Pareto efficiency, or Pareto optimality, is an important concept in economics with broad

applications in game theory, engineering and the social sciences. The term is named after
Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency
and income distribution. Informally, Pareto efficient situations are those in which any
(additional) change to make any person better off is impossible without making someone else
worse off.
Given a set of alternative allocations of, say, goods or income for a set of individuals, a change
from one allocation to another that can make at least one individual better off without making
any other individual worse off is called a Pareto improvement. An allocation is defined as
Pareto efficient or Pareto optimal when no further Pareto improvements can be made. Such an
allocation is often called a strong Pareto optimum (SPO) by way of setting it apart from mere
"weak Pareto optima" as defined below.
Formally, a (strong/weak) Pareto optimum is a maximal element for the partial order relation of
Pareto improvement/strict Pareto improvement: it is an allocation such that no other allocation is
"better" in the sense of the order relation.
Pareto efficiency does not necessarily result in a socially desirable distribution of resources, as it
makes no statement about equality or the overall well-being of a society.[1][2]
Pareto efficiency in economics
An economic system that is Pareto inefficient implies that a certain change in allocation of goods
(for example) may result in some individuals being made "better off" with no individual being
made worse off, and therefore can be made more Pareto efficient through a Pareto improvement.
Here 'better off' is often interpreted as "put in a preferred position." It is commonly accepted that
outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an
important criterion for evaluating economic systems and public policies.
If economic allocation in any system (in the real world or in a model) is not Pareto efficient,
there is potential for a Pareto improvement — an increase in Pareto efficiency: through
reallocation, improvements to at least one participant's well-being can be made without reducing
any other participant's well-being.
In the real world ensuring that nobody is disadvantaged by a change aimed at improving
economic efficiency may require compensation of one or more parties. For instance, if a change
in economic policy dictates that a legally protected monopoly ceases to exist and that market
subsequently becomes competitive and more efficient, the monopolist will be made worse off.
However, the loss to the monopolist will be more than offset by the gain in efficiency. This
means the monopolist can be compensated for its loss while still leaving an efficiency gain to be
realized by others in the economy. Thus, the requirement of nobody being made worse off for a
gain to others is met.
In real-world practice, the compensation principle often appealed to is hypothetical. That is, for
the alleged Pareto improvement (say from public regulation of the monopolist or removal of
tariffs) some losers are not (fully) compensated. The change thus results in distribution effects in
addition to any Pareto improvement that might have taken place. The theory of hypothetical
compensation is part of Kaldor-Hicks efficiency, also called Potential Pareto Criterion. (Ng,
1983).
Under certain idealized conditions, it can be shown that a system of free markets will lead to a
Pareto efficient outcome. This is called the first welfare theorem. It was first demonstrated
mathematically by economists Kenneth Arrow and Gerard Debreu. However, the result does not
rigorously establish welfare results for real economies because of the restrictive assumptions
necessary for the proof (markets exist for all possible goods, all markets are in full equilibrium,
markets are perfectly competitive, transaction costs are negligible, there must be no externalities,
and market participants must have perfect information). Moreover, it has since been
demonstrated mathematically that, in the absence of perfect information or complete markets,
outcomes will generically be Pareto inefficient (the Greenwald-Stiglitz Theorem).[3]
Explicit consideration of Pareto-efficiency of economic factors (labor, capital) and value added
of sectors is given by Dalimov (2008, 2009). It shows that a pair of the value added and labor
income behave within and between regions as a linked pair obeying to the heat equation (i.e. they
move as just any gas or a liquid obeying to the heat and/or diffusion equations).
Modification of the heat equation has been found as responsible for the dynamics of the factors
for a case of international economic integration. Pareto-efficiency here is considered as most
optimal (mathematically) re-allocation of the factors taking place due to economic integration. It
fits one of clear definitons of Pareto-optimality applied to economics stating that Pareto-
efficiency of economic parameters is achieved if there could be no better change of these
parameters (Jovanovich, 2005). In other words, there has to be fulfilled a condition of the first
spatial derivatives of the factors tending to zero after economic integration.
Economically a starting point for analysis was an idea that labor migrates to place of better
wages while capital - to areas with higher returns (as example, consider unification of Germany,
with labor moving from east to west, and capital being invested from West Germany to eastern
part of the unified state), with direction of respective migration flows being opposite to each
other. But the outcome of the analysis has shown that only value added of sectors (not capital)
and annual wages of labor act as linked pair of parameters. Economically this means that
businesses make value added in less developed integrated areas, while labor still moves to places
with higher wages. The other straight conclusion is with the dynamic equation obtained (non-
homogeneous heat equation) which for decades has been considered in physics as quite
developed tool of analysis. So now one may attempt to use results previously obtained in physics
and apply them for variety of tasks concerning migrating parameters in economics.
Generally, Pareto-efficiency in economics is observed when there come measures changing trade
environment within considered region (either state or a group of neighbor states). This is a reason
why Pareto-efficiency is one of the intrinsic features of economic integration, both theory and
practice.