Unit 5 The rules of the game: Who gets what and why

5.10 Lessons on the impact of institutions on efficiency and fairness

The outcomes of the different cases we have considered are summarized in Figure 5.22.

This diagram shows that in Case 1, Bruno gets 31 bushels of grain, Angela gets 15 bushels of grain and has got 16 hours of free time. In Case 2, Bruno gets 23 bushels of grain, Angela gets 23 bushels of grain and has got 16 hours of free time. In Case 3 (contract N), Bruno gets 12 bushels of grain, Angela gets 23 bushels of grain and has got 19.5 hours of free time. In Case 3 (after negotiation), Bruno gets 14 bushels of grain, Angela gets 32 bushels of grain and has got 16 hours of free time.

Figure 5.22 Comparing the cases: the amount of grain produced, Angela’s free time, and how the grain is divided between the two players.

In the first, second, and fourth columns, 46 bushels of grain are produced. This is the quantity produced when the allocation is Pareto efficient; given the available technology and Angela’s preferences, this is what happens when Angela has 16 hours of free time. In contract N, when the legislation has been introduced but before Bruno and Angela negotiate with each other, only 35 bushels of grain are produced.

Figure 5.22 also shows that Angela’s share of the output is higher when her reservation option is better. It ranges from 15 out of 46 bushels (33%) under forced labour, to 32 out of 46 bushels (70%) when the legislation provides a strong reservation option and the two parties negotiate with each other.

The story of Angela and Bruno provides three lessons about efficiency and fairness:

  • When one person or group has power to dictate the allocation, subject only to not making the other party worse off than in their reservation option, the powerful party will capture the entire surplus. If they have done this, then there cannot be any way to make either of them better off without making the other worse off (point L in the figure). So this must be Pareto efficient! But it is unlikely to be considered fair.
  • If those who consider their treatment unfair have the power to influence the outcome through legislation and other political means, the result may be a fairer distribution in their eyes or ours, but may not be Pareto efficient (contract N). Societies can face trade-offs between Pareto efficient but unfair outcomes, and fair but Pareto-inefficient outcomes.
  • If we have institutions under which people can jointly deliberate, agree on, and enforce alternative allocations, then it may be possible to avoid the trade-off and achieve both Pareto efficiency and fairness—as Angela and Bruno did through a combination of legislation and bargaining between themselves (points between P and R).

Exercise 5.6 Evaluating outcomes from Bruno and Angela’s interactions

  1. For each of the outcomes from Cases 1, 2, and 3, answer the following questions:
    • Is this allocation Pareto efficient? Explain your answer.
    • Is this allocation fair, substantively and/or procedurally? Discuss.
  2. Discuss the meaning of the following statement, using two examples from the model of Angela and Bruno’s interactions (Sections 5.4 to 5.9): ‘Institutions that ensure all transactions must be voluntary (for example, in capitalist systems) give everyone “the power to say no”, but this power is only as good as the value of one’s reservation option.’