What Is a Pareto Improvement?

A pareto improvement is a type of economic event in which no party involved sustains a loss but at least one party does receive some amount of benefit. The general idea is that two or more entities can engage in transactions that allow some of those entities to participate in the deal with no ill effects, effectively maintaining their status quo. Other parties not only do not experience any type of negative consequence, but actually are better off as a result of their participation.

One of the easiest ways to understand how pareto improvement comes about is to consider two individuals who each have one piece of fruit. One party has an orange, but prefers apples. The other party has an apple, and possesses an equal liking for oranges and apples. The two individuals decide to exchange fruits, allowing the trader who prefers apples to now have something that he or she considers of greater value. The other individual has maintained the status quo with this trade, since he or she is equally happy with either an apple or an orange. With this arrangement, both parties ultimately end up with something that is considered an asset and will provide satisfaction without either party encountering any type of loss or distress.

Utilizing the concept of pareto improvement makes it possible to generate gains in some sectors of the marketplace without also triggering negative consequences in other areas of the market. The ability to use this strategy can help to provide additional stability in some sectors of the marketplace, allowing businesses to trade assets that are not considered of prime desirability for other assets that the company owners perceive as being beneficial to the business model. Since those undesirable assets may be considered of equal worth by someone else, the trading allows one business to gain something that is wanted, while the other business is able to move forward with the asset received from the trade with no negative effects at all.

The general financial theory around pareto improvement is that transactions of this type aid the economy in general, since nothing but positive results come about from the transaction. There is an understanding that enough of these type of trades will eventually lead to a market situation known as a pareto equilibrium. This equilibrium is simply a situation in which every pareto improvement that is currently possible has occurred, and that attempts at further trades cannot take place without some participant experiencing at least a minor degree of loss.