Developed by the Italian economist, Vilfredo Pareto, the Pareto optimality criterion is the situation in

which it is impossible to make anyone better off without making someone else worse off. This
situation is also called Pareto efficient. It follow that any change that improves the well- being of
some individuals without reducing the well-being of others, clearly improves the welfare of society
as a whole and should be undertaken.

Three aspects of Pareto optimality:

1. Efficiency in Exchange: Pareto optimality (or efficiency) in exchange is achieved when

allocation of commodities among the consumers is such that it is not possible to increase the
satisfaction of any person without reducing the satisfaction of someone else Pareto
optimality (or efficiency) in exchange can be achieved only when all consumers have the
same marginal rate of substitution between the same pair of goods. 2.

2. Marginal condition for production optimality That is, the marginal rate of technical
substitution (MRTS) between any pair of factors must be equal for all commodities and all
firms.
3. Marginal condition in product Mix It means that the marginal rate of transformation (MRT)
between any pair of goods must be equal to the marginal rate of substitution for any pair of
goods. It is also termed as “ Allocative Efficiency”

MARGINAL CONDITIONS OF PARETO OPTIMALITY: Pareto derived marginal condition to be

fulfilled to achieve optimum position. These conditions were later developed by Hicks and Allen.
Marginal conditions are based on following assumptions: These marginal conditions are based on the
following assumptions:

1. Each individual has his own ordinal utility function and possesses definite amount of each
product and factor.
2. Production function of every firm and the state of technology is given and remains
constant.
3. Goods are perfectly divisible.
4. A producer tries to produce a given output with the least-cost combination of factors.
5. Every individual wants to maximize his satisfaction.
6. Every individual purchases some quantity of all goods.
7. All factors of production are perfectly mobile.

1. Marginal condition for efficiency of distribution of commodities among consumers:

Efficiency in exchange (MRSX = MRSY)
The marginal rate of substitution of one good for another is the amount of one good
necessary to compensate for the loss of a marginal unit of another so as to maintain a constant level
of satisfaction. So long as the marginal rate of substitution (MRS) between two goods is not equal for
any two consumers, they will enter into an exchange which would increase the satisfaction of both or
of one without decreasing the satisfaction of the other.
 This condition can be explained with the help of the Edgeworth Box diagram. In Figure- 39.3,
goods X and Y, which are consumed by two individuals A and B composing a society, are represented
on the X and Y axes respectively. OA and OB are origins for A and B respectively. la1, Ia2, Ia3 and Ib1,
Ib2, lb3 are the indifference curves showing successively higher and higher satisfaction of consumers
A and B respectively. CC is the contract curve passing through various tangency points Q, R, S of the
indifference curves of A and B.
The marginal rates of substitution between the two goods for persons A and B are equal on
the various points of the contract curve CC’. Any point outside the contract curve does not represent
the equality of MRS between the two goods for A and B individuals.
If we take alternatively point K, where indifference curves Ia1 and Ib1 intersect each other
instead of being tangential, marginal rate of substitution between two goods X and Y (MRSXY) of
individual A is not equal to that of B.
With the initial distribution of goods as represented by point K, it is possible to increase the
satisfaction of one individual without any decrease in that of the other or to increase the satisfaction
of both by redistribution of the two goods X and Y between them. A movement from K to S increases
the satisfaction of A without any decrease in B’s satisfaction.
Similarly, a movement from K to Q increases B’s satisfaction without any decrease in A’s
satisfaction. The movement from K to R increases the satisfaction of both because both move to their
higher indifference curves. Thus, movements from K to Q or to S or to any other point on the
segment SQ of the contract curve will, according to Pareto criterion, increase the level of social
welfare.

