Topic 2: Specialization and Trade
By the end of this section, you will be able to:
- Define efficiency and understand its usefulness as a normative criterion
- Explain Pareto Improvements
British politician and author Benjamin Disraeli once wrote: “There can be economy only when there is efficiency.” While this statement is most definitely an exaggeration, efficiency is a very important concept in economics.
In the introduction, we explored the need to develop a normative criterion for the evaluation of subjective questions. In economics, one of the most important normative criteria is efficiency. Efficiency, economic efficiency, and Pareto efficiency are essentially synonymous:
if we are in a position such that a person cannot be made better off without making someone else worse off, then this position is efficient.
An exchange at this point would be inefficient.
For example, if you have a bag of your favourite candies, and a friend asks for one, as long as you feel as though you are losing something by giving him one, the exchange is inefficient – even if his increase in happiness means only a slight drop in yours. (Note that if giving him a candy makes you happier despite losing a candy, it could be efficient to exchange)
This is noticeably different than equitable, where resources are distributed in a fair manner. It follows that:
if we are in a position such that a person can be made better off without making someone else worse off, then this position is inefficient.
An exchange at this point would be efficient.
For example, if you accidentally purchase a pair of shoes that do not fit you but fit your friend, and your friend buys the same pair of shoes that do not fit her but fit you – you would both be made better off by trading shoes. This would be an efficient trade. The position you were in was inefficient.
An efficient exchange occurs when changes can be made that will:
- Make someone better off, while
- Not making anyone worse off
These “win-win” opportunities happen to be quite rare, as they are usually acted upon. Such win-win’s also have a special classification: A Pareto Improvement. It is difficult to find a perfect example of a Pareto improvement, as most actions harm at least one party. Using this terminology, we can determine that:
- A situation is efficient if there are no Pareto Improvements
- A situation is inefficient if there are Pareto Improvements
In a situation where there is an opportunity for a Pareto Improvement, the opportunity should be taken advantage of. A major limitation of this metric is that it gives us no direction on the desirability of changes that make some people better off while making others worse off other than to say they are inefficient.
This limitation is important. To further develop this idea, we must follow the path of Vilfredo Pareto.
The term Pareto Improvement is derived from the concept of Pareto Optimality and is specific to the optimal distribution of goods within a system.. The concept was developed by Italian economist Vilfredo Federico Damaso Pareto (1848 – 1923). At the age of 21, Pareto received a doctorate in engineering from the precursor to the Polytechnic University of Turin. His engineering background shaped the way he expressed economic theory by relying on graphs, maps, and statistical analysis to prove his hypotheses.
Over the years, Pareto became more disenfranchised from the Italian government, who he criticized for poorly handling labor strikes and social reforms. He believed democracy was fundamentally unsustainable and that a power elite would always rise and dominate the lower class. This interest in power laws and income distribution engaged him in political change. As it happens, Mussolini, the Italian dictator who would dominate Italian politics for many years, was inspired by Pareto’s ideas.
In economics, Pareto is best known for the concept of Pareto-optimal allocation of resources, and his law of income distribution. He also did work in consumer theory to show the utility of goods need not be measured to derive results.
- A position such that a person cannot be made better off without making someone else worse off.
- A solution that is ethically or legally just and fair, but may not be wholly satisfactory to any or all the involved parties.
- A position in such that a person can make at least one person better off without making someone worse off.
- Parato Improvement
- An action done in an economy that harms no one and helps at least one person.