EC107 Economics 1 2019-20 - warwick.ac.uk

EC107 Economics 1 2019-20 - warwick.ac.uk

EC107 Economics 1 2019-20 Property and Power: Mutual Gains and Conflict This Lecture follows closely CORE: Unit 5 Context Institutions (the rules of the game) matter for social outcomes (see Unit 4). Institutions can affect the income that people receive for their work (see Unit 2). What other factors determine final outcomes? What other criteria can we use to evaluate outcomes? How can we improve final outcomes? Robin Naylor, Department of Economics, Warwick 1 EC107 Economics 1

2019-20 Property and Power: Mutual Gains and Conflict In this Lecture, we will: Consider how institutions and power determine outcomes or allocations Evaluate these allocations using the Pareto-efficiency condition and fairness criteria Show how policies can improve outcomes Robin Naylor, Department of Economics, Warwick 2

EC107 Economics 1 2019-20 Pareto Efficiency Robin Naylor, Department of Economics, Warwick 3 EC107 Economics 1 2019-20 Pareto Efficiency Allocation: outcome of an economic interaction. (Describes who does what, and who gets what) An allocation is Pareto efficient if

nobody can be better off without making somebody worse off. Robin Naylor, Department of Economics, Warwick 4 EC107 Economics 1 2019-20 Pareto Efficiency An allocation is Pareto efficient if nobody can be better off without making somebody worse off. Pesticide example Compare just the 4 allocations shown in the Figure: (I,I) Pareto-dominates (T,T); (I,I), (I,T), and (T,I) are all Pareto efficient.

Robin Naylor, Department of Economics, Warwick 5 EC107 Economics 1 2019-20 Pareto Efficiency: limitations Often more than one Pareto efficient allocation. Pareto criterion does not help us choose among these allocations. Pareto efficiency is unrelated to fairness. Many allocations that could be unfair are Pareto efficient e.g. giving to your friend 1 cent of the $100 you found on the street. At least at first sight, (I, I) looks fairer than (I, T) or (T, I). Robin Naylor, Department of Economics, Warwick

6 EC107 Economics 1 2019-20 Fairness Allocations can be considered unfair for 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 Hence we need to evaluate the rules of the game as well as the outcome. Note Rawls Veil of ignorance, for taking an impartial perspective Robin Naylor, Department of Economics, Warwick 7

EC107 Economics 1 2019-20 Fairness and Economics Economics does not provide judgments about what is fair. But economics can clarify: How institutions (rules of the game) affect inequality Tradeoffs in the fairness of outcomes e.g. giving up equality of income for equality of opportunity Which public policies can address unfairness, and how Robin Naylor, Department of Economics, Warwick 8 EC107 Economics 1

2019-20 What determines the nature of allocations? Robin Naylor, Department of Economics, Warwick 9 EC107 Economics 1 2019-20 What determines the nature of allocations? Example: the trade-off between grain and free time Re-cap from Lecture 3: Angela faces a tradeoff 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 Robin Naylor, Department of Economics, Warwick 10 EC107 Economics 1 2019-20 What determines the nature of allocations? The combined feasible set Bruno is not a farmer, but makes a claim for some of Angelas grain. Think of Angela as the farmer and Bruno as a landowner. Angela has no right to use the land unless Bruno chooses to grant her a right in return for a share of the crop Angela produces. The combined feasible set shows all possible

allocations of production between two parties. The chosen allocation depends on institutions and policies. Robin Naylor, Department of Economics, Warwick 11 EC107 Economics 1 2019-20 What determines the nature of allocations? Feasible allocations The feasible frontier shows all the technically feasible outcomes (limited by technology and by resources). The biological survival constraint shows all the biologically feasible outcomes (limited by survival). Feasible allocations are given by the

intersection of these constraints. Robin Naylor, Department of Economics, Warwick 12 EC107 Economics 1 2019-20 What determines the nature of allocations? The biological survival constraint and ICs Note how Angelas biological survival constraint differs from her Indifference Curves. Notice in particular that Angela has a Reservation Indifference Curve which will differ from biologica survival constraint. The Reservation IC shows combinations of Grain and Free Time which yield the same utility to Angela as not working and hence as having just

2.5 bushels of grain (so it passes through Z). Robin Naylor, Department of Economics, Warwick 13 EC107 Economics 1 2019-20 What determines the nature of allocations? A specific assumption about ICs Bushels of grain To make our analysis as simple as possible, we are assuming that for any amount of free time she takes, Angelas MRS is the same regardless of how much grain she has. So, for example, when Angela has 15 hours of free time, the tangents to each and every one of her ICs are parallel to each other meaning that her

MRS is constant at 15 hours. We assume that this is also true at any number of hours. 1 5 Angelas hours of free time The ICs are just vertical translates of each other. Robin Naylor, Department of Economics, Warwick 14 EC107 Economics 1 2019-20 What determines the nature of allocations? Coercion: Imposing allocations by force Suppose Bruno can enforce any allocation he wants in effect, Angela is his property.

