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:
Application of fairness to all participants.
Imagining a "veil of ignorance" where participants do not know their future positions.
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.