The Two Biggest Ideas of Vilfredo Pareto in Economics

#economics The name Pareto is associated with some of the most important economic terms and it reappears in different guises throughout most areas of economics, especially as far as the level of microeconomics, namely such subjects as labour economics, environmental economics, public economics etc. is concerned. The Pareto rule symbolises the pragmatic side of economy in general and highlights the individualistic base of the economic logic showing that balanced interests of individuals lead, in general, to the market equilibrium. In this post we are going to discuss the ideas of Vilfredo Pareto which have become crucial for modern economics (microeconomics, public economics, labour economics and environmental economics). We are going to start with the Pareto definition of Pareto efficiency applicable in microeconomics and will go on to discuss the so-called Pareto principle which is frequently used in statistics and finance.

Pareto Definition: Efficiency and Optimality in Economics mean Pareto Efficiency and Pareto Optimality

“The individual neither intends to promote the public interest, nor knows how much he is promoting it... He intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”                                                                                 - Adam Smith

Who was Pareto? Vilfredo Pareto is an Italian mathematician and economist who lived in the 19th century. He developed some ideas which have become a clue to understanding the modern world of economics and have become economic terms which anyone has to know. For example, the notions of Pareto efficiency and Pareto optimality which are attributed to as the Pareto definition of microeconomics and can often be mixed up. In finance and investment appraisal we use the so-called Pareto principle, or the Pareto rule of 80-20 which states that 20% of the input produces 80% of the result. Let's now concentrate on the Pareto definition of efficiency and optimality.

Idea One: Pareto Efficiency in Microeconomics

Pareto Definition: Pareto Rule (Pareto Efficiency vs. Optimality in Economics)

 

What does the word efficient mean from the point of view of economics? When we take a look at the level of microeconomics, by saying efficient we usually mean that something is Pareto efficient. More precisely, according to Pareto and the modern economic theory saying that something is efficient would mean that it is impossible to make somebody better off without making somebody else worse off in the whole economic model. Thus, when everyone is better off as a result of some kind of change, but we can no longer achieve any improvements without placing someone at a disadvantage, we are dealing with the Pareto efficient allocation of resources.

If we use the word optimal in economic sense, we should be precise and not confuse it with the notion of Pareto efficiency. Although in real life the words optimal and efficient are synonyms, in economics we say optimal (or Pareto optimal) when we want to convey the idea that the given allocation is the best of all possible options from the social point of view. Following from that, if as a result of a change we have chosen a Pareto efficient allocation which is the best among other Pareto efficient allocations, we face a Pareto optimal outcome.

Let's now have a look at some examples from the world of economics. We are dealing with Pareto efficiency examples in microeconomics in the following situation. Imagine that we have two people with different preference levels for two products. For the time being, they are rationed with exactly the amounts of the products they would prefer to consume. That is a Pareto efficient situation, for should we ask one of them to share some of his ration with the other, he would be worse off and the other one would be better off. 

Let's come closer to life though. Suppose the state increase the tax level (public economics), enforces the environmental protection legislation (environmental economics) or introduces the minimum wage (labour economics), would that be Pareto efficient? No. Because our first ideas do not come from the assumption of perfectly competitive markets. 

In fact, we operate with models in economics which do not exist in life. Thus, rarely do we find Pareto efficiency and optimality in real life. However, in environmental economics, labour economics, public economics and other branches where we apply microeconomics we do. By using perfect models, i.e. models which treat people homogeneously and to which can be applied the ceteris paribus approach (all other conditions are equal), we regard markets as being perfectly competitive where the concept of Pareto optimality and Pareto efficiency do exist and are essential.

The aforementioned level of abstraction helps us to build the economic notion of social welfare (=aggregated single preferences). It follows from welfare theorems that in perfect conditions, we always have a Pareto efficient allocation provided that we are in Pareto equilibrium. 

Summary (Pareto definition):
Pareto efficiency is a situation in which it is impossible to make someone better off without making someone else worse off. Pareto optimality can be observed when we can select the best allocation having a choice of all possible options.

Pareto Criterion: Pareto Efficiency and Optimality vs. Pareto Improvement

Pareto Efficiency | Pareto Optimality | Pareto Improvement (Pareto inferior or Pareto Superior)

Let's remind that in economics, we call Pareto efficiency an allocation of resources such that we cannot make somebody better off without making somebody else worse off. Thus, a situation in which all resources are used efficiently, i.e. it is impossible to make somebody better off without making somebody else worse off is called a Pareto efficient situation. If that situation represents the best available choice for society, we also regard it as Pareto optimal. The Pareto optimum,  or Pareto equilibrium, represents, consequently, societal optimality based on economic efficiency.

A Pareto improvement (Pareto inferior or Pareto superior improvement) is an economically efficient improvement. A Pareto improvement excludes the possibility that somebody's utility (to learn more about utility and welfare, read the article about utility and welfare) is improved by somebody else's utility. Thus, a Pareto improvement can only be realised in a perfectly competitive market.

Summary (Pareto equilibrium and Pareto Improvement):
A Pareto inferior or Pareto superior improvement is an economically efficient improvement presupposing the existence of Pareto equilibrium and societal optimality.

3 Conditions for Pareto Efficiency

In economics, there are three Pareto efficiency conditions which determine the Pareto criterion.

Unanimity

Even in perfect conditions we still cannot fully compare allocations between individuals, i.e. we cannot observe unanimity which is crucial for the presence of the Pareto criterion. If all individuals prefer one bundle to any other, we may conclude that society, should prefer that alternative as well. That is a perfect, ideal situation.

Transfer 

Even in economic 'model reality', we have to allow transfers of resources between individuals. That creates a base for the potential Pareto improvement. By that we mean that the products can be transferred, but not necessarily need to be. Thus, the potential Pareto improvement implies that there has to be a transfer. That may not always be the case. According to the Kaldor-Hicks compensation principle, if transfers could be made to achieve unanimity on a particular choice, the choice is socially desirable, even if the transfers are not actually made.

Voting 

Finally, as we see the advantages of the most important efficiency and optimality approaches in economics, we may conclude that the Pareto criterion requires unanimity. The potential Pareto improvement with the compensation principle need the criterion of transferability which is not always observable. Thus, voting is what is left. Although, in principle, it cannot guarantee the intensity of preferences, unanimity and side-payments are not prerequisites in that case.

Idea Two: Power Law 

Pareto Distribution and 80-20 Rule (the Pareto Rule)

The second biggest idea of Vilfredo Pareto concerned the principles of statistics and financial investment appraisal. The Pareto rule, or as it is also called the Pareto Principle states that 20% of input accounts for 80% of output.

The Pareto principle is based on the empirical observations of Vilfredo Pareto and is reflected in the Pareto statistics model. For Pareto, the most illustrative example was that 20% of the landowners of the Italy of the 19th century owned 80% of land.

Today, the ideas of Pareto have been developed and applied to different areas of economics and business such as management, HR, marketing and investment appraisal. Pareto principle examples can be encountered in each of the aforementioned branches. The ground idea is the following: only 1/5 of your efforts give big results, the other 4/5 are responsible for less than satisfactory achievements.