EC3161 Spring 2020 - Michael King

EC3161 Economics of Policy Issues 1

Economics of Policy IssuesEC3161

Spring 2020Lecture Notes 2

Michael King


Social Justice: Outline

1. Social justice and insurance

2. Moral hazard3. Social justice

without government

EC3161 Economics of Policy Issues

Social justice and insuranceA. Risk Aversion and the Rationale for InsuranceB. Social Welfare Functions C. Distribution Model: Two-person D. Introducing the Leaky Bucket of Distribution E. Choice of social welfare function F. Introducing the Laffer CurveG. Given the Distortions, The Choice of Welfare FunctionH. Work Ethic and Adverse Selection

3


1. Social Justice & Insurance• What is the justification for involuntary

income transfers?• How much income should be transferred

from one person to another?– Redistribution contradicts Pareto efficiency and is

contrary to the natural right of possession of people to their own income.

ØWe set aside principal-agent problems.ØWe shall see that efficiency and social justice cannot

be separated.


1. Social justice as full insurance – achieved when people who fare well in life

fully compensate those who do not fare well– after the income transfers all people have

equal ex-post outcomes

2. More broadly, social justice refers to an egalitarian society based on the principles of equality and solidarity.


Lets build a little model to help…• Future personal incomes unknown

• yA is known average income• The distribution of the random component of

income µ can take various forms• The distribution of µ determines the pre-tax

income distribution in a society• µ can be due to innate ability, family

environment or health outcomes (fate).

A. Risk Aversion and the Rationale for Insurance


• We shall consider two cases of uncertain income– µH and µL are exogenous to personal actions, meaning that

individuals’ ex-post incomes depend only on fate or luck (we focus on this case for now)

– µH and µL are endogenous to personal actions, meaning that individuals influence whether they experience a good or adverse outcome (moral hazard - we consider this in the next section)


• A simple case:

• People know E(y)=yA

• They do not know if they will have yH or yL (Based on luck)• Veil of ignorance: people know nothing about their future selves.

– People behind a veil of ignorance don’t know what will happen them but know the income distribution they will face.


Risk Averse• When facing uncertainty, people are usually risk-

averse.• Risk-aversion can be calculated by the level of

unwillingness to accept a fair gamble.– Risk neutral not willing to pay anything to avoid a fair

gamble.• For risk-averse people, the marginal utility of

income is declining (value additions to incomes less than avoidance of income losses).

• Lets model risk aversion in this simple model…..


• Expected utility and the fair gamble

• Note: expected utility from fair gamble (EU) < expected utility from average income (U(Ey))

• The income yC is the certainty-equivalent income that gives expected utility EU with certainty.

p


• Price prepared to pay to avoid gamble completely:

• The positive value of ρ confirms risk aversion.

• “How much are you prepared to pay to personally avoid ex-post inequality?”– The answer is ρ


Would private insurance markets work in this case?

• The insurance company receives a payment on average of yA= Ey from each person.

• The insurance company pays out yC per person.• The profit of the insurance company is ρ =(Ey – yC) per

person.• Profit is assured by the law of large numbers.• The profits of the insurance company depend on risk

aversion: ρ=0 gives no profits.– If individuals pay less than ρ for insurance they will gain from

taking out insurance. – When competition in the insurance market eliminates above-

competitive profits, ρ is the personal gain from insurance for insured individuals.


• The voluntary pooling of risk through competitive insurance markets is efficient.– Pareto-improvement takes place as all people

gain ρ from the risk sharing.• With social justice defined as ex-post

equality, competitive insurance markets efficiently solve the problem of ensuring social justice.


• In reality, there are no insurance markets behind the veil of ignorance.

• People seek insurance because of uncertainty or risk: when people know who they are, they no longer want insurance.

• Therefore we ask the government to provide social insurance by acting as if the insurance market for income had existed behind a veil of ignorance.


• Through the legal monopoly on coercion, governments can ensure that – people who experienced the good outcome µH pay taxes to finance income transfers to people who experienced the unfortunate outcome µL

• Question: How will society define the level of social welfare?


B. Social welfare function

• A social welfare function includes judgments about the distribution of benefits and costs among the people in a population

• With n people in a society

• This is a utilitarian social welfare function


• Pareto improvement increases social welfare.

• Social welfare can increase without Pareto improvement.

• ωi is an individuals weight in the measurement of social welfare.

• Every person has a equal positive weight (anonymity).


• A common utility function rules out the possibility that some people were capable of benefiting more from income than others.

