Economic Theory 1A ● Week 5 ● 2021

PROPERTY AND POWER

Mutual gains and conflict
Outline
2

 Introduction to key concepts

– Power
– Institutions

 Efficiency and fairness

– Pareto efficiency
– Substantive and procedural equity
– Approaches to equity

 A model of choice with technological constraints

 Introducing coercion and conflict into the model

 Introducing property rights and distributional claims under law

READING: Core Unit 5 (Section 5.1 – 5.11)

 3

Introduction to
key concepts
Introduction
4

 Economic outcomes are determined by:

– Technology
– Biology (people’s natural biological requirements eg food, sleep)
– People’s preferences
– Economic institutions( rules, both written and unwritten that govern
interactions between individuals)

 Power is the ability to do and get the things we want in opposition to the
intentions of others.

 Interactions between economic actors can result in mutual gains, but also in
conflicts over how the gains are distributed.

 Institutions influence the power and other bargaining advantages of actors.

 The criteria of efficiency and fairness can help evaluate economic

institutions and the outcomes of economic interactions.
Institutions
5

 We can distinguish between “rules” and “players” in a game .

 Obviously, the capabilities of the players is important, but the rules can change
the type of characteristics and capabilities that are legitimately rewarded

 An economic institution can be thought of as the “rules” of the economic game

 the rules of the game affect:

– how the game is played
– the size of the total payoff available to those participating
– how this total is divided
– Eg in a firm, there might be very capable workers, but what they actually
receive in compensation will determine how hard they work.

 Changing the rules can affect economic incentives for certain kinds of
behaviour.

 Incentive: Economic reward or punishment, which influences the benefits and

costs of alternative courses of action.
Power in economics
6

 Power: The ability to do and get the things we want in opposition to the
intentions of others.

 Power in economics takes two main forms:

– It may set the terms of an exchange: By making a take-it-or-leave-it offer

– It may impose or threaten to impose heavy costs: Unless the other party acts
in a way that benefits the person with power ( eg slavery)

 Bargaining power: The extent of a person’s advantage in securing a larger

share of the economic rents made possible by an interaction
Labour Market
7

 In the labour market:

– The power to set the terms of the exchange typically lies with those
who own the factory or business:
– they are the ones proposing the wage and other terms of the
employment contract

 Those seeking employment have low bargaining power, since usually

more than one person is applying for the same job.

 Because the place of employment is the employer’s private property,

the employer may be able to exclude the worker by firing her unless
her work is up to the specifications of the employer.
Evolution of Institutions in Labour Market
8

 Institutions such as trade unions and the right to vote for workers,
gave wage earners the bargaining power to raise wages substantially.
 9

Introduction to
efficiency and equity
Economic allocation
10

 One way of thinking about the economic consequences of social choices is to

describe the outcome as an economic allocation.
 Economic allocation: The outcome of an economic interaction
Pareto criterion

■ The first way in which an allocation is evaluated is through the pareto

efficiency criterion.

■ An allocation is Pareto efficient if nobody can be made better off without

making somebody else worse off.

■ Once the whole pie is allocated, it is impossible to make someone better off,
without taking from another

■ Pareto-criterion can help us evaluate efficiency and judge between two

allocations.

■ The Pareto criterion says nothing about fairness

■ A very unequal distribution of food – even one that means some people will
starve while others are eating very well – can be Pareto efficient as long as
all the food is eaten by a person who wants to eat, and none is thrown away.

■ So an allocation can still be pareto efficient even if moving means a poor

person can be made better off but a rich person would be made slightly
worse off
Pareto criterion 2: comparing economic allocations
12

 Suppose that we want to compare two possible allocations, A and B, that may
result from an economic interaction.

 Can we say which is better?

 If everyone involved in the interaction prefers A, then A is a better allocation

than B.

 This criterion for judging between A and B is called the Pareto criterion, after
Vilfredo Pareto, an Italian economist and sociologist.

 According to the Pareto criterion:

– Allocation A dominates allocation B if at least one party would be better off

with A than B, and nobody would be worse off with A.

– We say that A Pareto dominates B.