Since the slope of an indifference curve represents the marginal rate of substitution (MRSXY)
at any point of the contract curve, hence at tangency points of the indifference curves MRSXY of the
two individuals are equal. Therefore, points on the contact curve represent the maximum social
welfare.
However, a movement along the contract curve in either direction will make one individual
better off and the other worse off since it will put one individual on his successively higher
indifference curves and the other on his successively lower indifference curves. we cannot say
anything about the best of them with the help of Pareto criterion.
 2. Marginal condition for efficiency in the allocation of factors among firms: Efficiency in
production (MRTSL = MRTK)
The second condition for Pareto optimum assumes that the factors of production available
in an economy should be utilized in the production of goods in such a manner that it is impossible to
increase the output of one firm without a decrease in the output of another or to increase the
output of both the goods by any reorganization of factors of production.
This state of equilibrium would be achieved if the marginal rate of technical substitution
(MRTS) between any pair of factors are the same for any two firms producing two different products
and using both the factors to produce the goods.
This condition too can be explained with the help of Edgeworth Box diagram relating to
production. This is depicted in Fig. 39.4. Let us assume two firms A and B producing the same
product by using two factors labour and capital. The available quantities of labour and capital are
represented on X and Y axes respectively. OA and OB are the origins for firms A and B respectively.

Isoquants Ia1, Ia2, Ia3 and Ib1, Ib2, Ib3 of firms A and B respectively represent successively
higher and higher quantities of output which they can produce by different combinations of labour
and capital. The slope of the isoquants, which are convex to the origin, represents the marginal rate
of technical substitution (MRTS) between two factors.
MRTS of one factor for another is the amount of one factor necessary to compensate for the
loss of the marginal unit of another so that the level of output remains the same. So long as the
MRTS between two factors for two firms is not equal, total output of a product can be increased by
transfer of factors from one firm to another.
In terms of the above diagram any movement from K to S or to Q raises the output of one
firm without any decrease in the output of the other. The total output of the two firm’s increases
when through redistribution of factors between the two firms, a movement is made from the point K
to the point Q or S on the contract curve.
A glance at Figure 39.4 will reveal that movement from point K outside the contract curve to
the point R on the contract curve will raise the output of both the firms individually as well as
collectively. Therefore, it follows that corresponding to a point outside the contract curve there are
some points which will ensure greater total output of the two firms.
 As the contract curve is the locus of the tangency points of the isoquants of two firms, the
marginal rate of substitution of the two firms is the same at every point of the contract curve CC.
thus we can say that on every point of the contract curve, where MRTS between the two factors of
two firms is the same, the allocation of factors between the two firms is optimum.
But it is worth mentioning that there are several points on the contract curve and each of
them represents the optimum allocation of labour and capital as between the two firms. But which
one of them is best cannot be said on the basis of Pareto criterion because movement along the
contract curve in either direction represents such factor reallocation which increases the output of
one and reduces the output of another firm.

4. Marginal condition for efficiency in the allocation of factors among commodities: Efficiency
in product mix (MRS = MRT)
This condition relates to the pattern of production. The fulfillment of this condition
determines the optimum quantities of different commodities to be produced with the given
factor endowments. This condition states that “the marginal rate of substitution (MRS)
between any pair of products for any person consuming both must be the same as the
marginal rate of transformation (MRT) (for the community) between them.” According to
this condition, for the attainment of maximum social welfare goods should be produced in
accordance with consumer’s preferences. Let us explain this with the help of Fig. 39. 5.

In Fig. 39.5 commodities X and Y have been represented on the X and Y axes respectively. AB
is a community’s transformation curve between any pair of goods X and Y. This curve
represents the maximum amount of X that can be produced for any quantity of Y, given the
amounts of other goods that are produced and fixed supplies of available resources.
IC1 and IC2 are the indifference curves of a consumer. Its slope at a particular point
represents the marginal rate of substitution between the two goods. The MRT’ of the
community and MRS of the consumer are equal to each other at point R at which the
community’s transformation curve is tangent to the indifference curve IC2 of a
representative consumers, Point R represents optimum composition of production in which
commodities X and Y are being produced and consumed in OM and ON quantities.
This is because of all the points on the community’s transformation curve, point R lies at the
highest possible indifference curve IC2 of the consumer. For instance, if a combination of
goods X and Y represented by S is being produced and consumed, the consumer would be at
a lower level of welfare because S lies on his lower indifference curve IC1 which intersects
the community’s transformation curve instead of being tangential to it.
As a result, at point S, MRSXY of the consumer is not equal to the MRTXY of the community.
With the situation at S there is a possibility of moving the consumers to a higher indifference
curve by changing the direction (i.e. composition) of production i.e. by increasing the
production of X and reducing the production of Y. Thus, the optimum direction of production
is established at point R where community’s transformation curve is tangent to the
indifference curve of a consumer in the society.