Institutions and Exchange Models

Institutions and the Rules of the Game

• Institutions are the written and unwritten rules governing human behavior.
• Examples include democracy, laws, and even historical systems like slavery.
• Organizations like car manufacturers aren't institutions.
• Institutions, in democracies, often aim to protect individuals.

Angela and Bruno: A Model of Exchange

• Angela can farm or have free time.
• Angela farms where her marginal rate of substitution (MRS) equals her marginal rate of transformation (MRT).
• Bruno has complete power over Angela (slavery).
• Bruno maximizes his gain (grain) by forcing Angela to work at a point where her share of grain is minimized.
• Bruno's actions are constrained by the production possibilities frontier (PPF) and Angela's biological needs for survival.
• Allocation happens in a specific area.

Introducing Property Rights

• If Angela has property rights, Bruno can offer her a deal, taking some of her harvest in return.
• Angela will only agree to work on terms better than her reservation option (alternative).
• The reservation indifference curve represents Angela's acceptable options.
• Economic rent is the difference between what Angela values and her best alternative.
• The total of economic rents is surplus. This exchange maximizes benefits for both parties (Pareto efficient).

Surplus and Pareto Efficiency

• Bruno maximizes surplus by letting Angela work at a point where her work time is beneficial for him than complete control over the production.
• If Angela works at her reservation indifference curve, Bruno gets all the economic rent.
• Both allocations (with or without crop sharing) can be Pareto efficient.
• Pareto efficiency means no one can be made better off without making someone else worse off.
• A Pareto efficiency is often represented by a curve whose points are Pareto efficient. A point on this curve represents where no further cooperation is available for mutual gain.

Property Rights and Laws

• Laws, including those protecting farmers, shift indifference curves, increasing Angela's gains.
• The difference between her new and previous indifference curve is the economic rent.
• Reducing work hours for Angela might decrease the surplus for total participants, even with a law, which is not necessarily Pareto-efficient.
• Agreements may necessitate compensation for Bruno for time and opportunity.

Measuring Economic Inequality

• Economic inequality is assessed by fairness, considering initial endowments.
• The Gini coefficient is a measure of income inequality (0 = perfect equality, 1 = maximal inequality).
• Larger Gini coefficients indicate more income inequality.
• The Lorenz curve plots income distribution; a straight line signifies perfect equality.
• Comparisons use Gini coefficient, rich-poor ratios, and 90/10 ratios.

Government Role in Inequality

• Government taxation and redistribution can influence income inequality.
• Laws promoting fair income distribution can lower Gini coefficients.