– An allocation is Pareto efficient if there is no alternative technically feasible

allocation in which at least one person would be better off, and nobody
worse off.
An interaction: The pesticide game again
■ When Anil and Bala each play their dominant strategy, the outcome is (Terminator,
Terminator).
■ Anil and Bala each receive payoffs of 2, but both would be better off if they both used IPC
instead.
■ The predicted outcome is therefore not the best feasible outcome. 
■ There is another feasible allocation where both are better off.

A C

B D
Feasible allocations
Payoffs in the pesticide game

B
Evaluating outcomes with Pareto-criteria
■ Pareto efficient: An allocation with the property that there is no
feasible alternative allocation in which at least one person would be
better off (prefer more), and nobody worse off (prefer less)

■ A Pareto-dominates D.

■ A, B and C are all Pareto efficient

– The Pareto criterion does not tell

us which efficient allocation is C
better

– It does not give us any ranking of

A, B and C A

■ Anil playing IPC and Bala free riding D

by playing Terminator (i.e. C) is
Pareto efficient…

■ ….but we (and Anil) may think this is

B
unfair. 
Pareto-criterion’s limitations in comparing allocations
16

 There is often more than one Pareto-efficient allocation In the pest-

control game there are three pareto efficient allocations
 In this case, the Pareto criterion does not tell us which of the Pareto-
efficient allocations is better It does not give us any ranking of efficient
allocations
 Pareto efficiency has nothing to do with fairness efficient allocations
are not necessarily fair.
 If an allocation is Pareto efficient, this does not mean we should
approve of it:

– Bala may free-ride on Anil which Anil may think is unfair.

– A very unequal distribution of food can be Pareto efficient as long

as all the food is eaten by someone who enjoys it even a little.
Fairness: Substantive and procedural

■ An allocation can be judged as unfair based on substantive or procedural

grounds
■ We might say an allocation is unfair because some people are seriously
deprived of basic needs, while others consume luxuries.
– This concern is for “substantive fairness”, how unequal is the allocation
– These judgements of fairness, which are based on the characteristics of the
allocation itself (not how it was determined)
– In terms of income, for example, or subjective wellbeing or the distribution
of wealth.
■ We might say an allocation is unfair because the rules of the game are not fair.
– This concern is for “procedural fairness”, how was the allocation arrived at
– For example, by force or racial discrimination, by competition on a level
playing field, or by hard work.
– In this case the “rules of the game” or the institutions that resulted in the
allocation may be unfair
Is this Fair? Why?
18

 A and B are walking down the street. They both spot a R100 note,
which A picks up and offers one cent to B.

 What if A has just lost her job and is homeless while B is well off?

 What if they split it so that they each get R50?

 What if the 50/50 split was because B threatens to beat A up if she

doesn’t do this?
The Rawlsian veil of ignorance
19
 A way to clarify our own ideas of fairness that can
sometimes help us find common ground.

 Evaluate the constitutions, laws, inheritance

practices, and other institutions of a society as an
impartial outsider.

The American philosopher John Rawls (1921–2002) proposed three steps:

1. Adopt the principle that fairness applies to all people, regardless of who
they are.

2. Imagine a ‘veil of ignorance’: We do not know the position we will occupy

in the society we are considering male or female, healthy or ill, rich or
poor, black or white, and so on. In the example before we could be the
person picking up the money, or the one with him/her.

3. From behind this veil of ignorance, we can make a judgement and design
institutions that are regarded as fair, regardless of which person we are.
 20

A model of choice
and conflict
 Model of choice and conflict
21
 We are going to look at economic interactions, their resulting allocations, and how these change,
when the rules of the game change

 Outline of the approach:

– Initially, Angela works the land on her own, and gets everything she produces.

– Next, we introduce a second person, who does not farm, but would also like some of the
harvest. He is called Bruno.

– At first, Bruno can rule by force: Angela is compelled to work for him. In order to survive, she
has to do what he says.

– Later, the rules change: the rule of law replaces the rule of force. Bruno can no longer coerce
Angela to work. But he owns the land and if she wants to farm his land, she must agree, for
example, to pay him some part of the harvest.

– Eventually, the rules of the game change again in Angela’s favour. She and her fellow farmers
achieve the right to vote and legislation is passed that increases Angela’s claim on the harvest.

 We will analyse the changes in terms of both Pareto efficiency and the distribution of income
between Angela and Bruno.

