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Understanding Institutions and Economic Allocations: Rules of the Game

Investigate how institutions impact economic power and allocations. Learn about Pareto-efficiency, fairness, and the role of power in shaping outcomes. Explore the concepts of efficiency, fairness, and moral judgments. Examine different perspectives on fairness and equity in economic institutions. Follow a scenario illustrating the impact of institutions on individuals' choices and outcomes, from slavery to contractual arrangements.

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Understanding Institutions and Economic Allocations: Rules of the Game

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  1. Lecture 6:Institutions and Allocations Juuso Välimäki September 26, 2019

  2. Introduction In thecoursethusfar: • Choice and scarcity • Elements of gametheory Todyay: ”TheRules of theGame” • Pareto-efficieny and fairness • How doinstitutionsaffecteconomicallocations? • Introduction to themeasurement of incomeinequality Next week: • Themostcentralinstitutions of thecapitalistsociety: markets and firms

  3. Institutions and allocations Institutions • Societallyagreeduponrestraints on behavior: ”rules of thegame” • Formal: laws, contracts, propertyrightsetc • Informal: customs, traditions, socialconventions etc. Power • Theability to direct a person’sactionsagainstherwill • Bargainingpower / settingtheterms of trade • e.g. power to make a take-it-or-leave-it offer, power to reject an offer • Forcinganotyheragentthroughharmor a threat of harm Institutionsdetermineeconomicpower and thusalsoallocations: sharing of theeconomiccake as well as incentives to produce it

  4. Efficiency and fairness

  5. Paretoefficiency movingfromallocation (M,M) to (L,L) is a Pareto-improvement (L,M), (L,L) jand (M,L) areallPareto-efficientallokaations, if Ann and Bob onlycareaboutthenselves 5 Outcomesorallocations • Determinedbywhodoes and whattheyreceive (recalltheoutcomesfromgametheory) Paretoefficientallocations • Youcannotmakeanybodybetteroffwithoutmakingsomeoneworseoff NumerousParetoefficientallocations L,M 4 L,L 3 Bob 2 M,M M,L 1 0 4 5 1 0 2 3 Ann

  6. Pareto-efficiency and fairness Pareto-efficiencydoesnotmake a judgment on thefairness of theallocation • ManyPareto-efficientoutcomesarewidelyconsideredunfair • e.g. I owneverything, youownnothing (ifallindividualsprefermore to less) Economicsdoesnottellwhatallocationsarefairor just orequitable • this is ultimately a moraljudgment and reasonablepeoplemaydisagree on therightethicalprinciples to apply? • economicsseeks to answerwhattypes of economicinstitutionsresult in desirableoutcomesaccording to theselectedmoralcriteria • quiteoftendesirablepropertiesare in logicalconflictwitheachother and there is a need for compromise

  7. (Incomplete) perspectivestowardsassessingfairness Veil of Ignorance • John Rawls: whichsocietywouldyouchooseifyoudonotknowyour position in it? (cf. Hobbes and Locke) Equalopportunities vs. equaloutcomes: e.g. wouldyouratherchoose a societywhere • incomedifferencesaresmallbuttherole in thesociety is predeterminedbythe position of theparents? • or: incomesdifferwidelybutparentalincomeshave no effect on children’sincomes (orotheroutcomes)? • obviouslythere is no correctanswer to suchquestions, butthisthoughexperimentforcesyou to reflect on thenature of equity

  8. Institutions ja allocations

  9. Startingpoint: Alex is an independentfarmer Alex cultivateshisownland and eatsthe output • Trade-offbetweengrain and leisure - > indifferencecurves • More laborbringsmoregrain -> productionpossibilityfrontier Optomalchoice at C • MRS=MRT at C Alex’ indifference curves C 9 Alex’ production possibilities frontier Grain 0 24 16 Leisure

  10. Unfortunatedevelopment: Alex enslaved Barry entersthescene • Barry owns a gun Alex not • Barry doesnotworkbutgrabs a share of Alex’ production • He alsodictatestheworkinghours How to see an allocation in thepicture? • E.g. Barry orders Alex to work for 12 hours and grabshalf t he grain How does Barry maximizehsshare of grain? 10,5 Barry’s share 5,25 Grain Alex’ sharea 0 24 12 Alex’ working hours Alex’ leisure

  11. Alex enslaved Barry’sconstraints’ • Productionpossibilityfrontierdeterminestechnologicallyfeasibleallocations • survivalfrontierdeterminesAlex’sbasicneeds for survival • Themore Alex works, themore food he needs to survive Production possibilities frontier Potential allocations Survival frontier Grain 0 24 Alex’ leisure

  12. Alex enslaved Barry optimizes • Is Barry maximizinghissharebydemanding 16 hours of work? • No: marginalrate of transformationexceedsthebiologicalmarginalrate of substitution • in otherwords, an extrahour of workincreasesgrainproductionmorethanwhat is needed for survival C 9 Barry’s share MRT K 3,5 Biological ’MRS* Alex’ share Grain 0 16 24 Aöex’ leisure

