Pareto efficiency criterion
A particular allocation of resources, or a particular arrangement, is said to be Pareto efficient or Pareto optimal (or equivalently, is said to have Pareto efficiency or Pareto optimality) if there is no Pareto improvement possible. A Pareto improvement is an alternative allocation or arrangement in which no party is worse off and at least one party is better off.
The criterion of Pareto efficiency is termed the Pareto efficiency criterion or Pareto criterion.
- Generally, all points on a frontier are Pareto efficient, while all points on the inside are not. For instance, given a production possibility curve, the Pareto efficient production possibilities are precisely the possibilities on the curve, while production possibilities in the interior region are not Pareto efficient because production of both goods can be increased.
- Pareto efficiency is a fairly weak criterion and there can be multiple very different arrangements that are Pareto efficient, as described for instance by the multiple points on the production possibility curve.
- Because of this problem of Pareto efficiency being too weak to yield unique allocations, we often consider a modified version where gainers are in a position to compensate losers (known as the compensation principle). For instance, an outcome in which gets 100 units and B gets 3 units is not a Pareto improvement over an outcome in which and both get 5 units, but if we allow to provide partial compensation to , we can get an outcome that is a Pareto improvement over an outcome where and both get 5 units. A modification of the Pareto criterion that accounts for potential compensation (Without necessarily including the compensation as part of the arrangement itself) is termed the Kaldor-Hicks efficiency criterion, also called the potential Pareto criterion.