Introduction to Economics (607.

110)

5. Property & power

paul.schweinzer@aau.at

October 12, 2022

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5. Property & power

Textbook: core-econ, unit 5.

A. Introduction
B. Evaluating outcomes
C. Determining allocations
D. Institutions and Inequality

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The context of this topic

Unit 4. Institutions (the rules of the game) matter for social outcomes.
Unit 2. Institutions can affect the income that people receive for their
work.
Now we are concerned with:
Ï What other factors determine final outcomes?
Ï What other criteria can we use to evaluate outcomes?
Ï How can we improve final outcomes?

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The current topic

Ï Consider how institutions and power determine outcomes or

allocations.
Ï Evaluate these allocations using the Pareto-efficiency condition
and fairness criteria.
Ï Show how policies can improve outcomes.

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B. Pareto efficiency—the fundamental idea of economics
An allocation is the outcome of an economic interaction. It describes
who does what, and who gets what. (E.g., an outcome of a game.)
An allocation is called Pareto efficient if nobody can be made better
off without making somebody worse off.
5
Outcomes better for both than I, I

4 Outcomes better for both than T, T

Pesticide example:
Bala’s payoff

3 Outcomes better for both than T, I

(I,I) Pareto- Outcomes better for both than I, T

dominates (T,T); 2
T, T
I, I = Both use Integrated Pest Control (IPC)
(I,I), (I,T), and 1 T, T = Both use Terminator

(T,I) are all T, I = Anil uses Terminator, Bala uses IPC

0
Pareto efficient. 0 1 2 3 4 5
I, T = Anil uses IPC, Bala uses Terminator

Anil’s payoff

A change in an allocation is called Pareto improvement (relative to the

initial allocation), if no-one is made worse off through the change but
at least one individual is made better off.
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Pareto efficiency: Caveats
There is often more than one Pareto efficient allocation. But the
Pareto criterion does not help us to choose among these allocations.
5
Pareto efficiency is I, T
unrelated to the idea 4

of fairness.

Bala’s payoff
3
Many allocations that
could be considered 2
T, T
unfair are Pareto
efficient, e.g., giving 1
to your friend only 1
cent of the €100 you 0
0 1 2 3 4 5
just found together
Anil’s payoff
on the street.

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Fairness

In order to discuss fairness, we need to evaluate the rules of the

game (institutions) as well as the outcome of the interaction.
Allocations can be considered unfair for (at least) two reasons:
1. Inequality of final outcome (e.g., wealth, well-being):
Substantive judgement of fairness.
2. How they came about (e.g., force vs. fair play, equal
opportunity, conforming to social norms):
Procedural judgement of fairness.
One way of evaluating the fairness of allocations is Rawls’
Veil of Ignorance: it is a hypothetical construction which leads an
individual to take an impartial perspective (“maximin”).

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Fairness & economics

Economics does not provide judgements about what is fair.

But economics can clarify:
Ï How institutions (rules of the game) affect inequality.
Ï Tradeoffs in the fairness of outcomes, e.g., giving up equality
of income for equality of opportunity.
Ï Which public policies can address unfairness, and how.

In the remainder of this unit we explore some economic interactions

and evaluate the resulting allocations.

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C. Example: Angela the farmer
12
MRS = MRT
Ï Angela faces a tradeoff
between grain produced 9
C

Bushels of grain
and free time. Angela's indifference
Ï Initially, she farms the curves

land by herself and

keeps all the grain.
Ï Recall optimal decision Angela’s feasible
making (unit 3); the A
frontier
0
optimal allocation is
0 16 24
where MRS = MRT.
Angela’s hours of free time

MRS: preferences—trade-off made willingly between free-time and grain

production because of idiosyncratic tastes.
MRT: technology—free-time that must be sacrificed (labour needed) to
produce another unit of grain.
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Combined feasible set
12
Feasible frontier:
Total grain Angela and Bruno
Ï Now Bruno, who is not 10.5
produced combined
a farmer, also wants
some of Angela’s grain. What G

Bushels of grain
Bruno gets
Ï The combined feasible
set shows all possible 5.25
E

allocations of output
between the two What F
parties. Angela gets

Ï The chosen allocation H

0
depends on institutions 0 Angela’s free time 12 Angela’s work 24
and policies.
Angela’s hours of free time

At H, Bruno takes everything and Angela is unlikely to survive long.