– Remember that we can determine objectively whether an outcome is Pareto efficient or not.

– But whether the outcome is fair depends on your own analysis of the problem, using the
concepts of substantive and procedural fairness.
Technology and preferences in the model
22

 Angela’s harvest of grain depends on her hours of work; this technical

relationship between work (input) and grain (output) is described by a
production function.

 Angela works the land for a number of hours each day and enjoys the
remainder of the day as free time.

 She values grain, but she also enjoys (and so values)free time. Depending on
her preferences she has a choice between free time and work/grain

 The slope of the feasible frontier is the marginal rate of transformation

(MRT) of free time into grain. It tells us: for each unit of free time she gives up
to work, how much grain she can produce. This is independent of Angela’s
preferences. It depends on the technology of production.
 Angela as an independent farmer
Technology
 Angela’s harvest of grain depends
on her hours of work; this technical
MRT at point C relationship between work (input)
12 and grain (output) is described by a
production function.

 The slope of the feasible frontier is

the marginal rate of
transformation (MRT) of free time
C into grain.
Bushels of grain

 It tells us: for each unit of free time

she gives up to work, how much
grain can she can produce. This is
Angela’s independent of Angela’s
feasible preferences.
frontier
 What happens to the MRT as we
decrease free time? It decreases
because the more angela works ,
the less productive she becomes in
0 terms of transforming working
hours into grain
0 24
Angela’s hours of free time
 Angela as an independent farmer
Preferences  Angela works the land for a number
of hours each day and enjoys the
remainder of the day as free time.

12 MRS at  She values grain, but she also enjoys

point C free time. Depending on her
preferences she has a choice
between free time and work/grain
 We represent her preferences as
C indifference curves, showing the
Bushels of grain

combinations of grain and free time

that she values equally.
 The slope of the indifference curve is
called the marginal rate of
substitution (MRS) between grain
and free time: if she sacrifices one
unit of free-time, how much grain
should she get to remain equally
Angela’s indifference set
satisfied as before.

0
0 24
Angela’s hours of free time
Indifference Curves
25

 The higher the indifference curve the more benefit to Angela.

 The steeper the indifference curve, the more Angela values free time
relative to grain

 The more free-time she has (moving to the right), the flatter the curves
—she values free time less (and will not be prepared to give up as
much grain as before for an extra unit of grain). (MRS is lower)

 When Angela has less free time the indifference curves are steeper (as
she will willingly give up more grain per unit of free time gained) (MRS
is higher)
 Angela as an independent farmer
Choice meets technology
 The best Angela can do,
given the limits set by the
12 Angela’s
feasible frontier, is to work
indifference
set
for 8 hours, taking 16
hours of free time and
producing 9 bushels of
9
C grain.
Bushels of grain

 Any other point on the

feasibility frontier is on a
lower indifference curve

 At this point C, the

marginal rate of
substitution (MRS) is equal
Angela’s
feasible
to the marginal rate of
frontier transformation (MRT)

0
0 16 24
Angela’s hours of free time
 27

Introducing
Coercion and conflict
into the model of choice
Enter Bruno!!!!
28

 Bruno is not a farmer. He will claim some of Angela’s harvest.

 We will study different rules of the game that explain how much is
produced by Angela, and how it is divided between her and Bruno.
 Angela produces grain

Lets say Angela takes 12 hours free

12
time and works for 12 hours, then
she produces 10.5 bushels of grain.
Total grain 10.5
produced
Bushels of grain

Feasible frontier
Angela and Bruno
combined
0
Angela’s free time Angela’s work
0 12 24
Angela’s hours of free time
 Bruno takes half!

 Let Bruno then appear with a

gun and demand half.
12
 After this interaction, at point
E, the outcome (i.e. the
10.5 economic allocation) is that
5.25 bushels go to Bruno, and
Angela retains the other 5.25
What bushels for her own
Bushels of grain

Bruno gets
consumption.

