10.f.

Pareto Efficiency; Productive, Consumptive, and Trade Efficiency

When someone says 'efficiency,' what do you think of? How well you manage your time? How many miles per
gallon your car gets? How many hours a certain light bulb lasts? These are all everyday applications of the general idea
behind efficiency—trying to maximize the output or benefit received from a limited resource. But efficiency as an economic
concept is a bit more intricate. We'll start with the big picture, and then we'll address the details.

Pareto Efficiency
Pareto efficiency is a concept that originated with Vilfredo Pareto—a 19th century Italian economist (with
backgrounds in engineering, sociology). His idea of Pareto efficiency is the following:

Definition: Pareto efficiency has been achieved if there is no way to make one person better off without making another
person worse-off.

Taking goods from individual A and giving them to individual B would not be increasing Pareto efficiency—
individual B gains, but individual A loses. Voluntary trade, on the other hand, is typically an example of Pareto efficiency:
individuals are only willing to go through with the trade because both will receive benefit from it. Important exceptions to
this are voluntary trade transactions that yield (negative) externalities—unintended effects on a third party—such as
pollution. Because the third party is made worse off, this transaction does not move the system closer to Pareto efficiency.

Looking further into Pareto Efficiency

Now that we know what Pareto efficiency is, we can examine its components. Productive, consumptive, and trade
efficiency are different types of Pareto efficiency—but you need all three in order to have overall Pareto efficiency. You can
loosely think of efficiency in terms of a baseball diamond: bases 1-3 represent productive, consumptive, and trade
efficiencies. Once you've run each of these bases (achieved each of the efficiencies), you can proceed to home base—Pareto
efficiency. Home run!

Productive + Consumptive + Trade = Pareto

(Each efficiency (P, C, T) is necessary but insufficient, on its own, for overall Pareto efficiency)

1.) Productive Efficiency:

a.) If you can't produce more of one good (X, for example) without producing less of another good (Y). (Many
textbooks also define productive efficiency as when the firm is employing all of its available resources in a way
that maximizes output and minimizes costs.)

Condition: production bundle must be on the PPC

Figure 10.f.1) This diagram shows the production possibility curve/frontier for goods X and Y. All points on the PPC itself
(such as B and C) are efficient in production because they satisfy the above condition. Starting from point C (11Y and 9X),
you cannot produce more X without producing less Y—moving to point B (9 to 12 units of X) entails a gain of 3 X, but it
comes with the loss of 4 Y (11 to 7). This reasoning works regardless of whether you move up or down the PPC.
Looking at Figure 10.f.1) also shows how productive efficiency is a precondition for Pareto efficiency. Point A is not
efficient in production because you can produce more of either one or both goods (X and Y) without producing less of the
other. (A→B = +7 X, no decrease in Y output; A→C = +4 X, +4 Y). Thus, moving from A to B or C enables you to make
one person better off without making anyone else worse off (rise in Pareto efficiency). You can hand out 4 X and 4 Y to
someone (and increase that person's benefit) by moving from A to C, without taking any X or Y from others (reducing their
benefit).

b.) All producers face the same marginal cost of production (Note: because a firm's supply is determined based
upon it's MC, the above condition is the same as saying that all firms face the same supply curves).

Condition: MCa = MCb [Sa =Sb]

—The marginal cost of X (cost of producing an additional unit of X) faced by firm A is equal to that faced by firm
B.
Figures 10.f.2) and 10.f.3) Firm A will decrease its production (from 15 to XA) and Firm B will increase its production
(from 15 to XB) until MCA = MCB ($36, in this example). At these altered outputs, productive efficiency is attained.

2.) Consumptive Efficiency:

Condition: MBa = MBb [Da = Db]

—The marginal benefit of X (the benefit of consuming an additional unit of X) for consumer A is equal to that of
consumer B.
Figure 10.f.4: Consumer A decreases his/her consumption and consumer B increases his/her consumption until DA (MBA) =
DB (MBB).Why would the marginal benefits of individuals approach each other and equal out? Think of it this way: When
consumers A and B consume 10 units of X, they value each unit at $10 and $18, respectively. Therefore, a middleman could
buy several units of X from consumer B at $11 (or any price greater than $10 and less than $18), and sell them to consumer
A for $17 (or any price less than $18 and greater than $11). The middleman would earn a profit from the transaction. And
the terms of trade are favorable to both consumers—everyone benefits. The system achieves consumptive efficiency and
moves closer to Pareto efficiency.

