Question

What does it mean when a market fails?

If a situation is Pareto-efficient, are Pareto improvements possible?

Does a Pareto improvement necessarily pass the cost-benefit test? Is the converse true? Explain

Answer 1

Market failure is the economic situation characterized by the inefficient distribution on the free market of goods and services. The individual motivations for rational behavior do not result in fair outcomes for the community in market failure.
In other words, for him or herself, each person makes the right decision, but those prove to be the group's wrong decisions. It can sometimes be shown in conventional microeconomics as a steady-state disequilibrium in which the quantity given is not equal to the quantity expected.

Pareto efficiency, or Pareto optimality, is an economic state where resources can not be reallocated to make one person better without making one person worse. Pareto efficiency implies the most economically efficient allocation of resources, but does not imply equality or equity. An economy is said to be in an optimal state of Pareto when no economic changes can make one person better without making at least one other person worse off.

Pareto efficiency is when an economy has its resources and goods allocated to the maximum efficiency level, and no change can be made without making anybody worse.
Efficiency of Pure Pareto exists only in principle, although the economy will shift towards efficiency of Pareto.
Alternative Pareto-based economic efficiency metrics are often used to make economic policy, as it is very difficult to make any adjustments that will not make any person worse.

CBA's theoretical framework as it applies to distribution equity is one source of controversy. Consider a policy that makes some people better-off and no people worse-off. Such a policy is said to produce an "improvement of Pareto," and the cost-benefit test would obviously pass. Nonetheless, most initiatives are likely to produce winners and losers, and CBA simply allows the winners to outweigh the losers. While the winners may compensate the losers to produce an increase in Pareto, the cost-benefit analysis only applies a "potential Pareto rule," which means that compensation, although possible, does not need to take place and is rarely done in practice.