Intro to Econ: Fourth Lecture – Pareto-efficiency and markets

When people say that markets are efficient then they mean the notion of Pareto efficiency I provided in a previous post: An allocation is Pareto efficient if there is no other allocation that is a Pareto improvement. An allocation is a Pareto improvement over another allocation if the former is at least as good as the latter for everyone involved and strictly better for at least one person.  As we saw, Pareto efficiency has nothing to do with fairness. If I have everything there is to be had in the world and I want to have all this stuff then this is Pareto efficient. Because any other allocation would require me to give up something and, as I do not like to do this, this other allocation is not a Pareto improvement because I am not as happy as before.

While some Pareto inefficient allocations may be better in terms of fairness than some Pareto efficient allocations, any Pareto inefficient allocation can, by definition, theoretically be Pareto-improved upon. If you provide a Pareto inefficient allocation, the first question is why do you not provide one that is a Pareto improvement over the one that you do provide? Economists tend to treat Pareto-efficiency as a minimal requirement for a reasonable allocation. Markets (under some conditions and if they work as we suppose) produce Pareto-efficient allocations. So markets (under some conditions of no externalities and no informational asymmetries and if they work as we suppose) satisfy this minimal requirement for providing reasonable allocations. But real lovers of markets probably believe in them for more than just the Pareto efficiency reason. No lover of markets can, however, claim that markets by themselves necessarily lead to fair allocations, however this is defined. Unless you define fairness in such a way that all most fair allocations are all Pareto-efficient allocations. I doubt that this is a reasonable definition of fairness in all contexts. It is certainly not how I would define fairness.

I still think that Pareto efficiency is important, though, for two reasons. One is that Pareto-efficiency is a property that some markets have and so we should know about if we study these markets. The other is that if we do have a Pareto inefficient allocation then: “really, why?” we can’t help asking. The third of these two reasons is of course that you should know about it because all other economists (should) know about it. So it is important for the communication between economists that we know what we talk about when we talk about Pareto efficiency or Pareto improvements.

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3 thoughts on “Intro to Econ: Fourth Lecture – Pareto-efficiency and markets

  1. Pingback: Intro to Econ: Fourth Lecture – Rationing and Ticket Scalping | Graz Economics Blog

  2. There is an alternative notion of efficiency, which I always felt is a little more relevant to real-world policy questions than the very high bar of Pareto. (I can’t think of many policies which would really make no one worse off.) Under the alternative (Marshallian) definition of efficiency, the question is not only “Are you better off?” but “How much are you better off”, i.e. “How much would you pay to get the allocation that is being offered?” Of course, the problem with this definition is that willingness to pay is higher for rich people than for poor – although I guess one could re-weigh the answers various people give by a factor inversely related to their income.

    This definiton underpins the “cost-benefit analysis” which pervades public discourse from small questions like “Should we build a water power plant in Graz?” to big ones like “Should we cancel the debt of developing countries?”

    My favorite discussion, in the context of an economic analysis of law, is this chapter from David Friedman’s “Law’s Order”:
    http://www.daviddfriedman.com/Laws_Order_draft/laws_order_ch_2.htm

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