What is Pareto Efficiency?

Definition: A Pareto Efficiency is an economic theory that describes a situation where an improvement in one variable’s scenario can’t be done without adversely affecting another variable. In other terms, it means that one side can’t be better without making the other side worst.

What Does Pareto Efficiency Mean?

This theory was developed by Vilfredo Pareto and it calculates the most efficient scenarios for two interrelated variables. This efficiency is reached when any increase made on one of the variables will reduce the other. This economic concept doesn’t have anything to do with equality; it can actually result on a very unequal distribution, because its goal is to achieve the highest possible value both parties can realize without affecting each other negatively.

This theory is used for the purpose of allocating resources. It has different applications in many fields such as economics, engineering, mathematics and business, among others. The Pareto Efficiency Frontier is a curve line that describes the best possible outcomes that can be achieved by two interrelated variables. By using this chart an analyst can conclude what the most efficient outcome is for any situation where the two variables are involved.

Here’s an example.

Example

Cocoa Juices Co. is a company that produces cocoa-based beverages. The company has two different products: an instant powder for home-made hot cocoa and a ready-to-drink cold liquid beverage. The company has a limited amount of raw material and it has to determine the most efficient allocation of this material between the two production lines. Product #1 (the powder) uses 0.7 pounds of cocoa and Product #2 (the liquid beverage) uses 0.3 pounds of cocoa. They only have 30 pounds of raw cocoa available and they need to know how to achieve the most efficient solution for this dilemma.

The Pareto Efficiency theory can be employed to solve this. As we previously described, this theory is used to calculate the most efficient situation for two interrelated variables. In this case, by analyzing the behavior of both variables with a Pareto Efficiency Frontier chart the company can conclude which distributions will be the ones that achieve the highest possible efficiency.