5.25 E

What
Feasible frontier
Angela
Angela and Bruno
gets
combined

0
Angela’s free time Angela’s work
0 12 24

Angela’s hours of free time

 Economic allocations
F Angela works for about 18 hours (with 6 hours of free time) and receives
about 4 bushels of grain and Bruno get about 7 bushels of grain

12
11 G Angela works for about 18 hours (with 6 hours of
10.5 free time) and receives about 7 bushels of grain and
Bruno get about 4 bushels of grain

G
7 H Angela works 12 hours a day and
Bushels of grain

receives nothing (Bruno takes the entire

harvest), so Angela would not survive.
5.25 E

Of the allocations that

F are possible (E, F, G and
4
H), the one that will
occur depends on the
H rules of the game
0
0 6 12 24
Angela’s hours of free time
Feasible allocations
32

 Production is on the production feasibility frontier

 If Angela does not work the land, Bruno gets nothing (there are no
other prospective farmers that he can exploit).

 As a result, Bruno – who is concerned about his future grain

consumption – will not take so much grain that Angela will die

 Therefore there is a biological limit to the degree to which Bruno can

exploit Angela
– If Angela does not work at all, she needs 2.5 bushels to survive
(point Z).
– Also Angela cannot continuously work more than about 18 hours
per day (her maximum working day)
– This is the biological survival constraint: the relationship between
hours of work and grain consumption necessary to survive.
– Points below the biological survival constraint are biologically
infeasible.
 Technically feasible set

Z: If Angela does not work at all,

Angela’s biological she needs 2.5 bushels to survive
survival constraint
12
If she gives up some free time
and expends energy working,
she needs more food, so the
Technically curve is higher when she has
infeasible
less free time.
Bushels of grain

Technically
feasible set

The technically feasible set:

• lies above (and cannot be
Biologically below) what is biologically
infeasible feasible
2.5 Z • lies below (and cannot be
above) what is technically
feasible
0
0 6 Maximum amount of work 24
Angela could do and still survive
Angela’s hours of free time
The problem is Bruno’s claims on output
34

 The technically feasible allocations are the points in the lens-shaped

area bounded by the feasible frontier and the biological survival
constraint (including points on the frontier).

 If Angela could consume everything she produced (the height of the

feasible frontier) and choose her hours of work, her survival would not
be in jeopardy since the biological survival constraint is below the
feasible frontier for a wide range of working hours.

 The question of biological feasibility arises because of Bruno’s

claims on her output.
Bruno’s choice: Allocations imposed by force
35

 With the help of his gun, Bruno can choose any point in the lens-shaped
technically feasible set of allocations. But which will he choose?

 Bruno reasons like this:

– For any number of hours that I order Angela to work, she will produce the
amount of grain shown by the feasible frontier.
– But I’ll have to give her at least the amount shown by the biological
survival constraint for that much work, so that I can continue to exploit her.
– I get to keep the difference between what she produces and what I give
her.
– Therefore I should find the hours of Angela’s work for which the vertical
distance between the feasible frontier and the biological survival constraint
is the greatest.

 The amount that Bruno will get if he implements this strategy is his
economic rent, meaning the amount he gets over what he would get if
Angela were not his slave (zero) i.e. the amount above his next best
alternative (or reservation option)
BRUNO’S CHOICE At high working
36
hours the survival
frontier becomes
Bruno can command Angela
steeper
to work
Bruno can choose any allocation in If Bruno makes
the technically feasible set. Angela work for more
than 11 hours, the
amount he can take
falls as working hours
The maximum distance increase.
between frontiers
The vertical distance between the
feasible frontier and the biological
survival constraint is greatest when
Angela works for 11 hours (13 hours
of free time).

Allocation and distribution at the

maximum distance
If Bruno commands Angela to work for 11
hours, she will produce 10 bushels, and
needs 4 to survive. Bruno will get to keep
6 bushels for himself (the distance AB).
BRUNO’S CHOICE
37

The best Bruno can do for himself

Bruno gets the maximum amount of
grain by choosing allocation B, where
Angela’s working time is such that the
slope of the feasible frontier is equal to
the slope of the biological survival
constraint: MRT = MRS.

What Bruno gets

If we join up the points then we can
see that the amount Bruno gets is
hump-shaped, and peaks at 11 hours
of work (13 hours of free time).
Bruno maximizes where MRT = MRS
38

 The lower panel graph is hump-shaped, and peaks at 13 hours of

free time and 11 hours of work (where Bruno gets 6 bushels of
grain)

 The slopes of the feasible frontier and the survival constraint (the
MRT and MRS) also help us to find the number of hours where
Bruno can take the maximum amount of grain.

