ALL THE NOTES YOU WILL NEED TO PASS THE EXAM. Second-year first-semester microeconomics notes, all chapters start to finish. Notes made from the lecture slides, textbook and lecturer talking points thus making them in-depth and comprehensive.
ECO2003F
Unit 5: Introduction to Context & Concepts
- How do institutions influence the bargaining power of economic agents in economic exchanges,
and thus how the gains from exchange are allocated.
1. In economic interactions when there are mutual gains possible there must be conflicts over how
these mutual gains will be distributed.
2. Institutions and the exercise of power are critical in how the gains are distributed
Background concepts:
Institutions are the written and unwritten rules that regulate:
• What people do when they interact in joint project
• The distribution of the economic rents of their joint e!ort
Closely related to power (power to change the terms of exchange)
• The ability to set the terms of an exchange (e.g. the wage)
• Impose penalty
- Further, we are interested in the fairness and e"ciency of the allocations that result.
Two things to keep in mind about how we use the term ‘institution’:
• Organizations are not institutions: we call an entity with a proper name an ‘organization’,
and reserve the word ‘institution’ for a set of rules of a game
• Institutions include social norms as well as laws: formal institution is the rule in football
In a model the Proposer’s bargaining power is limited because the Responder has the power to
refuse
Pareto Efficiency
Allocation: outcome of an economic interaction (describes who does what, and who gets what)
An allocation is Pareto e"cient if by making somebody better o! someone else becomes worse o!
TO BE PARETO EFFICIENT THE POINT MUST SATISFY MRT = MRS
Pesticide example: (I,I)
Pareto-dominates (T,T)
(I,I), (I,T), and (T,I) are all
Pareto e"cient.
Is Point Z Is it Pareto
e"cient?
Yes, if we were to move to (I,T)
Balas payo! would
decrease.
What about point X?
No, as Balas payo! stays
the same while Anils payo!
increases.
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Pareto E"ciency: Caveats
• Often more than one Pareto e"cient allocation. Pareto criterion does not help us choose among
these allocations.
• Pareto e"ciency is unrelated to fairness.
Pareto optimal if there is no other outcome that makes every player at least as well o! and at least
one player strictly better o!
• If an outcome is not Pareto e"cient it cant be optimal because both persons or one person could
be made better o!.
• Not all Pareto e"cient outcomes are optimal
Evaluate the rules of the game (institution) as well as the outcome.
Allocations can be considered unfair for two reasons:
1. Substantive judgement of fairness: evaluations of the outcome itself i.e. how the pie is shared.
Inequality of final outcome (e.g. wealth, well-being)
2. Procedural judgement of fairness: if the process is fair the outcome is considered fair even if its
unequal (defines justice as the outcome of a fair process)
How they came about (e.g. force vs. fair play, equal opportunity, conforming to social norms)
Rawls’ veil of ignorance: Taking an impartial perspective
Rawls (1971) Theory of Justice
1. Each person should have the same rights and liberties
2. Social and economic inequalities are justified only if
(a) they are attached to o"ces and positions open to all under conditions of fair equality of
opportunity, and
(b) they are to the greatest benefit of the least advantaged, meaning that some lesser degree of
inequality would make the least advantaged even worse o! (Di!erence Principle)
High unequal society = implement policies to make it more unequal is ok so long as the least
advantaged are made better o!
Economics does not provide judgements about what is fair but it can clarify:
• How institutions (rules of the game) a!ect inequality/allocation
• Tradeo!s in the fairness of outcomes e.g. giving up equality of income for equality of opportunity
• Which public policies can address unfairness, and how
Angela the farmer
Independent farmer Angela chooses whether to spend her time on leisure (t) or producing
agriculture (grain) for her consumption —> We can map out the feasible production frontier
The choice Angela has between free time and bushels of grain
is reflective of what is known as opportunity cost.