The allocation that maximises his economic rent is where the slope of the biological constraint (MRS) equals the slope of the feasible frontier (MRT). MRS = MRT Note how this differs from the free choice Angela would choose were she the landowner. Angelas Preferences (ICs) are irrelevant under coercion: only her biological constraint matters. Robin Naylor, Department of Economics, Warwick 15 EC107 Economics 1 2019-20 What determines the nature of allocations? Voluntary exchange: Bargaining Technically feasible, but unacceptable to Angel as below her

reservation indifference curve Suppose that Angela and Bruno are now both free agents: i.e., free from coercion by the other party. How they divide up the joint surplus (and achieve mutual gains from voluntary exchange) depends on: 1. Each partys reservation option 2. The relative bargaining power between the parties The economically feasible set shows all possible allocations that benefit both parties. Robin Naylor, Department of Economics, Warwick 16 EC107 Economics 1 2019-20

What determines the nature of allocations? Voluntary exchange: Bargaining When Angela is free to choose how much free time to take (and hence how much output to produce) in a voluntary contract, the outcome will be within the economically feasible set. Within this set, both Angela and Bruno can be better off than without a deal. In the diagram, the joint surplus is maximized when the Angela chooses free time (and hence work hours) such that the slope of the feasible frontier (i.e., the MRT) is just equal to the slope of Angelas reservation indifference curve (i.e., her MRS). Robin Naylor, Department of Economics, Warwick 17 EC107 Economics 1 2019-20

What determines the nature of allocations? Voluntary exchange: Bargaining C D Suppose that legal or other arrangements mean that Bruno has all the bargaining power within a voluntary exchange. He would want to offer Angela a contract which she would just be prepared to accept i.e., that was just on her reservation IC. She wouldnt accept any outcome on a lower IC as she can choose to walk away from such a deal. Bruno will choose to offer Angela the outcome at D: the point on Angelas Reservation IC which maximizes the surplus (the vertical distance CD) accruing to Bruno; with Angela working Robin Naylor, Department of Economics, Warwick

18 EC107 Economics 1 2019-20 What determines the nature of allocations? Voluntary exchange: Bargaining C 9 Bruno will choose to offer Angela the outcome at D: the point on Angelas Reservation IC which maximizes the surplus (the vertical distance CD) accruing to Bruno with Angela working 24 16 = 8 hours (less than under coercion) and keeping 4.5 bushels (more than under coercion). 4.

5 D 1 6 Bruno receives 4.5 bushels (= 9 4.5: less than when he was able to coerce Angela, constrained only by her biological survival constraint). Bruno captures all the surplus, CD. Robin Naylor, Department of Economics, Warwick 19 EC107 Economics 1 2019-20 What determines the nature of allocations? Voluntary exchange: Bargaining

How might the bargaining and the contracting proceed? For example, what rent will Bruno charge to Angela for the opportunity to farm his land? C 9 4. 5 D 1 6 We assume that Bruno is aware of Angelas ICs, including her Reservation IC. Hence, he knows that Angela will choose to work for 8 hours. He also knows that when she works 8 hours, the minimum she would accept is 4.5 bushels of grain.

So thats the contract he offers: effectively, he charges her a rent to farm his land. The rent is equal to: 9 4.5 = 4.5 bushels of grain. Robin Naylor, Department of Economics, Warwick 20 EC107 Economics 1 2019-20 What determines the nature of allocations? 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 indifference curve equals that of the feasible frontier Previous Slide). Total surplus is lower when both parties have to

agree to the proposal. Coercion forces Angela to work more hours than she would choose (and hence produce more output) given the amount of grain she receives (i.e., the bare survival level). Robin Naylor, Department of Economics, Warwick 21 EC107 Economics 1 2019-20 What determines the nature of allocations? Voluntary exchange: Bargaining When Bruno can make a take-it-or-leave-it offer, the outcome is at D. More generally, we have seen that the joint surplus is maximized whenever the outcome is along the section CD in the economically feasible set: i.e., where the slope of the feasible

frontier (the MRT) is just equal to the slope of Angelas reservation indifference curve (her MRS). CD identifies the contract curve. Robin Naylor, Department of Economics, Warwick 22 EC107 Economics 1 2019-20 What determines the nature of allocations? Voluntary exchange: Pareto Efficient Bargaining The allocation chosen will be on the Pareto efficiency or Contract curve (the line segment CD). At C, Angela gets all the surplus.

