Pareto efficiency, or Pareto optimality, is a state of allocation of resources such that no individual can be made better off without making at least one individual worse off. When inefficiency exists, it is possible to improve the well-being of some without injuring others. Transactions that decrease efficiency destroy value, creating deadweight losses, and should be avoided. Institutions maximize value by exploiting profitable opportunities and by minimizing deadweight costs. Just as in mechanics, friction is the enemy of efficiency. Financial frictions may be created by things such a s transaction costs, taxes, lack of transparency, actuarial smoothing, regulatory barriers and costly bankruptcy.
From Phishing for Phools (pages 5-6):
There is a perhaps surprising result that, indisputably, lies at the very heart of economics. Back in 1776, the father of the filed, Adam Smith, in The Wealth of nations, wrote that , with free markets, as if “by an invisible hand… [each person] pursuing his own interest” also promotes the general good.
It took a bit more than a century for Smith’s statement to be precisely understood.According to the modern version, commonly taught even in introductory economics, a competitive free-market equilibrium is “Pareto optimal.” That means that once such an economy is in equilibrium, it is impossible to improve the economic welfare of everyone. Any interference will make someone worse off. For graduate students, this conclusion is presented as a mathematical theorem of some elegance – elevating the notion of free-market optimality into a high scientific achievement.
The theory, of course, recognizes some factors that might blemish such an equilibrium of free markets. These factors include economic activities of one person that directly affect another (called “externalities”); they also include bad distributions of income. Thus it is common for economists to believe that, those two blemishes aside, only a fool would interfere with the workings of free markets. And, of course, economists have also long recognized that firms that are large in size may keep markets from being wholly competitive.
But that conclusion ignores the considerations that are central to this book. When there are completely free markets, there is not only freedom to choose; there is also freedom to phish. It will still be true, following Adam Smith, that the equilibrium will be optimal. But it will be an equilibrium that is optimal, not in terms of what we really want; but an equilibrium that is optimal, instead , in terms of our monkey-on-our-shoulder tastes. And that, for ourselves, as for the monkeys, will lead to manifold problems.
Standard economics has ignored this difference because most economists have thought that, for the most part, people do know what they want. That means that there is nothing much to be gained from examining the differences between what we really want and what those monkeys on our shoulders are, instead, telling us. But that ignores the field of psychology, which is, largely, about the effects of those monkeys.