5

Economics of Inequality: Preferences and Fairness - Evaluating Allocations

POWER: Defined as the ability to do and get the things we want in opposition to the intentions of others.
Voluntary participation in interactions occurs because individuals expect an outcome better than their next-best alternative, aiming to obtain economic rents (gains from exchange).
The distribution of these economic rents, or how the surplus is shared, is determined by each person's bargaining power.

The rules of the Ultimatum Game directly shape players' ability to achieve high payoffs, serving as a direct manifestation of bargaining power.
In this game, the responder holds the power to reject an offer, which can significantly alter the outcome.
Conversely, in the Dictator Game, the proposer possesses all the power, as the recipient has no recourse to reject the offer.
Experimentally, roles (Proposer or Responder) and thus bargaining power are often assigned randomly. However, in real economies, the assignment of power is rarely arbitrary.

Institutions: These are the formal (written) and informal (unwritten) rules governing interactions, including:
- Laws and regulations.
- The prevailing economic system.
Endowments: These refer to the resources and characteristics individuals possess:
- Financial assets, land, and other possessions.
- Personal attributes such as schooling, knowledge, skills, or even minority status.

Pareto Dominance: An allocation A is said to Pareto dominate allocation B if, in allocation A, at least one party is better off than in B, and no party is worse off.
Pareto Optimality (Efficiency): An allocation is considered Pareto optimal if there is no other technically feasible allocation where at least one person could be made better off without making anyone else worse off.

An Italian economist and sociologist, known for his work on equilibrium in physics before his contributions to economics.
Most famous for the concept of efficiency that bears his name.
Also well-known for the Pareto Distribution, which emerged from his empirical studies suggesting that wealth distribution does not follow a typical bell curve.
This led to Pareto's Law, from which his famous 80-20 rule was derived, stating that the richest 20\% of a population typically commands 80\% of the wealth.

The application of the Pareto criterion can be explored in various game theory scenarios:
- The Invisible Hand Game
- The Prisoner's Dilemma
- The Ultimatum Game

Often, more than one Pareto-efficient allocation can exist.
The Pareto criterion does not provide guidance on which of the Pareto-efficient allocations is superior or preferable.
A crucial point is that Pareto-efficient allocations are not necessarily fair.

In the Ultimatum Game, if a Proposer offers only one cent out of a total of 100 dollars, Responders in experiments globally tend to reject such offers, typically deeming them unfair.
Fairness can be applied to the outcome (the allocation itself) or to the rules that generated the outcome.

Substantive Judgements of Fairness: These judgments are based directly on the characteristics of the allocation itself, such as:
- The degree of inequality in terms of income, wealth, or subjective well-being.
Procedural Judgements of Fairness: These evaluations focus on how an allocation came about, rather than the characteristics of the outcome. The rules of the game are assessed based on aspects like:
- Voluntary exchange of private property: Whether property was acquired legitimately (inheritance, purchase, labor) without fraud or force.
- Equal opportunity for economic advantage: Whether individuals had an equal chance to acquire a large share, or if discrimination (based on race, sexual preference, gender, parentage) created disadvantages.
- Deservingness: Whether the rules considered individual effort, hard work, or adherence to social norms.

Procedural Fairness: The experimental rules for the Ultimatum Game are generally perceived as procedurally fair by most people.
Substantive Judgements: However, when it comes to the outcome, subjects often judge an allocation where the Proposer takes 90\% of the pie as substantively unfair.

People's perceptions of fairness vary widely:
- Some consider any level of inequality fair, provided the rules of the game are just.
- Others identify an allocation as unfair if basic needs are unmet for some, while others enjoy extensive luxuries.

The American philosopher John Rawls proposed a method to clarify arguments about fairness and facilitate common ground on values.
His approach involves three key principles:
1. Universality of Fairness: The principle that fairness applies equally to all individuals.
2. Veil of Ignorance: To make impartial judgments, one must imagine being behind a