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Pareto efficiency

Pareto efficiency. Is that outcome good? Pareto efficiency Is only one part. Pareto improvement is a comparative term. One outcome (A) is a Pareto improvement over another (B) if at least one person prefers A to B and nobody prefers B to A.

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Pareto efficiency

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  1. Pareto efficiency Is that outcome good?Pareto efficiencyIs only one part.

  2. Pareto improvement is a comparative term • One outcome (A) is a Pareto improvement over another (B) if at least one person prefers A to B and nobody prefers B to A. • In other words, there could be a unanimous vote to move from B to A. (If anybody is made worse off it’s not a Pareto improvement!) • FYI, cost-benefit analysis is based on the idea of potential Pareto improvements.

  3. Pareto (in)efficient is a superlative term (like tallest) • Outcome A is Pareto inefficient if there is some other outcome (B) that is a Pareto improvementover A. • Outcome A is Pareto efficient if there is no other outcome (B) that is a Pareto improvementover A. • Every outcome is either Pareto efficient or Pareto inefficient.

  4. Chains of Pareto improvements

  5. Complications • There is not just one Pareto efficient outcome in any situation; usually there are many. • So the Pareto ideas give us a partial ordering. • We’re used to complete orderings, e.g., with numbers x and y either x ≥ y or y ≥ x. • But Pareto is a partial ordering, e.g., (x1,x2) ≥ (y1,y2) if and only if x1≥ y1 and x2≥ y2. • Another partial ordering: Is city A southwest of city B, or is city B southwest of city A?

  6. Pareto efficiency and “good” • A Pareto inefficient outcome is in some meaningful sense “bad”… • …but a Pareto efficient outcome is not necessarily “good”. (Why?) • Because Pareto efficiency is only one component of fairness. • If you give one kid all the cake, that’s Pareto efficient!

  7. How do we get Pareto efficiency?

  8. How do we get Pareto efficiency? • Remember the Coase theorem: If there’s nothing to stop people from trading, nothing will stop people from trading… • …and so they will trade until they’ve exhausted all possible gains from trade. • In other words: until they’ve reached a Pareto efficient outcome! • Note: “a”, not “the”.

  9. Pareto’s view on distribution • When it comes to fishing permits or carbon permits or anything else, a good starting point is the idea that economists as economists will have no professional opinion about the distribution of these permits, i.e., equity. • More on carbon later, but for now note that this is good because it gives you freedom! • Coase example (dentist/machinery).

  10. Pareto’s view on tax policy • You might be an economist if… • …you hate taxes because they’re so inefficient. • Why is this joke funny? (If it’s funny? ) • Why bothers normal people about taxes? • Equity issues: who pays what. • What bothers economists about taxes? • Efficiency issues: the deadweight loss of taxes.

  11. Pareto’s view on tax policy • The deadweight loss of taxes comes from people averting their behavior to avoid paying the tax; this leads to Pareto inefficiency. • Example: There’s an income tax, so I choose to play golf instead, or there’s a tax on coffee so I choose to buy tea instead. • Example: The B&O tax in WA, which pyramids. • Distorts by promoting vertical integration.

  12. Pareto’s view on tax policy • The deadweight loss of taxes comes from people averting their behavior to avoid paying the tax; this leads to Pareto inefficiency. • Because these choices are sub-optimal, the economic cost of the tax is greater than the amount of revenue collected. • The difference is the deadweight loss. • Extreme example: Laffer curve.

  13. Pareto’s view on tax policy • The deadweight loss of taxes comes from people averting their behavior to avoid paying the tax; this leads to Pareto inefficiency. • So on efficiency grounds economists tend to favor taxes that minimize distortions, often broad-based taxes with low marginal tax rates. • One exception: Pollution taxes like carbon taxes or other corrective taxes. (More later.) • Like corrective lenses, these are good!

  14. Pareto’s view on monopoly • Most people hate monopolies because they charge high prices. • But this is not why monopolies lead to Pareto inefficient outcomes. • (Monopolies are people too .) • A monopoly that can engage in perfect price discrimination (charging each person their maximum willingness-to-pay) does not lead to a Pareto inefficient outcome.

  15. Pareto’s view on monopoly • Monopolies lead to Pareto inefficiencies, e.g., when they charge everyone the same price, because that uniform price will be higher than marginal cost, meaning that there will be unrealized gains from trade. • Example: It costs a company $0.10 to make each pill, but it might be profit-maximizing for them to charge $10 each. There’s a Pareto inefficiency if I’d pay up to $5 for the pill.

  16. Beyond Pareto • We’re about to see some made-up situations with clear-cut examples of Pareto inefficiencies, Pareto improvements, etc. • But in most real-life situations it’s impossible to make Pareto improvements. (Someone is always going to be worse off.) • One theoretical basis for cost-benefit analysis is the idea of potential Pareto improvements.

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