King's College London

Last week I read a blog about the role of economics in children’s services - written by a social worker, by his admission attempting to “know the enemy”, and with a lucid explanation of some of the important terms in economics.

One of these terms was Pareto Efficiency and (by extension) the idea of a Pareto improvement. This is an important term in economics. We teach it to every first year student, and we don’t go to the trouble of unteaching it during most undergraduate courses. Simply put, a Pareto efficient situation is one where:

No individual can be made better off without making someone else worse off.

Logically, a Pareto improvement is hence one which “makes someone better off without making anyone else worse off”.

This is a useful thing to learn about when you’re studying the welfare implications of perfectly competitive markets. In this kind of market, people start off with endowments – some amount of money or stuff, and make trades. Trades will only take place if they’re Pareto improvements. If I’ve got a bunch of chickens, and you’ve got a bunch of cows, I’ll only trade, let’s say, five chickens for one cow if those chickens are worth less to me (in terms of utility) than the cow is. You’ll only trade if the opposite is true – the chickens are worth more to you than the cow. Trade comes about either because I generally like chickens less than cows (and vice versa for you), or if I’ve got so many chickens that I want the cow for variety. Trade keeps happening until we reach some local maximum utility.

As I say, Pareto Efficiency is a useful thing for us to know about, but there are two issues when we try to use it in the real world.

First, we’re not dealing with a perfectly competitive market. We might not find the right person to trade with, and our chickens and cows aren’t as infinitely divisible as we might like (certainly not if you want them alive). There are costs of transactions, and market power exists.

Second, and more importantly, Pareto efficiency provides a strict brake on intervention by a third party (let’s say, for the sake of argument, a government). If you think markets are even broadly competitive, then any equilibrium will tend to be Pareto optimal, and so you can’t achieve a Pareto improvement by intervening – any intervention that will make someone better off will make someone else worse off.

Valuing Pareto Efficiency is inherently (small c) conservative. If almost any equilibrium is Pareto optimal then, if Pareto optimality is our yardstick, we could do anything to intervene.

Imagine a world where one person holds all the wealth and power, and everybody else has nothing – or at least, are subsisting. Nobody would think this was a just world, but it is a Pareto Efficient world – we cannot make anyone better off without making someone (our absolute monarch) worse off. Outside of our somewhat fanciful example, anything redistributive is still ruled out. In a world where some people starve, and others leave resources idle (or use them to send themselves to space), then Pareto efficiency doesn’t seem very… efficient. As is often the case, economists are our own worst enemies, teaching neat examples that undermine the case for our own usefulness.

If you’re harking for a more efficient allocation of resources, then economics offers up another form of efficiency – Kaldor-Hicks efficiency. A change is a Kaldor-Hicks improvement if the people who benefit from it could (theoretically) compensate the people who lose out. Or, put another way, if a change adds more to happiness of the people who benefit than it does the sadness of those who lose out, it’s Kaldor-Hicks improvement.

In practical terms, this gives us a lot more scope to intervene. Because there is diminishing returns to income – the last £1000 you earned is worth less to you than the first £1000 you earned – then taking money from someone rich and giving it to someone poor probably amounts to a Kaldor-Hicks improvement. Of course, counter-arguments can be made – usually that heavy redistribution might shrink the total amount available by weakening incentives or bureacratcy – but, when we’re thinking about the economics of public policy, and how we can improve outcomes, Kaldor-Hicks at least gives us a fighting chance to make a change.