At point D, Angela is sending 9 hours of free time and she’s
producing 11 grain. If she decides to take an extra hour of free
time (moving it up to 10) production falls to 10.7.
Thus the opportunity cost of Angela spending an extra hour
free time is 0.3 bushels of grain this is also called the MRT.
Marginal Rate of Transformation (MRT): The quantity of good
that must be sacrificed to acquire one additional unit of
another good.
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= | slope of FF |
= marginal product of labour
Indi!erence curves (IC): Combinations of points that
provide a given level of utility.
• Higher IC, the higher utility
• The utility along a single IC is the same
Marginal Rate of Substitution (MRS): Trade-o! that a person
is willing to make between two goods
= | slope of IC |
MRS is steeper at point A as Angela values an extra hour of
free time more (she’s willing to give up more grain). At point
B she would give up less grain for free time as free time is
less valued at point B (she already has a lot of free time).
The steeper the indi!erence curve, the more Angela values
free time relative to grain
Coercion
Now if we introduced coercion- the practice of persuading someone to do something by using force
or threats
Bruno owns the farm and can enforce any allocation —> Angela gathers the grain —> Bruno wants
some of Angela’s grain —> Angela is the only available producer for Bruno
• How much time will Angela allocate to production?
• How much will Bruno take?
This is represented by the combined feasible
frontier —> the red line
Bruno wants compensation from Angela for using
his farm and Angela wants compensation from
Bruno for farming his grain
• The chosen allocation depends on institutions
and policies set in place
• Points G, F, E and H are all part of a feasible
allocation.
• Point Z reflects the amount of grain Angela
requires to survive if she does 0 hours of work
(24 hours free time)
As she works more hours the amount of grain she
needs to survive starts to increase (increasing at
an increasing rate) becuz work requires e!ort and e!ort
requires nutrition (from grain)
Feasible Allocations:
The feasible frontier shows all production outcomes
(determined by technology).
The biological survival constraint shows all the biologically
feasible outcomes (limited by survival).
--> shows the minimum amount of grain that she needs
for each amount of work that she does; points below
this line would leave her so undernourished or
, 4 of 44
overworked that she would not survive
--> if she expends more energy working, she needs more food; that’s why the curve rises from
right to left
Technically feasible allocations are given by the intersection of these constraints (technically
feasible set)
--> all the combinations that are possible within the limitations of the technology (the production
function) and biology (Angela must have enough nutrition to do the work and survive).
Imposing Allocations by Force
Suppose Bruno can enforce any allocation he wants
How much time will he force Angela to work?
If Angela works 11 hours she produces 10 bushels of grain but
requires 4 to survive thus leaving a surplus of 6 i.e. the gap
between the red line a the green line.
As seen by the parabola graph as Bruno makes Angela work
more hours the surplus starts to fall.
The maximum Bruno can get occurs where Angela’s working
time is such that the slope of the feasible frontier is equal to
the slope of the biological survival constraint:
MRT=MRS
—> the POI of graph one and the TP of graph 2
The allocation that maximises Brunos economic rent is where
the slope of the biological constraint (“MRS”) equals the slope Angela’s hours of free time
of the feasible frontier (MRT). “MRS” = MRT
At any point before the optimal allocation the MRT is greater than the MRS (an additional hour of
work will generate more output than what Angela would require to survive given that additional hour
of work, so consequently the surplus rises)
At point B Bruno makes Angela work 11 hrs, he pays her for 4
hrs worth of grain and the surplus goes too Bruno. Thus all the economic rent goes to him. Angelas
economic rent is zero, she
is stuck on her reservation amount. She’s captured none of the surplus of production.
• Economic Rent: A payment or other benefit received above and beyond what the individual would
have received in his or her next best alternative (or reservation option)
- If I would accept R100 an hour and I get a job o!er for 150, my employment rent is 50.
• Gains from exchange/trade: The benefits that each party gains from a transaction compared to
how they would have faired without the exchange.
• Joint surplus: Sum of economic rents
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