At D, Bruno gets all the surplus. An any other point on the Contract curve, Angela and Bruno split the surplus, and each will receive an economic rent arising from their voluntary exchange. Robin Naylor, Department of Economics, Warwick 23 EC107 Economics 1 2019-20

What determines the nature of allocations? Voluntary exchange: Institutions and Policies A law that regulates working hours and pay gives Angela more bargaining power. Suppose that Angela and workers on other farms lobby successfully for a new law which restricts maximum required hours to 4 (i.e., minimum free time to 20), while stipulating a minimum pay of 4.5 bushels. Angelas reservation option is now F. Robin Naylor, Department of Economics, Warwick 24 EC107 Economics 1 2019-20 What determines the nature of allocations? Voluntary exchange: Institutions and Policies

Angelas reservation option is now F and her new reservation IC is IC2. Bruno cannot legally enforce on Angela a contract on a lower IC than IC2. He cannot offer less than 4.5 bushels and he cannot require her to accept less than 20 hours of free time. Angela cannot be required to work for more than 4 hours, but she is permitted to choose to work for more if that is her free choice. In order to incentivise Angela to work the surplusmaximizing 8 hours, Bruno must offer her Robin Naylor, Department of Economics, Warwick 25 EC107 Economics 1 2019-20 What determines the nature of allocations? Voluntary exchange: Institutions and Policies Bruno must offer her

at least point G on the CG segment of the Contract Curve: i.e, with Angela retaining 6 bushels of grain (and hence paying a rent of 9 6 = 3 bushels). 6 Allocations must give each party at least as much as their reservation option. Bruno gets 3 bushels (his reservation option is?). Angela gets 6 bushels and works 8 hours and is just indifferent relative to her new reservation option as she is on IC2 in both cases. The new law has made Angela better off and Bruno worse off. Robin Naylor, Department of Economics, Warwick 26 EC107 Economics 1 2019-20 What determines the nature of allocations?

Voluntary exchange: Institutions and Policies We have seen that: Technology and biology determine which allocations are technically feasible. Preferences influence which allocations are economically feasible (Paretoimproving). Institutions and policies also determine which allocations are economically feasible. The allocation which emerges depends on parties preferences (what they want) and their bargaining power (their ability to get it) and hence on institutions and policies. Robin Naylor, Department of Economics, Warwick 27 EC107 Economics 1 2019-20 Measuring Inequality Lorenz curve: Shows the extent of inequality and allows comparison of distributions.

Gini coefficient: Measure of inequality, approximated as the deviation of the Lorenz curve from the perfect equality line. Ranges from 0 (perfect equality) to 1 (maximum inequality). Robin Naylor, Department of Economics, Warwick 28 EC107 Economics 1 2019-20 Measuring Inequality: an example Piracy was surprisingly fair and democratic unlike in the British Navy, pirates on The Rover distributed their spoils relatively equally between crew members. Why do you think this was?

Robin Naylor, Department of Economics, Warwick 29 EC107 Economics 1 2019-20 Addressing Inequality Redistributive government policies (income tax and transfers) can result in a more equal distribution of disposable income. Differences in inequality in disposable income across countries depends on the effectiveness of these policies. Robin Naylor, Department of Economics, Warwick 30

EC107 Economics 1 2019-20 Addressing Inequality: 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. Robin Naylor, Department of Economics, Warwick 31 EC107 Economics 1 2019-20

Addressing Inequality: Operation Barga Land tenure reform allowed farmers to keep a greater share of their crop, and protected them from eviction. Decreased income inequality. Work motivation and agricultural productivity also improved. Robin Naylor, Department of Economics, Warwick 32 EC107 Economics 1 2019-20 Summary 1. Two criteria used to evaluate outcomes Objective: Pareto efficiency Subjective: Fairness (substantive and procedural justice) 2. Allocations depend on preferences and power/institutions

Institutions can determine reservation options and bargaining power The Gini coefficient measures the inequality of allocations Public policies can make allocations more efficient or fairer Robin Naylor, Department of Economics, Warwick 33

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