• The symmetry of the social welfare curve around the 45o line shows that social welfare is independent of the identities of the people.


• Distribution of pre-determined income

• The frontier SV = utilities possible for the two people from different possible distributions of income.

• All distributions of Y along SV are Pareto efficient.

• SV is symmetrically concave around the 45o line reflecting identical utility functions and diminishing marginal utility of income.

• In the second diagram person 2 has a greater personal capability for enjoyment of income than person 1 (OV exceeds OS).

C. Two Person Distribution Model


• Ex-post equality at E maximizes social welfare is also the outcome of private voluntary insurance markets (complete insurance).

• Alternatively, redistribution through government (from F to E).– The compulsory taxes of government introduce an

excess burden of taxation (leaky bucket of redistribution).

– If income transfers are financed by government borrowing, the taxes and excess burdens are in the future.


• The efficiency losses of redistribution (the leaky bucket)

• People personally bear efficiency losses of the leaky bucket (Person 1 = BCD, Person 2 = JVZ).

• Further losses = cost of tax admin, cost of taxpayers compliance, government systems and tax evasion.

• They take into account the efficiency losses when, behind a veil of ignorance, they choose redistribution.

D. Introducing the Leaky Bucket


• F1 and F2 are alternative utilities obtained through market per-tax incomes after person 1 and 2 have emerged from behind the veil of ignorance.

• F1 is favourable for Person 1 – greater ability, more fortunate family circumstances or better educational opportunities.

• F1 and F2 are equally likely and symmetric – from behind the veil of ignorance.

• Behind the veil of ignorance people are identical and there is ex ante equality.

• At F1 and F2 people know who they are and there is inequality.


• The leaky bucket defines feasible redistribution• Point E with welfare W2 is not feasible• Feasible redistribution is along F1A or F2A• Excess burden increases with taxes collected• Through effects, the efficiency costs of the leaky bucket also

reduces economic growth (lower future incomes)


E. Choice of social welfare function

• Two limiting social welfare functions:– Jeremy Bentham– John Rawls


• Jeremy Bentham (1748–1832): “the greatest good for the greatest number” or equal weights to all (dist. does not matter).

• For two people and with diminishing marginal utility.


• John Rawls (1921–2002) and the weakest link.

• The Rawls objective is not equality but maximization of the utility of the worst-off person.

• Rawls social welfare function provides complete insurance.• Because of the Laffer curve and limitations of tax revenue, complete

insurance and ex-post equality are not necessary consequences.


• Bentham and Rawls as limiting cases

• Bentham and Rawls are limiting cases of aversion to inequality• Intermediate welfare function: Two peoples social weights equal at 45o line.

Otherwise the person with lower utility has a higher weight.• Social aversion to inequality is measured by the amount of utility that can be

taken from a high utility person and transferred to a low utility person while keeping social welfare constant (i.e. the slope of the welfare contour).


• With no leaks in the bucket of redistribution, aversion to inequality does not affect social insurance

• Any symmetric social welfare function provides complete insurance and ex-post equality


• The reason for different social insurance provided by different social welfare functions is different sensitivities to the efficiency costs of redistribution through the leaky bucket.

• Bentham is the most sensitive to efficiency costs of redistribution through the leaky bucket.

• Rawls is not sensitive to efficiency losses at all as long as the worst-off person is not harmed.


• The Laffer curve limits the amount of tax revenue that is available for redistribution of income.

• The Laffer curve can prevent complete insurance under Rawls.• Bentham social insurance is not hindered by constraint of Laffer curve.

F. The Laffer Curve


G. Given Distortions, The Choice of Welfare Function is Key

• Behind the veil of ignorance, which of the different social welfare functions expressing social aversion to inequality is chosen?

• Question only relevant when there is a leaky bucket as without it both functions result in complete insurance.


• The case for choosing Bentham– Rational behaviour under uncertainty is maximisation of expected utility.– Expected utility is defined by giving weights to different outcomes equal

to the objective probabilities of the different outcomes arising.

• n people behind a veil of ignorance know that

• After the Bentham social insurance contract has been implemented (incomplete insurance).


• Choice of a Bentham social welfare function behind the veil of ignorance is rational in maximizing expected utility.

• Rawls gives positive weight in social welfare to whoever will be the worst-off person and gives zero weight to everybody else.

• Bentham rationally accounts for the likelihood that, after emerging from behind the veil of ignorance, an individual will not be the worst-off person.


Bentham’s lottery and Rawls’ certainty in life

1. Bentham offers a lottery through incomplete insurance.2. Rawls offers certainty in life after people emerge from

behind the veil of ignorance and discover who they are.

