CORE-Econ - The Economy 2.0: Microeconomics - Chapter 5 Summary
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Course
Economics
Institution
The Open University (OU)
Book
The Economy 2.0: Microeconomics
A summary of Chapter 5 of CORE-Econ's book: The Economy 2.0:Microeconomics. The summary includes: notes on all content covered in the chapter; graphs, tables and diagrams (alongside explanations for clarity); and a bullet point summary of the chapter.
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Unit 5: Who Gets What and Why
Institutions are formal laws and informal rules which govern social interactions and shape the behaviour of
individuals within a society. In economic terms, institutions are the 'rules of the game’ (in game theory), which
determine who can do what, when they can do it, and how actions influence pay-offs (benefits received).
In the ultimatum game, the rules (institutions) dictate the size of the pie, designate the Proposer, outline the
Proposer's options (offering any fraction of the pie), specify the Responder's choices (accept or refuse), and
determine the resulting allocation. Changing these rules alters the outcomes. For instance, with two Responders,
lower offers are more likely to be accepted since each Responder is uncertain about the other's decision, enabling
the Proposer to make lower offers and gain higher pay-offs. Institutions thus determine who can perform certain
actions and how the resulting pay-offs are distributed, thereby influencing the power individuals have to achieve
their desired outcomes in interactions with others.
Power (the ability to do and get the things we want in opposition to the intentions of others) in economic
interactions manifests in two forms:
• Structural power is the ability to walk away from a deal and is determined by the value of the next best
alternative.
• Bargaining power, influenced by structural power, dictates the terms of an exchange and can be enhanced by
setting terms or imposing costs on the other party.
In the ultimatum game, the Proposer typically has more bargaining power due to the ability to make take-it-or-leave-
it offers, but this power is limited by the Responder’s ability to refuse. If the rules change, such as allowing the
Proposer to divide the pie without the Responder's input (as in the dictator game), the Proposer's bargaining power
becomes absolute. Similarly, improving the Responder’s next best alternative increases their power and alters the
Proposer’s offers.
In real-world scenarios, power dynamics are evident in labour and product markets. Employers usually have
significant bargaining power because they set the terms of employment and can terminate workers. Workers can
gain structural power through income support or union membership, which limits how low wages can be set.
Similarly, in product markets, firms with few competitors have pricing power, while consumers have structural power
when alternatives are available.
Historically, the rise in labour productivity in Britain during the eighteenth century did not immediately lead to higher
wages. It was only in the nineteenth century, with increased demand for labour and the establishment of trade
unions and voting rights, that workers gained enough structural and bargaining power to secure substantial wage
increases. Institutions, therefore, play a crucial role in determining the distribution of power and resources in both
economic games and real-life interactions.
Evaluating Economic Interactions: Fairness and Efficiency
Economic interactions can be evaluated using two main criteria: Pareto efficiency and fairness. The ultimatum game,
where a Proposer offers a division of a sum and the Responder can accept or reject it, illustrates these concepts.
Typically, offers perceived as unfair, such as one cent out of $100, are rejected. However, perceptions of fairness can
change based on context, such as the relative needs of the individuals involved.
Substantive and Procedural Fairness
, Fairness can be judged in two ways:
1. Substantive Judgements of Fairness: These are based on the characteristics of the allocation itself, such as
how equal or unequal it is in terms of income, well-being, or freedom. For example, an allocation might be
deemed unfair if it results in significant income inequality.
2. Procedural Judgements of Fairness: These focus on the fairness of the process that led to the allocation.
Factors include whether actions were voluntary, whether there was equal opportunity, and whether the
process was free of fraud or force.
In the ultimatum game, procedural fairness is often ensured through random selection of Proposers, anonymity, and
voluntary actions. Substantive fairness depends on the offers made and accepted.
Fairness in Real-World Contexts
In real economies, procedural fairness is more complex. Discrimination, unequal opportunities, and involuntary
actions can lead to perceptions of unfairness. People's values differ on what constitutes fairness, with some
prioritizing equality of income and others emphasizing equal opportunities or freedom from deprivation.
The Veil of Ignorance
Philosopher John Rawls proposed evaluating fairness from behind a "veil of ignorance," where one does not know
their position in society. This perspective encourages impartial judgement of institutions and policies, imagining
oneself in any possible societal role.
Clarifying Fairness in Economics
While philosophy and economics cannot resolve all value disagreements, economics helps clarify:
• Connections Between Unfairness Dimensions: Understanding how certain rules or advantages affect
inequality.
• Trade-offs Between Fairness Dimensions: Balancing income equality with equal opportunity.
• Public Policy Implications: Analysing how policies addressing unfairness might impact other goals, like
efficiency.
Evaluating Economic Policy: Efficiency and Fairness
To judge the impact of an economic policy, we gather evidence to describe the resulting allocation and ask:
1. Is it Pareto efficient?
2. Is it fair?
3. Is it better than the original allocation by these criteria?
Evaluating economic interactions involves assessing both the
outcomes and the processes leading to them. By considering
both substantive and procedural fairness, and using tools like the veil of ignorance, we Figure 5.2: Efficiency and Fairness
can make more informed and impartial judgements about fairness in various contexts.
Modelling How Institutions Affect Economic Interactions
The following model is used to study how institutions influence economic interactions, focusing on who does what
and who gets what. Institutions affect people’s choices, power dynamics, income distribution, efficiency, and fairness.
The model features Angela, a farmer, and Bruno, a landowner, showing how different rules affect their power and
outcomes. Angela values grain and free time, while Bruno seeks maximum grain. The model uses indifference curves
and production functions to analyse preferences and feasible sets, illustrating the impact of institutional rules on
work hours, grain division, and overall utility.
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