Pareto Optimality

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Pareto optimality is often an illusory hope. Markets can theoretically produce Pareto-optimal results, but there are plenty of reasons why they might not. Nor do markets help us choose which Pareto Optimum we'd want of many possible optima. Pareto improvements assume many things which are not true, such as that inequality doesn't matter. They also are frequently used in bait-and-switch: lump-sum transfers to make sure everybody benefits are often conveniently forgotten. And there are other solutions (including centralized solutions and naked coercion) which can also produce Pareto-optimal results

A single market transaction results in a Pareto improvement for the two exchanging. But if this transaction is instead of a transaction with a third party, then there is a significant loss to the third party if they have produced with expectation of exchange. An economy of Pareto improving transactions can still have losers. Every company that ever went out of business due to competition in a market is an example of how nothing but Pareto improvements still creates losers as conditions shift.

Nor are the initial conditions of markets (property) Pareto efficient.

Links

Matching Theory (5 links)
(Also known as Stable Allocations.) Lloyd Shapley and Alvin Roth won the Nobel prize in economics for this theory. Noah Smith says "Matching Theory is basically an algorithm - a mathematical technology - for finding optimal matches between pairs or groups of people. It incorporates human preferences, optimization, and strategic behavior, so it is economics." It is also a good example of Central Planning that can work better than actual markets, and works well in the real world for organ donations.
Pareto at Melos [More...]
Pareto optimality claims can be made on behalf of the most morally objectionable way of allocating resources, naked coercion. And the first fundamental theorem of welfare economics relies on false premises, and thus doesn't say anything about the virtues of actually-existing markets.
Pareto Fail [More...]
People who claim that they base their economic justice views on the idea of Pareto Improvements are trying to pull a fast one: four reasons are described.
Pareto, Inequality and Government Debt [More...]
"Pareto efficiency [is] obviously not a value free criteria. So those who argue that economists should only look for Pareto improvements – changes where no one is made worse off -- are making a value judgement." Focussing on Pareto improvements ignores the diminishing marginal utility of consumption.
The Davos Lie (4 links)
A term coined by Larry Summers. The old idea that since free trade increases overall benefits, the winners could compensate the losers with some of the gains to create a Pareto improvement where everybody wins. But the real world fact is that this compensation does not occur, increasing poverty and inequality dramatically.
Welfare economics: an introduction [More...]
Steve Waldman at Interfluidity presents a 4 or more part blog posting on the basics and limitations of Pareto Optimality. The takeaway message in part 4 is that we must decide on distribution before letting markets move towards a Pareto Optimum.

Quotations

Every first-year graduate student learns the First Fundamental Theorem of Welfare Economics, which says essentially that provided a long list of conditions are satisfied, a market equilibrium is efficient in a particular way--that is, you cannot make someone better off without making someone else worse off. Now you can read the theorem in two, radically different ways. One is to say: "There you have it! We knew Adam Smith was right all along, but here it is stated in mathematically precise way and proved to everyone's satisfaction. Now let the government get out of the way and have the markets work their magic." The other is to say: "Wow, hold on! You mean we need so many conditions for markets to produce efficient outcomes? No externalities, no returns to scale, no market power, markets for everything and for every point in time... I better get my theorems of the second-best straight!"
Dani Rodrik, "If you are a progressive, you've got to love neoclassical economics"