5.2-5.7

Allocation and the Pareto Criterion

  • Allocation: Description of roles, consequences, and distribution of resources among participants.

The Pareto Criterion

  • Definition: Allocation A Pareto dominates Allocation B if at least one party is better off with A and no parties are worse off.

  • Importance: Facilitates comparisons between different allocations in terms of preference and welfare.

  • Example: In economic interactions, if everyone prefers allocation A over B, A is judged better based on the Pareto criterion.

Evaluating Institutions and Outcomes

  • Context: Used to assess economic interactions in various scenarios (fishing, farming).

  • Outcomes: Include outcomes of games such as the ultimatum game where allocation describes the division of resources.

  • Key Insight: Preference does not equate to monetary gain; a better allocation can make someone "better off" even with less financial gain.

Great Economists: Vilfredo Pareto

  • Background:

    • Lived: 1848–1923, Italian economist and sociologist.

    • Notable Work: "Manual of Political Economy" (1906).

  • Contributions:

    • Emphasized empirical investigation in economics.

    • Developed Pareto's Law concerning wealth distribution favoring few rich and many poor.

    • Introduced the 80/20 rule: 20% of the population holds 80% of the wealth.

Illustrative Example: Allocations in Pest Control Game

  • Comparison of allocations using the Pareto criterion reveals (I, I) Pareto dominating (T, T).

  • Limitations: The criterion does not rank among Pareto-efficient allocations; it indicates superiority without specifying which is preferred.

Understanding Pareto Efficiency

  • Definition: An allocation is Pareto efficient if no alternative allocation can make someone better off without making another person worse off.

  • Characteristics:

    • Multiple Pareto-efficient allocations can exist simultaneously.

    • Pareto efficiency is not synonymous with fairness.

    • Example: An allocation where one party suffers significantly might still be Pareto efficient.

Fairness in Evaluating Allocations

  • Distinction Between:

    • Substantive Judgements: Based on the characteristics of the allocation (e.g., equality, income).

    • Procedural Judgements: Focus on how the allocation came about (e.g., fairness of the process).

  • Judging Fairness: Outcomes can be perceived as fair or unfair depending on the processes and equality involved.

Rawls' Theory of Justice

  • Steps to Fairness Analysis:

    1. Application of fairness to all participants.

    2. Imagining a "veil of ignorance" where participants do not know their future positions.

    3. Judging fairness based on outcomes from an impartial perspective.

Exercises on Fairness

  • Substantive Fairness: Evaluate if society is fairer with more equality in income, happiness, or freedom. Discuss potential trade-offs.

  • Procedural Fairness: Assess how fair the societal rules are in executing allocations.

Concept of Economic Rent

  • Definition: Economic rent refers to benefits exceeding a person’s next best alternative.

  • Importance in Transactions: It reflects the surplus gained from exchanges and helps in understanding bargaining power.

Allocation Imposed by Force vs. Voluntary Exchange

  • Transition from coercion to a legal market changes dynamics dramatically, ensuring exchanges are consensual.

  • Importance of Institutions: Laws regarding property rights play key roles in determining outcomes of economic interactions.

Conclusion

  • The Pareto criterion serves as a fundamental tool in economic evaluations, but it must be balanced with fairness considerations.

  • Multiplicity of factors including justice, procedural fairness, and economic rent affect evaluations of resource allocation.

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