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Feasible allocations
Angela’s biological

The feasible frontier shows 12

all the technically feasible
outcomes (limited only by
technology). lly

Bushels of grain
e
The biological survival
constraint shows all the
biologically feasible
outcomes (limited by
survival). The MRS along
the survival constraint is
2.5 Z
different from that based on
Angela’s preferences.
0
Feasible allocations are Maximum amount of work
0 24
given by the intersection of Angela could do and still survive

these constraints. Angela’s hours of free time

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Coercion: Imposing allocations by force
12

10
Suppose first that Bruno

Bushels of grain
9

can enforce any allocation

he wants: in effect, Angela
is his slave. 4

The allocation that maxi-

mises Bruno’s economic 0
rent is A; where the slope of 0 4

the biological constraint

(MRS) equals the slope of
6
What Bruno gets

the feasible frontier (MRT): 5.5

MRS = MRT.
Compare this to Angela’s
original preference-based 0
0 13 16 24
optimum C at (16,9)!
Angela’s hours of free time
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Voluntary exchange: Bargaining
Say, that Bruno is now the land owner. Angela’s options include govern-
ment survival rations Z: enough for her to survive even without work.
Angelas biological
survival constraint A l  ti
12
How parties divide up the
joint surplus (mutual gains) o

depends now on:

us els of grain
Ï Each party’s reservation
(“outside”) option.
Ï The relative bargaining 

power between the B

parties. Z
2
Angelas reservation
The economically feasible set option
shows all possible allocations
0
that benefit both parties. 0 24
Angela’s hours of free time

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Coercion vs. bargaining

Ï Under coercion, the allocation

chosen is where the slope of
the biological constraint
equals the slope of the
feasible frontier.
Ï Without coercion, joint
surplus is maximized where
the slope of the reservation
indifference curve equals that
of the feasible frontier.
Ï Total surplus is lower when
both parties have the option
of agreeing to the proposal.

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The Pareto efficiency (“contract”) curve
The Pareto efficiency curve is the set of all Pareto efficient
allocations (also called the contract curve, CC):
A  
12 indifference curve
w  
Angelas reservation
 ! "# 0
Ï The CC connects indiff
 
  1
C
all points in the

us els of grain
$

feasible set where

MRS = MRT.
Ï The joint surplus 
D
is the same, but  4'(

the distribution of
the surplus differs Feasi % le
frontier: Angela
at each point on and &runo com% ined

the curve. 0
0 1) 24
Angelas ours of free time

In our example, the contract curve is the set of allocations [C,D].

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Pareto-efficient bargaining
The allocation chosen is on the Pareto efficiency curve, in set
[C,D]. This means that the optimal output is produced and then
shared between the two parties:
EGHIJKLM NIMO PIKMQNJI
Ï At C, Angela gets 12 indifference curve
RSIG KG QGTIUIGTIGO
all the surplus. Angela0s reservation PKVWIV XY 0
indif24748;4 ;<7=4> ?@1
Ï At D, Bruno gets \

us els of grain
[
all the surplus.
Ï At any other point
on the curve (e.g., /
]

G), Angela and - 4cd

Z

Bruno split the

surplus, and each
receive a positive ^easi _ le
frontier` Angela
and aruno com_ ined
rent, depending on 0
their power. 0 1, 24
Angela*s +ours of free time

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Institutions and policies: Legislation
Angelals reservation
12 indifmnonqrn rsotnu vx1
Ï Institutions and policies
affect the size of the

surplus and its distribution.

us els of grain
~

Ï The new allocation must „2

ƒ

give both parties at least …

as much as their new k

‚

reservation option. j 4€

} y

Ï E.g., a law that limits daily

working hours to 4 (for the yeasi z le
frontier {
Angela and |runo comzined
same amount of grain)
0
gives Angela more 0 1i 20 24
bargaining power. Angelaes gours of free time

Ï Angela’s new reservation option is F, so Bruno must offer her a

point in [C,G] to avoid her voting for the new (inefficient!) law.

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Angela the farmer: Lessons learned
Ï When one party dictates the allocation, subject only to satisfying
others’ reservation options, the powerful party will capture the
entire surplus. This is Pareto efficient but hardly fair!
Ï This unfair treatment may be resolved in an Pareto inefficient
allocation (point F). We face trade-offs between Pareto-efficient
but unfair outcomes, and fair(er) but Pareto-inefficient outcomes.
Ï Under institutions which allow people to jointly deliberate, agree
on, and enforce alternative allocations, it may be possible to
avoid this trade-off and achieve both efficiency and fairness.
More generally, the lessons from the story are that:
Ï Technology & biology determine which allocations are technically
feasible.
Ï Institutions & policies help determine which allocations are
economically feasible (Pareto-improving).
Ï The allocation chosen depends on parties’ preferences (what they
want) and their bargaining power (their ability to get it).
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Determining the resulting allocation

Bargaining
†ower

Institutions
Reservation
o†tion

Biology
Allocation
‡echnicall ˆ Šconomicall ˆ ‹outcomeŒ
feasi ‰le allocations feasi ‰le allocations who does what Ž
who gets what
Technology

