XI. EFFICIENCY, PARETO OPTIMALITY AND RESOURCE ALLOCATION: NORMATIVE ECONOMICS
Here we bring together two important concepts mentioned above: rationality and scarcity. Rationality implies that an individual will not voluntarily enter into a trade if that individual expects to be made worse off by the trade. Though sometimes one enters into trades misinformed, and regrets the trade, the same mistake is not repeated, and individuals learn also from the experience of others. Voluntary trade is expected to lead to an improvement in the wellbeing of both parties of the trade. People make trades, improving their wellbeing, until no further mutually beneficial trades can take place, until no mutually "profitable" trades are left to make. After all mutually beneficial trades take place, the only way to improve one person's wellbeing is to make another person worse off. This is the concept of efficiency in economics: that all mutually beneficial trades are made.
This concept is known as PARETO OPTIMALITY. A given set of ownership of various goods and resources is said to be Pareto optimal if and only if no change can be made in ownership of goods and resources that could make one person better off without making someone else worse off (this concept is named for its originator, the Italian engineer and economist, Vilfredo Pareto). Recalling that scarcity is a fundamental fact of life, we would hope that resources get put to uses that are valued most highly. Pareto optimality means just that.
A related concept is that of PARETO SUPERIORITY: an allocation of resources is said to be Pareto superior to another if it improves the welfare of one party without harming someone else, that is, if the trade or change in resource use is mutually beneficial.
It might help if we take a look at the two concepts of Pareto Superiority and Pareto Optimality graphically. Suppose that there are only two people in the world, Smith and Jones. If we were able to measure their well-being, then we could show their well-being graphically. We show the wellbeing of Jones along the vertical axis, and the wellbeing of Smith along the horizontal axis. There are limits to their well-being, shown by the curve ABCDFG (that is, we cannot have combinations of well-being for the two that lie above and to the right of curve ABCDFG).
Because of the talents and wealth they were born with, before any trading takes place between them, the two are at point H. If they made trades that are mutually beneficial, they must end up somewhere to the "northeast" of H, in an area bounded on the left by line BH, bounded from below by line BD and on the "northeast" by the arc BCD. Trade anywhere in this area gets them to a position that is Pareto Superior to point H. Trades create Pareto improvements or lead to Pareto Superior positions because each individual is RATIONAL. In other words, no one will agree to a trade that makes them worse off. If the exchange requires mutual agreement (a contract), then trade brings about Pareto Superior moves.
Points such as B, C, D and I are Pareto Superior to H. Points such as A, F and G are NOT Pareto Superior to H.
A position is Pareto Optimal if there are no points that can be obtained that are to Pareto Superior to that point. Points such as A, B, C, D, F and G are all Pareto Optimal positions, while points H and I are NOT Pareto Optimal positions.
What this means is that if you can make further mutually beneficial trades, people will find themselves in positions that are superior (Pareto Superior) to the old position. If such mutually beneficial trades are possible, then they cannot now be at a position that is Pareto Optimal. Also notice that trade gets us closer to the Pareto Optimal positions, not further away.
While it is possible that "Social Wellbeing" might be improved if one person were made better off while another made worse off, other rules would be debatable, but who would not want a change that made some better off while making none worse off. Notice that Pareto Superiority and Optimality are NORMATIVE CONCEPTS, but normative concepts that many could agree to. Nearly unanimous consent is possible because none are harmed by the change.
Some changes are said to be Pareto Superior, yet some are made worse off, such as the change from me owning a monopoly to produce all of the world's gasoline, to a more competitive oil industry. Here, the concept of sidepayments is used. The winners from oil being competitively produced (the consumers of oil), would have to win by enough to pay off the loser(s) (me, the one who use to have the monopoly) from this change by at least the amount of my losses, or lost profits. What is important here is that the winners win by more than the losses of the losers.
The marginal cost curve (if it reflects all costs of production) shows how much people value the resources (the labor, the machinery, the raw materials) that are required to make the good in question if those resources were put to their next most valued use. The demand curve for a good shows how much people value those resources in the production of that good. Suppose the demand curve is above the marginal cost curve for a certain level of production of good A. This means that people place a higher value on the resources making another unit of A than they place on those resources making their next most highly valued alternatives. This means that some individuals could be made better off if more of those resources were allocated to producing more A and less of other things (their next best alternatives). If, on the other hand, the marginal cost curve were above the demand curve for a given level of production of good A, then this means that people would rather have less A and more of their next best alternative. In other words, producing less A and more of those resources' next best alternative would involve a Pareto superior move, economic efficiency could be enhance if less A were produced and the owners of the resources that made A made something else, instead.
We are saying that if another unit of good A is valued more than
the units of the goods given up to make that next unit of A, then
some people could be made better off without making anyone else
worse off if another unit of A were made. If buyers value
another unit of A less than the goods that have to be given up
to get another A, then welfare can be improved be shifting some
resources out of production of A and into the production of the
next best alternatives for that resources.
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