Ø We cannot compare levels of social welfare measured by the different Bentham and Rawls social welfare functions.

Ø We can use a common utility function to compare personal utility as outcomes of different social welfare functions and social insurance contracts.


• The trade-off between ex-post equality and efficiency.• Choice of the social insurance contract through choice of a

social welfare function is a choice between greater ex-post equality and greater efficiency/overall better off through higher utility.


• A society may decide not to accept Bentham’s lottery and the associated ex-post inequality.

• Political parties take positions on the trade-off between efficiency and ex-post equality – that is, on the spectrum between Bentham and Rawls.


• A general representation for choice of social welfare functions between Bentham and Rawls, where 0<α<1.


• Choosing a social welfare function with α <1 is a decision to subjectively increase the weight on experiencing a bad outcome and a decision to discount subjectively the likelihood of experiencing a good outcome.

• In the limiting case of Rawls where α = 0, the likelihood of a good outcome is altogether ignored and all weight is placed on the lowest outcome.


• The reason for deviating from Bentham cannot be risk-aversion with respect to income because the utility function is the same in either case (already discounts for risk aversion). – Prospect theory: placing larger than objectively

justified weights on low probability big losses (loss aversion).

– Departure from Bentham can be explained by the wish to avoid regret. If the outcome is µL, there is regret that Rawls was not chosen, regret affects happiness, happiness might be maximised instead of utility.

– Belief that more equality leads to better societal outcomes.


H. Work Ethic and Adverse Selection

• How does a work ethic affect social insurance?– When a work ethic is present, people work because

of the intrinsic value of work and because of a feeling of disutility if they do not work.

– There are no (less) leaks in the bucket of redistribution, if all people have work ethic.

– In a society without a work ethic, the personal risk of experiencing an adverse outcome in Bentham’s lottery is balanced against the risk of having equal but perhaps no meaningful income under the complete insurance of Rawls.


• Why have voters in high-income welfare states persistently supported the high taxes and extensive income redistribution that approach Rawls-type social insurance?– High personal incomes have been sustained: A work

ethic has been present.– There is no resistance by taxpayers to paying high

taxes to finance redistribution to people who have been unlucky.


• Max Weber (1864-1920) studied how religion has influenced economic behavior

• The Protestant Ethic and the Spirit of Capitalism (1905)

• Bentham and a work ethic– A Bentham social welfare function would call

for extensive social insurance, if leaks in the bucket of redistribution are small.


Adverse selection and time inconsistency

• After emerging from behind the veil of ignorance, people will know whether they have experienced µH or µL

Adverse selection occurs when low-risk people (µH) leave an involuntary insurance pool.

• A government can prevent adverse selection by making the insurance contract involuntary.– Systematic income transfers from µH to µL people

• The case for compulsory insurance rest on time inconsistency problem.

• Time inconsistency arises when optimal present decisions about future behaviour are not longer optimal when the future arrives.


2. MORAL HAZARD• So far only pure luck has determined personal

outcomes through µH and µL.• We now recognize that personal outcomes

depend on a person’s effort at self-reliance.• µH and µL become endogenous consequences

of personal decisions.• Personal incentives to be self-reliant introduce

moral hazard.• Moral hazard occurs when the presence of

insurance affects personal decisions in ways that make payouts from insurance more likely.


• Moral hazard and personal effort• Moral hazard introduces personal effort as

a personal decision variable


• Two types of effort decisions– Taxpayers reduce work effort in response to taxes by

substituting leisure or free time for work (excess burden of taxation, the leaky bucket of redistribution).

– There is no uncertainty when taxpayers make this effort decision: taxpayers know that they are taxpayers.

• For prospective recipients of income transfers:– Effort decisions affect the likelihood being self-reliant.– This decision about effort to be self-reliant is made

under conditions of uncertainty about future personal income but certainty about income insurance.


• Voluntary insurance does not involve payment of taxes and so does not affect work effort of taxpayers.

• The effect of voluntary insurance is on effort to be self-reliant through moral hazard.

• Moral hazard involves asymmetric information– People have private information about whether they

have chosen high or low effort to avoid adverse outcomes.

– Others (including a private insurance company or the government) can observe an outcome yH or yL but cannot observe whether a person chose eH or eL


• Effort and luck: A simple model….

• Whether a person has high or low income depends on both luck and effort.

• Because of asymmetric information, whether low income is due solely to bad luck or also to low effort is not known to other people.


