Definition: Pareto efficiency explained simply
The Pareto optimum is defined by the fact that no constellation other than the Pareto optimum opens up a higher payoff for even one party.
Example of the Pareto optimum
The prisoner’s dilemma: Two criminals are interrogated independently of each other. They both have the options of confessing or not confessing. In making their decision, they do not know what the accomplice’s decision will be, but they know that the decisions together will affect the sentence of each as follows: If they both confess, they are both given a medium sentence (payoffs: 2.2). If neither confesses, both receive a low sentence (payouts: 3.3). If only one of the two confesses, the one who confesses receives immunity from prosecution, the other is sentenced to a maximum penalty (payoffs: 1.4). The benefit for both results from the combination of each individual’s answers. The equilibrium with payoffs (2, 2) is stable but not efficient. It is therefore not Pareto-optimal. In contrast, the constellation with the payoffs (4, 4) is efficient and therefore Pareto-optimal. However, the Pareto optimum is unfortunately unstable.
In decision-making situations in business practice, a tension can arise between an inefficient Nash equilibrium and an unstable Pareto optimum. In many situations, however, there are proven ways to enforce the Pareto optimum. For example, enforceable agreements can be made within companies and in value chains that allow for a relatively safe exploitation of Pareto-optimal equilibria. In competitive constellations, however, antitrust law speaks against binding agreements to jointly choose the Pareto optimum. A lack of trust leads to an inefficient Nash equilibrium.
Pareto-optimal in interaction with the Nash equilibrium
The Nash equilibrium is a two-sided or all-sided foregoing of an optimal payoff with the aim of avoiding a total loss. If a total loss is unacceptable to each of the participants, a Nash equilibrium will occur in which each participant profits only moderately but remains secure. In both the Pareto optimum and the Nash equilibrium, decisions depend on trust in the other participants and on the risk aversion of each individual. There are several reasonable decision options. The benefit for all participants can be increased by confidence-building measures in advance.
In good, resilient cooperative relationships where all parties see a prosperous future in the cooperation, efficient Pareto equilibria and Nash equilibria are likely to occur.
In commons problems where the participants do not know each other personally, e.g. contributions to environmental protection, an inefficient Nash equilibrium is more likely to result because no one wants to contribute more to the common good than they expect others to.
Pareto efficiency in business
For companies that cooperate with each other over the long term, it is advisable to build trust with each other across different transactions and to make the benefits of cooperative behaviour present for everyone. The more resilient cooperative relationships are, the higher the likelihood that all parties involved will opt for a payoff-optimised Pareto equilibrium.
In B-to-B supply chains with follow-up business, there is a higher probability of a payoff-optimised equilibrium than in business relationships that are limited to a one-off transaction, e.g. for the construction of a commercial building. But references also influence the trust perceived by third parties in a business partner and thus the likelihood of a payoff-optimised Pareto equilibrium in further business relationships.