Preferences

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D. Measuring economic inequality
In the previous example, inequality resulted directly from differences
in bargaining power and from unequal (initial) endowments.
¥ini coef¦§¨§©ª« ¦¬­ ®¯ª° ¬±ª©­²³§´µ ¶·¸¶ + B) = 0.9

Lorenz curve: Shows the 100

•
”
extent of inequality across a “

umulative share of land

share of land
population and allows
comparison of distributions.
Gini coefficient: Measure of
¤
£
inequality, approximated as ¢
¡

the deviation of the Lorenz  
Ÿ
ž
curve from the perfect 
œ
›
equality line. ‘

0
It is calculated as A/(A+B) 0  0 100
and ranges from 0 (perfect
0 farmers 10 landowners
equality) to 1 (maximum
–umulative share of the —o—ulation
inequality). from least to most land owned ˜™š
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Example: Pirate ships and the British navy
Distribution Gini
Pirate ship The Rover 0.06 100
British Navy ship Active 0.59
British Navy ship Favourite 0.60
Village sharecroppers & landowners 0.90

ative share of income (%)

½5
Piracy was surprisingly fair ÃÄ
it y
Â
eq
and “democratic:” unlike in r fe
ct ov
er
pe lR
ya
the British Navy, pirates on 50 ne
of
ÆR
o
Li ip
sh
The Rover distributed their ra
te
Åi
spoils relatively equally
¼
t ive
between crew members. º 25
avy
Í Îc
» ish Ì it e
º Br it voÊË
¹ yÈ Éa
h Çav
Br it is

0
0 25 50 ½5 100

¾¿À¿Á ative share of the ship's company from Á owest (crew) to

highest income (¾aptain) (%)

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Addressing inequality
Shown on the right is Dutch 100 Ù ff
Gross National Income data 90

m ative share of income (%)

Ñ0
from 2015, before and after
Ð0
taxes/transfers.
Ï0
Redistributive government 50
policies (income tax and 40
transfers) can result in a more Ò0
Õ
equal distribution of Ô 20
disposable income. Ô
Ó 10

0
Differences in inequality in
0 10 20 Ò 0 40 50 0
Ï 0
Ð 0
Ñ 90 100
disposable income across Ö× m ×Ø ative share of the pop ×Ø ation
countries depends on the from Ø owest to highest income (%)
effectiveness of these policies.
Differences between countries in disposable income inequality are
much greater than the differences in inequality of market incomes.

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Example: Operation Barga

Before 1973, land distribution in the Indian state of West Bengal

(home to more people than Germany) was highly unequal: a few
land-owners owned all land. Sharecroppers usually gave half their
crop to the landowners. The rural poverty rate was 73% in 1973.
Operation Barga was a land reform movement throughout rural
West Bengal. It bestowed on the sharecroppers (“bargadars”), the
legal protection against eviction by the landlords, and entitled them
to up to three quarters of their crop.
Operation Barga was launched in 1978 and concluded by the mid-
1980s. Through their increased share of output, it generated
incentives for bargadars to both work harder and invest more in the
land improvement. One study suggests that Operation Barga was
responsible for around 28% of the subsequent growth in agricultural
productivity in the region.

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Example: Operation Barga
ÝnitiaÜ Þini coefßàáàâãäå æçèæ
Þini coefßàáàâãäå éßäâê ÜéãÚ äâãëêâ êâßìêíå æçîï
Ï Land tenure reform 100

at ive sh are o f inco m e (%)

allowed farmers to keep LanÚownersÛ
a greater share of their share of
initiaÜ income
õ5

crop, and protected them

from eviction. 50

Ï Not Pareto efficient BUT

ðarmersÛ
decreased income ó
ò
share of 25
initiaÜ income
inequality.
m

ò
ñ
Ï Work motivation and 0
0 90 100
agricultural productivity
90 farmers 10 Ü anÚowners
also improved.
ôë m ë Ü at ive sh are o f t h e p o p ë Ü at io n

f ro m t h e Ü o w est t o t h e h igh est inco m e (%)

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Summary

1. Two criteria used to evaluate outcomes:

Ï Objective: Pareto efficiency.
Ï Subjective: Fairness (substantive and procedural justice).
2. Allocations depend on preferences and power/institutions:
Ï Institutions can determine reservation options and
bargaining power.
Ï The Gini coefficient measures the inequality of allocations.
Ï Public policies can make allocations more efficient or
fairer.

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In the next unit

Ï The role of other institutions: firms and markets.

Ï How firms work: owners, managers, and employees.
Ï Why unemployment is a feature of the way labour markets
function.

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