Economics is more or less a special sub-field of the human sciences in the sense that it has a specific, well-defined objective. This overarching objective of the economics' profession is called (economic or Pareto-) efficiency. While this sounds as a widely understood concept, the economists' definition of it is quite different in fact:

Pareto-efficiency occurs when it is impossible to make any individual better off without making at least one individual worse off.

To understand this definition a bit better, we have to go back to the very nature of the free-market economic system:

Imagine you are 11 years old and attending primary school. Its just another morning at school and you can't wait until the bell anouncing recess rings. After a short wait, it finally rings and you are liberated from the stuffy classroom by the bell. You run outside together with your friend Max. Once outside, you realize you haven't brought a snack with you. When you look to your right, you see Max with a banana in his hand. The fruit is a bit overripe: it is no longer uniformly yellow and has small brown spots speckled across its length.

Ripe banana

You know that Max is not a big fan of overripe bananas while coincidentally, you swear by its sweet, gooey taste. An idea suddenly pops up in your head: maybe you can try to buy the banana off Max? Unknown by you, this is how your and Max' preferences compare:

Max values the banana at 50 eurocents: eating the banana would give him the same pleasure as having 50 eurocents. This means that he wouldn't give up the banana for anything less than that amount. On the other hand, I love ripe bananas. The amount of pleasure I achieve from it is about €1. Consequently, this means that I am willing to pay anything below that amount to satisfy my appetite for a ripe banana.

Reservation prices

In economist's terms, those two numbers (50 eurocents and 1 euro) are called the reservation prices of respectively the supply and the demand side. The reservation price for the buyer is the highest price that buyer is willing to pay while the reservation price for the seller is the lowest price that seller is willing to accept.

Its at this moment that I ask you the economist's most crucial question: is the situation where Max has a banana and you haven't Pareto-efficient? In human words: is there a possibility to make somebody better off without make others worse off?.

Let us imagine a world with just you, Max and the banana. Currently, the total welfare in this world is €0.50. This is how happy Max is with his banana. If I (as an all-powerful Economics Czar) confiscate Max' banana and give it to you, his welfare would go down with €0.50 but yours would rise with €1.00. In short, the total societal welfare increases by €O.50. This seems like a desirable solution. This (frankly communist) solution, however, violates our definition of Pareto-efficiency: we did increase the total welfare but to do that we had to make some tricky decisions where we had to screw over Max to make somebody else (you) happy. It also suffers from another flaw: I (as Economics Czar) can never know everybody's valuations as well as those persons themselves.

Communism

Another solution is that you buy Max's banana. Any price between € 0.50 and € 1.00 would be acceptable to both parties and the result of negotiations between you two. Suppose you agree on a price of €0.75. You give €0.75 to Max and receive the banana in return. Your welfare increases by €0.25 (€1.00 because you get the banana but minus €0.75 because that's how much you pay for it) while Max's welfare also increases by €0.25 (€0.75 because that's how much he receives from you but minus €0.50 because that was his valuation of the banana). In total, the societal welfare increased by €0.50, just as in our last solution.

The advantage of this last solution is that it is Pareto-efficiënt: people are better off without making anybody worse off.

I want you to stand still and consider another important insight: nothing new was invented or produced in the example of this little world. We didn't have to rape the environment to come to this solution. Just the fact that people have different preferences (and capabilities) allows us to increase the world's welfare by using the mechanism of trade.

This is what economists dream of: a world were the total societal welfare is maximized by performing all welfare-increasing trades possible. Unfortunately, there are a lot of flaws and obstacles (called market failures) preventing us from reaching this ideal. This, however, is the topic for another post.

Now its time for an important sidenote: Pareto-efficiency doesn't mean that all wealth is distributed equally and fairly. The best analogy is that of a pie.

Pareto-efficiency means maximizing the size of this pie. How it is consequently distributed, doesn't factor in in our definition. As a result, it is possible that a situation where I eat 9/10s of the cake and I leave the remaining tenth for you and Max, constitutes a pareto-efficiënt outcome.

This leads us into the fairness debate. Each society has to figure out what level of equality they find fair. This is necessary because, unfortunately, people are not born identical: some are born smart, others are born beautiful, yet others are born handicapped. This will clearly have an impact on the intial distribution of wealth caused by the (free) market. Attempts have been made to build a sort of fairness mechanism into the system of the free market. Unfortunately, whenever we try this, efficiency is reduced => the total size of our 'pie' decreases. Sofar, the best solution is to let the market come up with its result after which the distributive tax mechanisms distribute the wealth in a fashion that the society at large considers 'fair'.