The next stage in development of Welfare Economics after Leon Walras was taken by Vilfredo Pareto, who also succeeded Walras in his professorship. This is all good technical economics that feeds our understanding of market successes and failures, and what to do about them. Unfortunately Pareto’s ideas have been perverted in the usual ways by the usual suspects, including Mussolini’s Fascists.
He introduced the concept of Pareto efficiency and helped develop the field of microeconomics. He was also the first to discover that income follows a Pareto distribution, which is a power law probability distribution. The Pareto principle was named after him, and it was built on his observations that 80% of the wealth in Italy belonged to about 20% of the population. He also contributed to the fields of sociology and mathematics.
Pareto efficiency or Pareto optimality
The following three concepts are closely related:
- Given an initial situation, a Pareto improvement is a new situation where some agents will gain, and no agents will lose.
- A situation is called Pareto-dominated if there exists a possible Pareto improvement.
- A situation is called Pareto-optimal or Pareto-efficient if no change could lead to improved satisfaction for some agent without some other agent losing or, equivalently, if there is no scope for further Pareto improvement (in other words, the situation is not Pareto-dominated).
The Pareto front (also called Pareto frontier or Pareto set) is the set of all Pareto-efficient situations.[2]
Under the assumptions of the first welfare theorem, a competitive market leads to a Pareto-efficient outcome. This result was first demonstrated mathematically by economists Kenneth Arrow and Gérard Debreu.[8] However, the result only holds under the assumptions of the theorem: markets exist for all possible goods, there are no externalities, markets are perfectly competitive, and market participants have perfect information.
In the absence of perfect information or complete markets, outcomes will generally be Pareto-inefficient, per the Greenwald–Stiglitz theorem.[9]
The second welfare theorem is essentially the reverse of the first welfare theorem. It states that under similar, ideal assumptions, any Pareto optimum can be obtained by some competitive equilibrium, or free market system, although it may also require a lump-sum transfer of wealth.[7]