3.) Trade Efficiency

Condition: For a given good, X, the marginal costs [supply] faced by producers (which must be equal, based upon
the conditions for productive efficiency) and the marginal benefits [demand] of consumers are equal to each other.

MCx = MBx = Sx = Dx

This is where the 'invisible hand' (a term coined by Adam Smith), comes in. The firm's objective is to maximize its profits
(in a competitive industry, a firm does this by producing the output at which MC = P). The consumers' objective is to
maximize their utility. In other words, producers and consumers are pursuing their self-interests. But the net effect of each
party's 'selfish' objectives is not only its own betterment, but also the betterment of society—and thus of the other party as
well.
This 'invisible hand' reasoning is often used to support laissez-faire policies—if the invisible hand guides markets to Pareto
efficiency, then government intervention will only impede this process and reduce efficiency, right? Not completely.
Nicholson and Snyder, however, warn that:

“Such sweeping a conclusion...vastly overstates the general applicability of the simple models we have been using.
No one should attempt to draw policy recommendations from a theoretical structure that draws so pays so little
attention to the institutional details of the real world. Still, the efficiency properties of the competitive system do
provide a benchmark—a place to start when examining why competitive markets may fail” (Nicholson and
Snyder, Microeconomics, Pg.475).

Another Way of Looking at Trade Efficiency: Combining Productive and Consumptive Efficiencies

You can't have overall Pareto efficiency unless you “tie together individual's preferences and the production possibilities.
(Nicholson and Snyder, Microeconomics)” In other words, both consumptive and productive efficiencies are needed for
Pareto efficiency. The following condition 'joins' the two productivities:
 MRS (Marginal Rate of Substitution—the slope of an indifference curve) =
RPT (Rate of Product Transformation—the slope of the production possibilities curve)

This ensures that consumers and producers value the two goods equally. The rate at which producers can
substitute/exchange production of one good for production of another is equal to the rate at which consumers are willing to
substitute consumption of one good for the other.

Figure 10.f.6: In this figure are shown the indifference curve for a community (which shows different consumption bundle
combinations of goods X and Y that would yield the same level of utility), and the production possibilities curve of that
community for those goods. At point A, the indifference curve is tangent to the PPC (the slope of these two curves [MRS
(marginal rate of substitution) and RPT (rate of product transformation—also called MRT, marginal rate of transformation),
respectively] are equal). Point A represents a Pareto efficient combination of X and Y.

Taking a Step Back—Real World Applications

Understanding what Pareto efficiency means is one thing. But knowing how to apply it to real-life economic decisions is
another. And the job of an economist includes both: not only making sense of graphs, but also using them for the betterment
of society. It is also important to remember that the above laws and graphs are used to illustrate economic concepts—they
are not 'how-to' manuals that transfer directly to real life (Rarely are real markets as simple as are the assumption-filled
markets in textbooks).

Practice Problems
Questions
(1) What are two ways of viewing productive efficiency?

(2) True or False: Productive efficiency is necessary and sufficient for Pareto efficiency.

(3) Define consumptive efficiency and trade efficiency (what are the conditions?)

(4) What type of efficiency addresses cases where one party incurs a loss?

(5) What some limitations of the 'invisible hand' explanation and the Pareto efficiency concept?

Answers
(1) a.)Production is at a point on the PPC, and b.) MC is equal for all firms (for a two-firm industry [A and B], MC A =
MCB).
(2) False. Productive efficiency is necessary but not sufficient; to achieve Pareto efficiency, all three efficiencies
(productive, consumptive, trade) must be satisfied.

(3) Consumptive efficiency requires that MB is equal for all consumers (for a two-consumer market [A and B], MB A =
MBB). Trade efficiency requires that MC is equal to MB (S = D).

(4) Kaldor-Hicks Efficiency. This efficiency is attained through transactions in which those that are made better-off
can compensate those that are made worse-off.

(5) They are economic concepts that should be used as a starting point, but that can’t always be applied directly to
real-life markets. For example, few transactions make no one worse off, so it’s difficult to consider Pareto
efficiency—often, Kaldor-Hicks efficiency is more appropriate. Also, some degree of government regulation of the
economy is always present—no present-day economy is driven entirely and exclusively by the invisible hand.