Learn what pareto efficiency is all about, and how to apply it to determine whether economic situations like monopoly, planned economy, and perfect competition are efficient.
Efficiency is a deceptively simple concept with invaluable contributions to economics. Efficiency offers us a qualitative way to differentiate between two or more economic systems and actually decide which system is "better" or "worse." For example, there is widespread agreement among economists that open competition is better than monopoly. How can economists say that? The answer lies with efficiency.
The most commonly discussed kind of efficiency is called Pareto efficiency. It is the kind of efficiency discussed in most introductory and intermediate economics textbooks, and it allows us to make distinctions based on one essential feature of a system. The question is, is it possible to make someone better off without making anyone else worse off? If the answer is no, the system is efficient.
A crucial distinction to make is that between efficiency and justice. For example, if one person received all of the production of an economy, while a second person received absolutely nothing, most people would agree that that scheme is less than fair. Is it Pareto efficient? Well, is it possible to make the second person better off without making the first person worse off? No – the first person will undoubtedly suffer, if only a little bit, from the loss of the extra goods. It may be true that the loss to the first person is smaller than the gain to the second person, but the fact remains that, to make the second person better off, you must do it at the expense of the first person.
Can you imagine a system that is not Pareto efficient, then? How about an economy for baseball tickets that are expected to sell out – people stand in line at the ticket counter, and call in incessantly on their cell phones, hoping to not get a busy signal. In the end, the people who were lucky enough to talk to a representative get the tickets.
Is that distribution of tickets efficient? No. One person may value his tickets at, say, $200, the price which he paid for them because he was lucky enough to get through to a representative who could sell him tickets. A friend of his, though, may value the same tickets at $400. It is possible to make both people better off at the expense of no one – the tickets are exchanged for, say, $300. Both people gain $100 from the exchange.
The existence of a black market for tickets in the case where the initial distribution of tickets was inefficient is not at all unique. Generally, people will unconsciously attempt to create an efficient system, thanks to trade or illegal markets.
The simple concept of Pareto efficiency, where it is impossible to make someone better off without hurting someone else, is therefore very useful not only in just describing different systems of distribution, but also in other instances, such as when predicting the existence of secondary markets.