  13. Alex enslaved Barry’soptimum at A,B • Alex works for 11 hours, gets 4 bushels of grainwhile Barry keepstheremaining 6 Longerhoursmake Alex worseoff • Lessleisure • No lesshungry(he getsthebareminiumum for survival) • Survivalcurve ≠ indifferencecurve A 10 Barry’s share B 4 Alex’ share Grain 0 13 24 Alex’ leisure

  14. Improvement: Alex as a contractfarmer Slaveryforbidden • Barry ownsthefieldsbutcannotforce Alex to work • Charitieskeepunemployed at subsistencelevel Barry and Alex mustnegotiatetheterms of employment • If Alex refuses, point Z results-> Barry mustoffer a dealthat at leastmatches Z from Alex’ point of view PPF A 10 • Z is Alex’ outside option or • reservation • option B 4 2,5 Z Grain 0 13 24 Alex’ leisure

  15. Alex as a contractfarmer Alex’ indifference curve Alex’ indifferencecurvethrough Z steeperthansurvivalcurve • To induce Alex to work, morecompensation is neededthan for meresurvival • If Barry offersthesamedeal as underslavery (B), Alex refuses Whatshoud Barry offer? PPF A 10 Feasible allocations acceptable to Alex B 4 Z 2,5 Grain 0 13 24 Alex’ leisure

  16. Alex as a contractfarmer One solution: Barry rentstheland to Alex for 4,5 bushels • Alex decides to work for 8h. Why? • MRS=MRT Alex canrefuse • Increases Alex’ welfare • ReducesBarry’swelfare • Reducesproduction Alex indifference curve’ 10 C 9 D 4,5 4 PPF Z Grain 0 13 24 16 Alex’ leisure

  17. Workers’ rights (via legislation) New law • 4 hoursworkingdaywith a minumumwage of 4,5 bushels of grain • Alex made betteroff Barry made worseoff Is thisPareto-efficient? C 9 E 6 Barry’s share F D 4,5 Alex’ share Grain 0 24 20 16 Alex’ leisure

  18. Workers’ rights A Paretoimprovement: • Let Alex work for 8h for 9 bushels. If Barry stillgets 1.5, Alex is leftwith 7.5 bushels and thismakeshimbetteroffthat at (E,F) • MRT > MRS at (E,F) and hencebykeepingtheextraproduction, Alex canimprovehisownwelfarewhilenotreducingBarry’s (sonstantshare to Barry) C 9 Björnin osa 7,5 H E F Akselin osa Viljaa 0 24 20 16 Akselin vapaa-aika

  19. Contractcurve Reservation indifference curve ThecurverunningthroughallParetoefficientallocations • Allallocationswith MRT=MRS • In thisexample, wehaveassumedthat Alex’ preferencesaresuchthatthisalwayshappens at 8h of labor (not a general property, though) • Allpoints on thelinebetween C and D arethusParetoefficient • Alex produces 9 bushels of grain, thesharesgoing to Barry and Alex differs for thedifferentinstitutions PPF C 9 D 4,5 Grain 0 24 16 Alex’ leisure

  20. What is going on? Key assumption that we make: Alex has the power to turn down Barry’s offer • Some authors give this power a grandiose name: freedom, autonomy etc. It reflects the idea that Alex has a point of recourse that cannot be taken away (inalienable rights) If Barry wants anything out of Alex, his offer must respect this autonomy • Barry must maximize subject to Alex’ power to reject offers If Barry gets to make a take-it-or-leave-it offer, he also has considerable power • Alex will be kept indifferent to his outside option But then Barry is simply moving along Alex’ indifference curve • Alex produces additional output according to MRT but requires compensation according to MRS. At optimum, MRT=MRS (Alex’)

  21. Efficientnegotiations and Coasetheorem If Alex owns land and keeps output, he works for 8h • This comes from the simple analysis along the lines of Lecture 2 When Barry owns the land and must hire Alex to work, he must offer a contract that gives Alex at least his outside option Alex is hired to work 8h • Alex’ outside option may be working at another farm or getting unemployment benefits etc Working exactly 8h is a special feature here • technically this relies on no income effects on grain, i.e. Alex’ MRS depends only on hours not grain In general, after negotiations labor is supplied efficiently • This holds regardless of who owns the land and this an instance of what is know of Coase theorem (property rights do not matter) • The sharing of surplus clearly depends on property rights

  22. Moral of thestory Production technology and biology set constraints for feasible allocations • technology -> PPF • biology -> survival frontier Instituutions ja preferences determine which one is chosen • institutions -> outside option • preferences -> what is acceptable • voluntary agreements and negotiations result in efficient outcomes (Coase theorem) Legislating allocations may result in Pareto-inefficient allocations • the most effective way of improving the welfare of a group may be to increase their bargaining power

  23. Empirics of incomeinequality

  24. Output sharing in therealworld Thepreviousmodelgave us a way to thinkaboutpower and output sharing in a world of twoindividuals, butwhatabouttherealworld and observedallocations? • ”size of thecake” ≈ income per capita, GDP (more on how to measurethis in Principles II) • ”sharingthecake” ≈ incomedistribution Real worldallocationsdepend on • Institutions and otherfactors • Otherfactors: individualdifferences in abilities etc. Incomedistributionoftenused as an indicator of howrealallocationsaredistributed • an incompleteindicator of this • doesnotincludethesize of thecake, distribution of workinghours, distribution of otherindicators of good life (allocation of health, education,…) • howlargearedifferences in income?

