externalities lead to the divergence of social
costs from private costs and of social benefits from private benefits. When social costs and
private costs and benefits diverge, perfect competition will not achieve Pareto optimality.
Under perfect competition private marginal cost (PMC) is equated to private marginal benefit
(ie the price of the product).

3. Public Goods:

Another cause of market failure is the existence of goods. A public good is one whose
consumption or use by on public individual does not reduce the amount available for others

Examples are city parks, defence, police, ocean or lake fishing. etc. Public goods have two
characteristics:

non-excludable and

non-rivalrous.

A good is non-excludable if it can be consumed by any one. It is non-rivalrous if no one has

an exclusive right over its consumption. Its benefit can be provided to an additional consumer
at zero marginal cost. Thus public goods being both no excludable and non-rivalrous are not
sold in a free market like private goods. They lead to market failure in the following ways.
The consumption of a public good is always 'joint and equal.

The Paretian condition for a public good is that its marginal social benefit should equal its
marginal social cost (MSB-MSC) But the characteristics of a public good are such that the
economy will not reach a point of Pareto optimum in a perfectly competitive market. Public
goods create positive externalities. The externality starts when the marginal cost of
consuming or producing an additional unit of the public good is zero but a price above zero is
being charged. This violates the Paretian welfare maximisation criterion of equating marginal
social cost and marginal social benefit. This is because the benefits of a public good must be
provided at a zero marginal social cost.

Public goods are not subject to the "exclusion principle" which means that their benefits are
available to everybody whether a person pays for them or not. But in the case of some public
goods, exclusion is practiced. The public good's use is restricted to those

who pay a toll tax. This does not lead to Pareto optimality because the toll tax restricts the
services of the bridge to only those who pay the toll tax. For Pareto optimality, its services
should be available to every consumer at a zero price. In the case of some public goods where
exclusion cannot be practiced, all payments for their services are purely voluntary. In such a
situation, many users have the tendency to avoid paying for their services when they know
their benefits can be obtained free. All such users are known as "free riders". Therefore, when
such a public goods is produced much less than the optimum quantity would be available to
its users.

4. Increasing Returns to Scale:

There are increasing returns to scale or decreasing costs due to technical externalities that
lead to market failure under perfect competition. When there are increasing returns to scale in
a perfectly competitive market, they either lead to monopoly or to losses. As output increases
under increasing returns to scale, the long run average cost (LAC) curve falls over the
relevant range. When the LAC curve falls, the LMC curve lies below it (LMC< LAC) and
firms under perfect competition incur losses. But they cannot remain under losses in the long
run and leave the industry. If this situation persists for some time, there will emerge either
oligopoly firms or a monopoly firm.

5. Indivisibilities:

The Paretian optimality is based on the assumption of complete divisibility of products and
factors used in consumption and production. In reality, goods and factors are not infinitely
divisible.Rather, they are indivisible. The problem of indivisibility arises in the production of
those goods and services that are used jointly by more than one person. An important
example is the use of a particular road by a number of persons in a locality. Every person
residing there uses the road. But the problem is how to share the costs of repairs and
maintenance of the road. In fact, none will be interested in its repairs and maintenance. Thus
marginal social costs and marginal social benefits will diverge from each other and Pareto
optimality will not be achieved.

6. Common Property Right:

Another cause of market failure is a common property resource. It most common example is
fish in a lake. Anyone can catch and eat it bout no one has an exclusive property right over it.
It means that a common property resource is non-excludable (any one can use it) and non-
rivalrous (no one has an exclusive right over it). The lake is a common property for all
fishermen. When a fisherman catches more fish, he reduces the catch of other fishermen. But
he does not count this is a cost, yet it is a cost to society. Because the lake is a common
property resource where there is no mechanism to restrict entry and to catch fish. The
fishermen who catch more fish impose a negative externality on other fishermen so that the
lake is over exploited. This is called the tragedy of the commons which leads to the
elimination of social gains due to the overuse of common property. Thus when property
rights are common, indefinite or non-existent, social costs will be more than private costs and
there will not be Pareto optimality

7. Asymmetric or Incomplete Information:

Consumers, producers and resource owners have perfect knowledge about market conditions
under perfect competition. But in the real world, there is asymmetric or incomplete
information due to ignorance and uncertainty on the part of buyers and sellers of goods and
services. Thus they are unable to equate social and private benefits and costs this is because
consumers are ignorant about the quality of goods that they buy benefits of goods. Similarly,
firms are ignorant and uncertain about future prices costs sales, actions of rivals, etc. In some
cases, information about market behaviour in the future may be available but that may be
insufficient or incomplete. Thus market failure is inevitable.

8. Incomplete Markets:

Markets for certain things are incomplete or missing under perfect competition. The absence
of markets tor such things as public goods and common property resources is a cause of
market failure.