07 August 2007

About Pareto Efficiency

In response to Adam’s comment about the idea of Pareto Efficiency.

Following the last posting, Adam asked the definition of “Pareto Efficiency,” namely is it unique and what metric is it based on?

Let me first point to a technical definition - http://en.wikipedia.org/wiki/Pareto_efficiency

Let me sat that this is a good question. Pareto efficiency is a subtle point. It means only that resources are not being wasted and that no one can improve his/her welfare (“utility” to economists) without lowering someone else’s welfare. So, as long as a government is enforcing property rights, once a Pareto Efficient allocation has been achieved, no one can do any better from further transactions.

What Pareto Efficiency does not say is that if individuals begin with non-efficient initial allocations (A would like to trade to improve A’s welfare and there is a B out there who is willing to trade with A and both A and B end up at least as well off as before they transacted) which of the many possible Pareto Efficient allocations will be achieved. A might increase his utility and B may stay the same in one efficient allocation. B might increase while A stays the same. They might both increase the same amount…. Because it is seemingly arbitrary to place weights on the importance of different individuals’ welfare, Economists sometimes only characterize optimality of allocations up to identifying the set of Pareto improving efficient allocations, a more generalized notion of optimality.
Again, this can all be seen diagrammatically in Figure 2 and explained with the accompanying discussion at http://cepa.newschool.edu/het/essays/paretian/paretoptimal.htm

If initial allocations are not efficient (as they usually are not), which of the very many Pareto Efficient allocations will be realized depends on who holds the bargaining power in the transaction. If A has full bargaining power then A can make B a take-it-or-leave-it offer and A will enjoy the surplus from transacting while B’s utility will remain the same or vice versa.

Bargaining power may depend on multiple factors; your desperation, your outside alternative options, whether bargaining is allowed to banter back and forth, your response time in the bantering relative to the depreciation of the good being bargained for.

In the presence of an externality, when there exist indirect effects to others welfare, which Pareto Efficient point gets achieved depends on the government’s intervention in determining who holds property rights. In essence, politicians weight welfare of individuals or firms against each other by decreeing initial property rights. In the common example, the government’s decree about whether a construction firm has the right to build an airport near a subdivision or whether the homeowners have the right to quiet surroundings determines which Pareto Efficient point in the set will be realized.

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