Application of pure theory
During this stage of Pareto’s career, his main applications of general theory were to the study of “virtual” economic movements, especially in the areas of welfare economics, international trade, and the theory of rent.
Pareto’s seminal “Il Massimo di utilita dato dalla libera concorenza” (Pareto 1894b [2008]) is one of his more important economic papers. In addition to introducing variable coefficients of production to economics, it demonstrates that a point of equilibrium under free competition must yield an economic maximum when the cost of productive services is minimized by the competitive process. He does this formally by showing that when society moves from an initial state that is not a point of free equilibrium to a subsequent one that is a cost minimizing state of free equilibrium, an economic residual (surplus measured in terms of the numeraire good) is generated from the more efficient use of productive services. Importantly, Pareto introduces the criterion in this article that social welfare is increased when the coefficients of production are altered in a manner that increases the product returned to each individual member of society but harms no one. Consequently, this is the article in which both the Pareto criterion and the first theorem in welfare economics (an economic maximum, in terms of the Pareto criterion, is given by a point of equilibrium under free competition) are outlined. In addition, the “compensation principle” is, as Chipman (1976 [1999]: 178) has reported, introduced in this article when Pareto discusses variation in the coefficients of production in socialist economies, when the second law of welfare economics (any point of economic maximum can be realized under conditions of free exchange) is also broached - but imperfectly. Nevertheless, he did demonstrate that redistributional goals are not achieved efficiently when pursued by altering the coefficients of production (for example, increasing wages paid for labour services).
This analysis of welfare generally, and welfare in socialist countries in particular, is further developed in the Cours (1896-97 [1971]: 722-34). However, the weak point of the article is also preserved in the Cours, with analysis focusing on production (albeit with variable coefficients of production) while largely setting aside the issue of exchange, which is necessary in a general specification of the fundamental theorems of welfare economics.
The application of general equilibrium theory to the study of international trade was initially undertaken by Pareto in “Teoria matematica dei cambi forestieri” (Pareto 1894a [2008]), which was subsequently extended (Pareto 1895b [2008]). Pareto modified Walras’s system to accommodate two markets (countries) for consumer goods, with the quantities of consumer consumption sourced from domestic production and from imports determined in equilibrium from new exogenously given international prices, subject to the constraint that the value of exports equals the value of imports in each market. Analysis in the Cours consolidated Pareto’s earlier work on this subject by illustrating the equalization of the price of traded goods and the welfare gains from free trade. As Andrea Maneschi (1993) reported, Bertil Ohlin was astonished that the Anglo-Saxon trade literature had totally overlooked Pareto’s application of mutual interdependence theory to several markets and not just one.
Pareto’s main original contribution to the theory of economic rent is outlined in the Cours (Gross and Tarascio 1998). He presented economic rents for produced goods as variations in income that derive from movement from complete free equilibrium to an incomplete state of free equilibrium. The new equilibrium state is incomplete because savings are not uniformly transformed into heterogeneous capital in the proportion required by relative prices under the new equilibrium or because of other obstacles to price adjustment. The acquisition of rent from the ownership of a particular capital good is the difference between the realized return on that particular good and the notional return that would have been earned if the return on particular capital goods was in line with the general rate of return on savings that are transformed into capital.
Consequently, the “rent acquired” from the services of a particular capital good is the difference between its rate of return and the general rate of return on savings. Importantly, the rent acquired may be positive or negative, depending on whether the movement to the new equilibrium places upward or downward pressure on the price of particular capital goods. Consequently, this notion of rent depends largely on different time constraints pertaining to the production of heterogeneous capital items. More generally, Pareto saw rents as a consequence of “obstacles to transformation” which, in addition to time, includes the Ricardian scarcity of natural resources as well as other limitations imposed by technology, costs and savings (Bird and Tarascio 1992 [1999]: 483).