Pareto efficiency and competitive markets

03/12/13 23:38:00    

By Michael Mealling

Earlier today a friend asked me about this:

infographic suggesting that the wealth sitting in the hands of the 400 richest families is somehow wrong. After looking through faireconomy.org its obvious its meant to suggest their money shouldn't belong to them and should be taken away to “do good” elsewhere.

From Wikipedia - Pareto Efficiency:

“In economics a Pareto efficient economic allocation is one where no one can be made better off without making at least one individual worse off.” … “It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an important criterion for evaluating economic systems and public policies. If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can be made to at least one participant's well-being without reducing any other participant's well-being.”

Now, the Fundamental theorems of welfare economics state that:

any competitive equilibrium or Walrasian equilibrium leads to a Pareto efficient allocation of resources. The second states the converse, that any efficient allocation can be sustainable by a competitive equilibrium. The first theorem is often taken to be an analytical confirmation of Adam Smith's “invisible hand” hypothesis, namely that competitive markets tend toward an efficient allocation of resources.

The assumption that most would make from this is that to do the maximally best job of distributing resources one should create the most open and free marketplace as possible. The problem is that for many pareto efficiency is not only not the goal, it is an error. Others critique the concept because of the theorem's assumptions:

However, the result only holds under the restrictive assumptions necessary for the proof (markets exist for all possible goods so there are no externalities, all markets are in full equilibrium, markets are perfectly competitive, transaction costs are negligible, and market participants have perfect information). In the absence of perfect information or complete markets, outcomes will generically be Pareto inefficient, per the Greenwald–Stiglitz theorem.

What that critique does not prove is that any system can ever have enough information quickly enough to make the decisions necessary to move to a more Pareto efficient state that can already be gained by the competitive market. Especially since the Greenwald-Stiglitz theorem depends on actors not having perfect information. If no actor can have perfect information then no organization of actors can either. The pareto efficiency provided by a competitive market may not be mathematically perfect but is the best that can ever be obtained.

In the case of the infographic above one is left with the assumption that the goal is not the efficient allocation of resources but the idea that the pie is fixed and that for one to win another MUST lose. Given simple observable reality that the pie is not fixed, then the idea may simply be the desire to make the other guy suffer. To simply take his stuff because you want it.

No matter how pretty the infographic, jealousy and theft are still ugly.