  25. Metric 1: Incomeshare of top 1% Source: World InequalityDatabase (https://wid.world)

  26. Metric 2: Lorenz-curve and Gini-coefficient Lorenz-curve • orderthepopulationfromthepooresttotherichest • what is theincomeshare of thepoorestxpercent? • drawthisshare as a function of x Gini-coefficient • 1- theratio of theareaunderthiscurve to theareaundercompletelyequaldistribution (ifallearnthesameamount, Lorenzcurve is givenbyf(x)=x ? (seepicture in twoslides) Next • Lorenz-curve in Finland excluding top 1% • thisexclusion just reflectsmeasurementproblems at the top of thedistribution in the data underlyingthegraphs

  27. Lorenz-curveDisposableincome in Finland 2013 (excluding top 1%) Lowest 90% receive 82% of disposableincome, <-> top 10% get 18% (excluding top 1%) Point of comparison: equalincome for all Lowest 20% of Finnsreceive 11% of disposableincome in 2013 (excluding top 1%). Source: Luxembourg IncomeStudyDatabase

  28. Lorenz-curve and Gini-coefficientDisposableincome in Finland in 2013 (excluding top1%) Gini-coefficient: How far are we from perfect equality? Values between 0 (full equality) and 1 (all income to a single individual) Gini-coefficient≈ A / (A+B)=0.241 in this case A B Matalatuloisimmat 20% saivat yhteensä 10% käytettävissä olevista tuloista Source: Luxembourg IncomeStudyDatabase

  29. Lorenz-curve and Gini-coefficientDisposableincome in Finland and theU.S. in 2013 (excluding top1%) 0.241 0.372 Source: Luxembourg IncomeStudyDatabase

  30. Taxes and transfers equalize the distribution Factor income (wages+entrepreneurialincome+capital income) Equalizing effect of taxes and transfers Disposable income (factor income + transfers - taxes) Source: Tulonjakotilasto (Tilastokeskus)

  31. Incomeinequality: Summary Manydifferentways to measureincomeinequality • Incomeshare of thehighestx percent • easilyunderstood, well-documentedover a long period for manycountries • popularized in particularbyPiketty for top shares • Gini-coefficient • Harder to grasp, describesthewholedistribution (but is still just a single number) Incomeinequalityif Finland • Sharp declineuntil 1980’s, after 1990 fairlyflat • Muchlessinequality in disposableincome Incomemeasured in a single yeartells a verypartialstory • Next: intergenerationalcorrelation and incomemobility

  32. Parental and children’sincome in the US Parentalincome (horizontalaxis) theirchildren’tincome (verticalaxis) Childrenwithparentsranked at the 25th percentile in parentalincomedistributionended on overage at the 40th percentile of theirowncohort’sdistribution Thechildren of therichestfamiliesrank on average 34 percentileshigherthanthechildren of thepoorest Source: Chetty, Hendren, Kline, Saez (2014):Where is theLand of Opportunity: TheGeography of IntergenerationalMobility in the United States. Quarterly Journal of Economics129 (4): 1553-1623. Ekstran ekstra (Chettyn ym. projektin viimeisin vaihe): https://youtu.be/P0NvsWDKwvs?t=2902

  33. ... and in Finland Thechildren of therichestfamiliesrank on average 16 percentileshigherthanthechildren of thepoorest Childrenwithparentsranked at the 25th percentile in parentalincomedistributionended on overage at the 46th percentile of theirowncohort’sdistribution Source: Tilastokeskuksen FOLK-aineistot (alustava tulos käynnissä olevasta projektista). Ensimmäinen tutkimus, joka osoitti tuloliikkuvuuden olevan Yhdysvalloissa pienempää kuin pohjoismaissa on Björklund, Jäntti (1997): IntergenerationalIncomeMobility in SwedenCompared to the United States. American EconomicReview87(5): 1009-1018.

  34. The Great GatsbyCurve Pleasenotethatthecausalinterpretation of thesecorrelations is not at allclear and underhotacademic and politicaldebate Source: Corak (2013): IncomeInequality, Equality of Opportunity, and IntergenerationalMobility. Journal of EconomicPerspectives27(3): 79–102.

  35. Luento 6: Summary Many ways to judge allocations • Pareto efficiency • Fairness The realized allocation reflest the preferences of the parties and the power in negotiations • Institutions have an effect on outside options and bargaining power • Changing institutions (political changes) has impacts on the efficiency and the fairness of allocations Next week • First steps in understanding firms and their behavior

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