 To the right of 13 hours of free time the biological survival

constraint is flatter than the feasible frontier (MRS < MRT). This
means that working more hours (moving to the left) would produce
more grain (MRT steeper) than what Angela needs for the extra
work (MRS less steep).

 To the left of 13 hours of free time (Angela working more), the

reverse is true: MRS > MRT. This means that she would need more
food to work an extra hour , than she can produce in that extra
hour.
 39

Property rights
and competing
claims
Introducing law and private property
40

 Previously Bruno enforced his will be force and his gun. Now assume,
the institutions have changed and Bruno is the property owner

 Bruno is now wearing a suit and is no longer armed.

 Bruno explains that this is no longer needed because there is now a

government with laws administered by courts, and professional
enforcers called the police.

 Bruno now owns the land, and Angela must have permission to use his
property.

 Bruno can offer a contract allowing her to farm the land and give him
part of the harvest in return.

 But the law requires that exchange is voluntary: Angela can refuse the
offer.

 If he makes an offer that is just a tiny bit better for Angela than not
working at all and getting subsistence rations, she will accept it.
Angela’s reservation indifference curve
41

 With the new law, the limitation is not Angela’s survival, but rather her
agreement.

 Instead of a biological survival constraint, Angela’s reservation

indifference curve is relevant

 Angela values her free time, so the more hours Bruno offers her to work,
the more he is going to have to pay.

 Point Z in Figure 5.6 is the allocation in which Angela does no work and
gets only survival rations (from the government, or perhaps her family).

 This is her reservation option (If she refuses Bruno’s offer, she has this
option as a backup.)

 Angela’s reservation indifference curve shows all of the allocations that

have the same value for her as the reservation option.
– Below or to the left of the curve she is worse off than in her reservation
option.
– Above and to the right she is better off.
42
Analysing Angela’s reservation indifference curve
43

 The biological survival constraint and the reservation indifference curve

have a common point (Z): at that point, Angela does no work and gets
subsistence rations from the government.

 Other than that, the reservation indifference curve is uniformly above

the biological survival constraint.

 Along the reservation indifference curve, Angela is just as well off as at

her reservation option, meaning that being able to keep more of the
grain that she produces compensates exactly for her lost free time.
Potential for mutual gains from exchange
44

 As long as Bruno gets some of the crop he will do better than if there
is no deal.

 As long as Angela’s share makes her better off than she would have
been if she took her reservation option, taking account of her work
hours, she will also benefit.

 This potential for mutual gain is why their exchange need not take
place at the point of a gun, but can be motivated by the desire of both
to be better off.

 All of the allocations that represent mutual gains are shown in the
economically feasible set in the Figure 5.6.

 Each of these allocations Pareto dominates the allocation that would

occur without a deal.

 In other words, Bruno and Angela could achieve a Pareto

improvement
What will Bruno choose?
45

 Mutual gains do not mean that the parties will benefit equally

 If the institutions in effect give Bruno the power to make a take-it-or-

leave-it offer, subject only to Angela’s agreement, he can capture the
entire surplus (and Angela is no worse off along her indifference curve)

 Bruno maximizes the amount of grain he can get at the maximum

height of the lens-shaped region between Angela’s reservation
indifference curve and the feasible frontier.

 This will be where the MRT on the feasible frontier is equal to the MRS
on the reservation indifference curve.

 figure 5.7a shows that this allocation requires Angela to work for
fewer hours than she did under coercion.
46
What will Bruno and Angela agree?
47

 Bruno would like Angela to work for 8 hours and give him
4.5 bushels of grain (allocation D).

 How can he implement this allocation? All he has to do is to make a

take-it-or-leave-it offer of a contract allowing Angela to work the land,
in return for a land rent of 4.5 bushels per day.

 This is a sharecropping contract, in which a landowner allows a farmer

to use land in return for a share of the crop.

 If Angela has to pay 4.5 bushels (CD) then she will choose to produce
at point C, where she works for 8 hours.

