Pareto efficiency in markets

A key idea when analyzing markets is Pareto efficiency, also called Pareto optimality. This is actually a simple idea. A market is Pareto efficient when you can’t make anyone happier without making someone else worse off. There are thus a whole frontier of points in a market which are Pareto optimal each involving different distributions of goods (and thus happiness) amongst the market participants.

Julianne Nelson explains how the idea of Pareto efficiency is used as the moral case for markets. Essentially it is a weak condition, if something isn’t Pareto efficient it can’t be ideal. If the distribution of goods is not Pareto efficient it is possible to make at least one person happier (while making no-one less happy) so non-Pareto isn’t something we’d ever want. Competitive markets, when they function well, drive towards Pareto efficiency. Trades are made until there are no happiness improving trades to be made meaning: “All competitive equilibria are Pareto optical” (Nelson, 1994, page 663).

The most obvious problem from a moral case is that endowments differ — one person perfectly efficiently using all the world’s resources for their own benefit is Pareto optimal but hardly desirable.

Nelson goes through the assumptions underpinning the logic of market efficiency. The challenge is that the assumptions don’t really apply anywhere in the real world. For example, many markets have externalities (i.e. where costs are borne beyond the person buying the good — my buying gas causes air pollution which hurts everyone), public goods exists (i.e. shared goods that can’t easily be restricted in use), and there is never really perfectly costless trading in the economy.

“We see that reality may diverge substantially from the assumptions that form the basis of the moral case for a market system.” (Nelson, 1994, page 665). Thus, Nelson suggests that, because markets are never completely perfect, ethical obligations come into play. The market mechanism is not enough. To Nelson there is a duty of civility and “this duty would include an obligation not to abuse market power and generally not to manipulate the system” (Nelson, 1994, page 665).

I think it is always worth considering the assumptions underpinning our ideas. What makes a market work well, and when, are crucial questions.

Read: Julianne Nelson (1994) Business Ethics in a Competitive Market, Journal of Business Ethics, 13, 9, pages 663-666.