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.