Economy

Unit 5: Property and Power: Mutual gains and con ict

A. Institutions, E ciency, and Fairness

A.1 Thinking About the Rules of the Game

Institutions (the rules of the game) matter for social outcomes. Institutions can a ect the income that people receive for their work.

A.2 How the (Economic) Pie Gets Divided

Consider how institutions and power determine outcomes or allocations. Evaluate these allocations using the Pareto-e ciency condition and
fairness criteria. Show how policies can improve outcomes.

A.3 Pareto-E ciency

Allocation: Outcome of an economic interaction. (Describes who does what, and who gets what)

An allocation is Pareto E ciency if nobody can be better o without making somebody worse o .

Pesticide example: (I,I)

Pareto dominates: (T,T); (I,I); (I,T); and (T,I) are all Pareto e cient.

A.4 Pareto E ciency: Caveats

Often more than one Pareto e cient allocation. Pareto criterion does not help us choose among these allocations.

Pareto e ciency is unrelated to fairness. Many allocations that could be unfair are Pareto e cient e.g. giving to your friend 1 cent of the 100€ you found
on the street.
A.5 Fairness

• Evaluate the rules of the game as well as the outcome.

• Allocations can be considered unfair for two reasons:

1. Inequality of nal 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

. Rawl's veil of ignorance: Taking an impartial perspective.

A.6 Fairness and Economics

Economics does not provide judgements about what is fair.

But economics can clarify:

• How institutions (rules of the game) a ect inequality

• Tradeo s in the fairness of outcomes e.g. giving up equality of income for equality of opportunity

• Which public policies can address unfairness, and how much they would cost.

B. Coercion, Bargaining, and Institutions

B.1 Example: Angela the farmer

Angela faces a tradeo between grain and free time. Initially, she farms the land by herself and keeps all the grain.

Recall optimal decision making (Unit 3): allocation is where MRS = MRT

B.2 Combine feasible set

Bruno is not a farmer, but wants some of Angela's grain.

The combine feasible set shows all possible allocations of production between two parties.

The chosen allocation depends on institutions and policies.

B.3 Feasible Allocations

The feasible frontier shows all the technically feasible outcomes (limited by technology).

The biological survival constraint shows all the biologically feasible outcomes (limited by survival).

Feasible allocations are given by intersection of these constraints.

B.4 Coercion: Imposing Allocations by Force

Suppose Bruno can enforce any allocation he wants - in e ect, Angela is his slave.

The allocation that maximizes his economic rent is where the slope of the biological constraint (MRS) equals the slope of the feasible frontier (MRT)
MRS = MRT
B.5 Voluntary exchange: Bargaining

How parties divide up the joint surplus (mutual gains) depends on:

1. Each party's reservation option

2. The relative bargaining power between the parties

The economically feasible set shows all possible allocations that bene t both parties.

B.6 Coercion VS. Bargaining

Under coercion, the allocation chosen is where the slope of the biological constraint equals the slope of the feasible frontier.

Without coercion, joint surplus is maximized where the slope of the reservation indi erence curve equals that on the feasible frontier.

Total surplus is lower when both parties have to agree on the proposal.
C. Pareto E ciency, Bargaining, and Legislation

C.1 The Pareto E ciency Curve

Pareto E ciency Curve: the set of all Pareto e cient allocations (also called the contract curve).

• Joins together all points in the feasible set where MRS = MRT.

• The joint surplus is the same, but the distribution of the surplus di ers at each point on the curve.

C.2 Pareto-e cient Bargaining

The allocation chosen will be on the Pareto e ciency curve (line CD)

• At C, Angela gets all the surplus.

• At D, Bruno gets all the surplus.

• In any other point on the curve, Angela ad Bruno split the surplus, and each receive a rent.

C.3 Institutions and Policies: Legislation

Institutions and policies a ect the size of the surplus ad its distribution.

The new allocation must give both parties at least as much as their new reservation option.

- e.g. A law that limits working hours gives Angela more bargaining power.

- Angela's reservation option is F, so Bruno must o er her a point on CG.

C.4 Angela the farmer: Lessons learned

• Technology and biology determines which allocations are technically feasible.

• Institutions and policies help determine which allocations are economically feasible (Pareto-improving).

• The allocation chosen depends on parties' preferences (what they want) and their bargaining power (their ability to get it)

or

D. Lorenz Curves and Gini Coe cients

D.1 Measuring Inequality

Lorenz curve: Shows the extend of inequality and allows comparison of distributors.

Gini coe cient: Measure of inequality, approximated as the deviation of the Lorenz curve from the perfect equality line.

• Rages from 0 (perfect equality) to 1 (maximum inequality).

D.2 Example: Pirates ships and the British Navy

Piracy was surprisingly fair and democratic - unlike in the British Navy, pirates on The Rover distributed their spoils relatively equally between crew
members.

D.3 Addressing inequality

Redistributive government policies (income tax and transfers) can result in a more equal distribution of disposable income.

Di erences in inequality in disposable income across countries depends on the e ectiveness of these policies.

D.4 Example: Operation Barga

• Before 1973, land distribution in West Bengal was highly unequal - a few landowners owned all the land.

• Sharecroppers usually gave half their crop to the landowners.

• Income inequality - 73% rural poverty rate in 1973.

• Land tenure reform allowed farmers to keep a greater share of their crop, and protected them from eviction.

• Not Pareto e cient BUT decreased income inequality.

• Work motivation and agricultural productivity also improved.

Summary

1. Two criteria used to evaluate outcomes:

- Objective: Pareto e ciency.

- Subjective: Fairness (substantive and procedural justice).

2. Allocations depend on preferences and power/institutions.

- Institutions can determine reservation options and bargaining power.

- The Gini coe cient measures the inequality of allocations.

- Public policies can make allocations more e cient or fairer.