What Is the Definition of Pareto Efficiency? Explain Why Economists Find the Concept Useful. What Are Its Limitations?

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When the only way to make an individual better off is to make another worse off, economists say that the allocation is Pareto efficient. This means that a Pareto efficient allocation must be both, consumption efficient on the contract curve and production efficient on the production possibility curve. It must, therefore, be allocation efficient, where the consumer's common value of the marginal rate of substitution between the two goods is equal to the marginal rate of transformation between the two goods. In a Pareto efficient allocation, there can be no more gains from trade. At such a point, the indifference curves of the two consumers must be tangent, as if they were not, there would be a mutual advantage to trade. This is the only point where it is only possible to make someone better off by making someone else worse off. A change is known as a Pareto improvement if it means that at least one consumer would be better off by the change and no consumer would be worse off.

Pareto efficiency is extremely useful for economists; The First Welfare Theorem states that when producers and consumers both are price takers, the equilibrium allocation is always Pareto efficient. Hence, a competitive economy essentially will ‘automatically' allocate resources efficiently as consumers can maximize their utilities. The Second Welfare Theorem states that any market that is Pareto efficient will have a set of given prices that creates competitive equilibrium in the economy. Economists may use this concept for game theory in particular.

There are, however, many limitations. There is still some lack of clarity as to where the consumers end up in the end because it only takes into account the preferences of specified consumers and does not pay attention to consumers not included. For Pareto efficiency to prevail, an equitable wealth distribution is not necessary. For example, an economy where the wealthy own most of the resources may be Pareto efficient. Hence, it may not...
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