 If Angela chose any other point on the feasible frontier and then gave
Bruno 4.5 bushels, she would have lower utility—she would be below
her reservation indifference curve.
Bringing together important concepts
48

 Economic rent is a payment or other benefit received above and

beyond what the individual would have received in his or her next best
alternative (or reservation option)

 joint surplus is the sum of the economic rents of all involved in an

interaction.

 bargaining power is the extent of a person’s advantage in securing a

larger share of the economic rents made possible by an interaction.

 In this example, the joint surplus is maximised where MRT=MRS, but

due to Bruno’s bargaining power (as landowner) he extracts the entire
surplus and Angela receives no economic rent and only her reserve
option along her indifference curve)
Comparing coercion with agreement
49

 When Angela was coerced:

 Using coercion, Angela was forced to work 11 hours.

 The MRT was equal to the MRS on Angela’s biological survival

constraint.

 When there is agreement between Angela and Bruno:

 Bruno offers a contract in which Angela pays him 4.5 bushels to rent
the land. She works for 8 hours, where the MRT is equal to the MRS on
her reservation indifference curve.

 If Angela works more or less than 8 hours, the joint surplus is less than
4.5 bushels.

 Although Bruno cannot coerce Angela he can get the whole surplus (as
Angela is on the indifference curve she receives 4,5 bushels but no
surplus or economic rent).
50
Impacts of adjustments in the framework
51

 If there is less land available the feasible frontier shifts down. Why?

 If the land is more productive, for example, due to good rainfall the
feasible frontier shifts up. Why?

 If there is improved productivity e.g. a new equipment that makes it

easier to produce grain then the biological survival constraint shifts
down. Why?

 If the food produced is more nutritious and the grower needs to eat
less to survive then the biological survival constraint shifts down. Why?

 If the government increases the amount of rations it provides this will

push the reservation indifference curve upwards. Why?

 Each of the above scenarios impacts on the size of what is technically

feasible and economically feasible to produce and on the size of the
joint surplus
Comparing coercion with agreement
52

 The peak of the hump of the surplus for Bruno (4,5 bushels) is lower
when Angela can refuse, compared to when Bruno could order her to
work (6 bushels).

 This offers proof that rules-based contracting provides better

outcomes for the poor than coercion (or slavery)

 For Angela coercion means she works 11 hours a day and gets 4
bushels of grain

 For Angela agreement means she works 8 hours a day and gets 4,5
bushels of grain
Pareto improvement vs mutual benefit vs zero sum game 53

 Pareto improvement

 a change that benefits at least one person without making anyone else
worse off

 e.g. Bruno benefits but Angela is no worse off along the reservation
indifference curve

 Mutual Gains

 where both parties benefit (although not necessarily equally e.g.

contract of employment)

 e.g. for Angela this is anywhere in the economically feasible set ABOVE
the reservation indifference curve

 Zero-sum game

 where anyone’s gain must be at the expense of someone else

Pareto efficiency curve and distribution of the surplus
54

 Pareto efficiency means that no Pareto improvement is possible

 it is impossible to change the allocation to make one party better off

without making the other worse off, due to:

 Firstly: all the grain produced is shared i.e. no Pareto improvement can
be achieved simply by changing the amounts of grain they each
consume. If one consumed more, the other would have to have less.
(zero-sum game)

 Secondly, MRS = MRT, i.e. no Pareto improvement can be achieved by

changing Angela’s hours of work and hence the amount of grain
produced (as at MRS=MRT the joint surplus is maximised)
Institutional arrangements determine how the grain is shared
55

 When Angela is free and works her own land she chooses to work
for 8 hours and produces 9 bushels of grain

 When Angela must pay rent to Bruno she works for 8 hours and
produces 9 bushels of grain

 In both cases there is a surplus of 4,5 bushels: the difference between

the amount of grain produced, and the amount that would give
Angela her reservation utility.

 When Angela is free and independent she keeps the surplus of 4,5
bushels for herself

 When she must pay rent to Bruno, Angela pays the surplus of 4,5
bushels to Bruno
Angela Independent vs Angela renting from Bruno
56
Pareto Efficiency Curve
57

 Figure 5.8 shows that there are a range of Pareto-efficient allocations.

 Point C is the outcome when Angela is an independent farmer.

 Point D is the outcome when Angela rents the land from Bruno.

