Pareto Efficiency

Categories: Financial Theory

Your housemate came home...to you taking your first bite into a chocolate bar. You make eye contact. You know he loves chocolate. Awkward. You could give him some of your chocolate bar, but then you would get less chocolate than you had planned for. Dilemmas, dilemmas.

Good news: you don’t have to give up any of your chocolate. Just tell your housemate you’re being Pareto efficient, or Pareto optimal.

Pareto efficiency is when resources that are distributed to players can’t be moved without hurting at least one player. If you gave him some of your chocolate, sure, he’d be better off, but you’d be worse off. You’d only give him some if it didn’t detract from your payoffs.

Bad news: Pareto efficiency has nothing to do with fairness and everything to do with efficiency. Remember the production possibilities curve (PPC)? That’s where you have two goods you could make with the same inputs...like cookies and brownies. The curve shows all the options (cookie, brownie, etc.) where you’re fully utilizing all of your inputs. That makes all points on the PPC Pareto efficient.

The ideal Pareto efficient outcome is when everybody is better off working together. When the choice is obvious for both sides (like...both sides gain brownies), then it’s the Pareto efficient choice.

The trouble comes when players are incentivized to not cooperate. If there was one, lone brownie between you and your roommate, you both could share and get half each, one of you could grab it with the other getting nothing, or both of you grab it, and both of you get nothing since it ended up on the floor. This is why Pareto optimality is not Nash equilibrium.

In this brownie game, you might find that both of you go for it and grab it. Both of you are thinking “I’ll get the highest payoffs if I grab it first!” Too bad, since both of you grabbing it means neither of you get anything. Both of you grabbing would be a Nash equilibrium, where it doesn’t make sense for either of you to do any different. Both of you cooperating would bring you to a better place: a Pareto optimal place.

This is why Pareto optimal is sometimes associated with a “social optimum,” since it’s socially optimal in the sense that you can’t move any resources around without at least one player being worse off. If the resources weren’t distributed evenly to begin with, then this “social optimum” might not look fair, but it is Pareto efficient.

Life’s not fair, and neither is Pareto efficiency.

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Econ: What are Consumer Surplus, Produce...9 Views

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And finance Allah shmoop What Our consumer surplus producer Surplus

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and Alec A tive efficiency shmoop in economics Surplus happens

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when you're getting more than you bargained for When the

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sweet smell of surplus is in the air it means

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somebody got a great deal either a consumer or a

00:20

producer If you're a consumer surplus means you paid less

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for a good or service then you would have been

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willing to pay For example let's look at a Karlis

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pregnant city dweller whose water just broke Yeah since the

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baby's saying It's Hypo time A mom's willing to pay

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a lot of money for a new uber to the

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hospital She might even be willing tio by the uber

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car there She really rather not have her baby's first

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sight to be that of a rat running into a

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gutter with an entire slice of pizza sending the wrong

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message You know but since it's just a normal of

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uber ride on a normal day in normal time well

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she ends up paying a normal price for that uber

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ride to the hospital because the benefit she's getting is

01:02

much higher than the price she'd be willing to pay

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for that ride She's reaping a consumer surplus on that

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ride Well consumer surpluses that area on your typical supply

01:11

and demand curve right under the demand curve there but

01:14

above where the two curves cross like right in there

01:17

Which makes sense if you think about it the demand

01:19

curve which is also the marginal utility curve represent what

01:22

you're willing to pay for a thing right What seems

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fair Anything above that line has you saying Hey man

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what a rip off No way No way I'm paying

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that much while anything below that line has you saying

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Wow What a great deal Too good to pass up

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if you ask me if your producer Well surplus means

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you can get away with selling a good or service

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for a higher price than you would have been willing

01:44

to sell it for Cha Ching Take virtual reality headsets

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Well the first V R headsets were the only ones

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on the market making them rare and you know super

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hi tech gyms The sole producer of the V R

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headsets capitalized on the V R hype and the rarity

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of it all by setting prices is high much higher

02:01

than the price they needed to sell them at in

02:03

order to cover all the cost that went into making

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them In layman's terms we might call this a price

02:08

mark up But people were willing to pay that higher

02:11

price to look like a blindfolded fool and enter other

02:14

realms So that's what the producers charged wouldn't you On

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the supply and demand graph producer surpluses the area above

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the supply curve which is also the marginal cost curve

02:24

but below where the two curves cross right in there

02:27

The actual line of supply curve is what producer willing

02:29

to sell their product for they won't sell anything below

02:32

the line since that would mean they wouldn't even be

02:34

covering their marginal cost like they'd be losing money on

02:37

every sale But selling above the line well thats extra

02:40

profits The higher producers can set their prices above their

02:43

marginal costs assuming consumers are willing to pay for it

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Well the more profits the producer surplus They're reaping what

02:50

happened when Mohr companies started to make Mohr v R

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headsets and there was competition in the marketplace with Mohr

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v R Options on the market v R Headsets became

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less rare When things to buy become more common prices

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go down Yeah whereas one company making V R headsets

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used to enjoy the make it rain monopoly power of

03:09

price setting multiple companies making V R headset makes the

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market competitive When consumers air shopping around in comparing prices

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producers turning to price takers that is they can no

03:19

longer sell their V R Headset said Well pretty much

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any price they want at such high prices because consumers

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will just go buy the same thing cheaper elsewhere Competition

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makes producer surplus shrink and shrink away If the V

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R headset market was perfectly competitive which would be all

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the our headsets made by all producers were exactly the

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same Well then producer surplus would pretty much completely disappear

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meaning it was a total commodity market when both consumers

03:45

and producers feel like they're getting a fair shake or

03:48

a fair trade while money for v R headsets In

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this case we have what's called Alec a tive efficiency

03:53

Well the elegant efficient point is we're supplying demand or

03:56

marginal cost and marginal benefit Cross consumers feel like they're

04:01

getting what they paid for not getting ripped off and

04:03

not getting a deal Producers are no longer rolling around

04:06

in beds covered in producer surplus money but they're not

04:09

losing money either When things were sold at analogue a

04:12

tive efficient level everybody's getting what they paid for no

04:15

more no less All the value is fair Which yeah

04:18

means that where their surplus there's inefficiency right If either

04:22

consumers or producers feel like they're getting a deal a

04:25

surplus while then the market isn't efficient Adam Smith's invisible

04:29

hand does its best to slap surplus out of the

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markets with competition Making things fair for both sides doesn't

04:35

always work out that way But while the invisible hand 00:04:38.14 --> [endTime] you know does what it can

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