 Every point between C and D represents a Pareto-efficient allocation.

 CD is called the Pareto efficiency curve: it joins together all the points in
the feasible set for which MRS = MRT. (sometimes called the contract
curve)

 At each allocation on the Pareto efficiency curve Angela works for

8 hours and there is a surplus of 4.5 bushels, but the distribution of the
surplus is different

 At point D Angela gets none of the surplus, at point C Angela gets it all.

 At the hypothetical allocation G, both receive an economic rent: Angela’s

rent is GD, Bruno’s is GC, and the sum of their rents is equal to the surplus
(CD).
58
Politics – sharing the surplus
59

 Angela and her fellow farm workers lobby for a new law that limits
working time to 4 hours a day, while requiring that total pay is at least
4,5 bushels. They threaten not to work at all unless the law is passed.

 This puts Angela on a higher indifference curve (IC2) above her

reservation indifference curve (IC1)

 Angela achieves an economic rent indicated by the distance between

IC1 and IC2 at 4 hours worked.

 Bruno’s grain (and economic rent) is reduced from CD to EF (2

bushels).

 When Angela works 4 hours, the MRS<MRT so it is not a Pareto

efficient outcome and gains to the joint surplus could be achieved by
increasing working hours to where MRS = MRT
60
Bargaining to a Pareto efficient sharing of the surplus
61

 The maximum joint surplus is where MRT = MRS, at 8 hours of work.

 Angela prefers F to D because it gives her the same amount of grain

but more free time than D.

 Angela could also do better than F e.g. she would prefer any
allocation on the Pareto efficiency curve between C and G.

 Angela can propose H where

– Bruno gets the same amount of grain: CH = EF.
– Angela is better off than she was at F as she works longer hours, but
has more than enough grain to compensate her for the loss of free
time (above IC2 curve)

 A win-win agreement could be struck by moving to an allocation

between G and H, between G and H Angela and Bruno can both be
better off than they are at F.
62
Recap of 2 step movement from D to H
63

 Step 1:

 From D to F, the outcome is imposed by new legislation. This was

definitely not win-win: Bruno lost because his economic rent at F is
less than the maximum feasible rent that he got at D. Angela
benefitted.

 Step 2:

 Once at the legislated outcome, there were many win-win

possibilities open to them. They are shown by the segment GH on the
Pareto efficiency curve.

 Win-win alternatives to the allocation at F are possible because F was

not Pareto efficient.

 In fact, a move to any point in the area between G, H and F would be a

Pareto improvement as Angela is above her indifference curve IC2,
and Bruno has more grain than EF, so both are better off.
Three lessons about efficiency and fairness
64

 At D: When one person or group has power to dictate the allocation,

subject only to not making the other party worse off than in their
reservation option, the powerful party will capture the entire surplus
and this is Pareto efficient but unfair.

 At F: Those who consider their treatment unfair can use legislation or

political means to achieve a fairer distribution, but this may not
necessarily be Pareto efficient. Societies may face trade-offs between
Pareto-efficient but unfair outcomes, and fair but Pareto-inefficient
outcomes.

 Between H and G: If we have institutions under which people can

jointly deliberate, agree on, and enforce alternative allocations, then it
may be possible to avoid the trade-off and achieve both efficiency and
fairness—as Angela and Bruno did through a combination of
legislation and bargaining between themselves.
The fundamental determinants of economic outcomes.

Bargaining power

Institutions

Reservation option
Allocation
Biology (outcome):
Economically who does
Technically feasible feasible allocations what & who
allocations
gets what

Technology

Preferences
Conclusion: the moral of the story
66

 Angela’s farming skills and Bruno’s ownership of land provided an

opportunity for mutual gains from exchange.

 The same is true when people directly exchange, or buy and sell,
goods for money.

 Suppose you have more apples than you can consume, and your
neighbour has an abundance of pears. The apples are worth less to
you than to your neighbour, and the pears are worth more to you. So
it must be possible to achieve a Pareto improvement by exchanging
some apples and pears. (This insight will be studied in the macro
semester when we discuss international trade.)

 When people with differing needs, property and capacities meet,

there is an opportunity to generate gains for all of them
(depending on the laws and institutional arrangements).