• Assumptions:– We consider income transfers made in accord

with a voluntarily agreed contract.– There is no taxation and no excess burden of

taxation.– Government is present only to provide the

legal framework for the voluntary insurance contract.

ØThe prisoners’ dilemma and moral hazard in a voluntary insurance contract.


• With incomes shared through the insurance contract, personal outcomes for incomes are:– When both people choose high effort eH, the likelihood is

maximized that, after income sharing, each person will have high income yH

– When both people choose low effort eL, the likelihood is maximized that, after income sharing, each person will have low income yL

• If one person chooses high effort eH and the other chooses low effort eL, the likelihood is maximized that the two people will share (yH + yL) and have

• Although personal incomes are shared through insurance, the cost of exerting high effort is personal and is not shared


• The sharing of incomes and the personal cost of effort give rise to a prisoners’ dilemma

• In the Nash equilibrium with moral hazard, the likelihood is maximized that everyone will have low income

• People “free ride” by choosing low effort


• The common-pool problem (as in the tragedy of the commons)• Earned income is a common pool• When n people share a common pool of income:

• Person 1 only keeps y1/n of own-earned income and earns Ya.• Low effort is thus the dominant strategy


• Without pooling of incomes, there is high E(U) from exerting personal effort because high income does not have to be shared.

• Everyone is better off without the disincentives of the common pool problem of shared incomes and without moral hazard.

• With participation in an insurance contract voluntary, exit from the contract ends the common pool problem of pooling and sharing of incomes (incomes are privatized).– Moral hazard results in the failure of voluntary

insurance.


Behavior without moral hazard

• When is there no moral hazard problem?– No random component of income.– Effort alone determines personal income.– Information about effort is no longer asymmetric.– There is no role for insurance because there is no

uncertainty about why income is low.• In this case the insurance contract specifies the

necessity of having been observed to have chosen high effort to receive payouts from insurance.


Moral hazard and adverse selection in diverse populations

• What happens when populations are diverse and are composed of both people with a work ethic and people subject to moral hazard?– Because of asymmetric information about choice of

effort at self-reliance, unlucky people who exerted effort to be self-reliant are indistinguishable from people who did not attempt to be self-reliant.

– People subject to moral hazard choose low effort to be self-reliant when insurance is available.

– People with a work ethic choose high effort to be self-reliant whether or not there is insurance.


• The dominant strategy of person 1 with a work ethic is to choose high effort.• Person 2’s best response to person 1’s choice of high effort is to choose low

effort • At 1,1 person 1 feels personally inadequate in not matching the high effort

of person 2 and feels guilt about exploiting their effort (or goodwill) The guilt feeling is not reciprocal.

• The Nash equilibrium is at (3, 4).


• In a diverse population, people with a work ethic can systematically subsidize people whose behavior is subject to moral hazard.

• The objective of self-reliance of person 1 with a work ethic allows person 2 to maximize utility by choosing not to be self-reliant.


Sources of Work Ethic• A work ethic may be expressive and

confirmation of self-identity.– Some people feel uncomfortable or personally

inadequate if they were to take advantage of insurance as a source of income.

• A work ethic may also be due to stigma – family and peers may be able to observe a person’s effort decision.

• Individual ability and human capital affect whether a work ethic is present.

• Is the work ethic related to religion (Max Weber)?


• Role of migration– There is adverse selection when people without a

work ethic locate in a welfare state. There can also be positive selection.

– Local residents may view immigrants as victims of exogenous bad luck.

– If sufficient immigrants do not integrate into self-reliant economic activity, the social insurance contract of the host welfare state may become unsustainable.

– Adverse selection occurs when taxpayers leave the welfare state.


• There may be a presumption that people do not have a work ethic because they have been observed not to be self-reliant – and because they are supported by income transfers.

• When the income transfers cease, people look for and find work and become self-reliant.

• Changes in incentives bring us to public policy responses to moral hazard.


Public policy responses to moral hazard

• Savings as voluntary self-insurance• The optimal personal response to income

uncertainty is not saving but risk pooling through voluntary insurance.– If adverse selection and moral hazard prevent

voluntary insurance, saving as self-insurance is the sole voluntary means of protection against adverse personal future outcomes.


Potential of Voluntary Insurance• If the insurance contract and income pooling are

voluntary, people with a work ethic can simply exit the insurance pool (failure of voluntary insurance).

• If all people with a work ethic leave the insurance pool, the people subject to moral hazard who behave strategically in choosing low effort have no one from whom to systematically receive income transfers.


• Voluntary insurance has failed, first because of adverse selection and then because of moral hazard.

• If there is to be insurance, the insurance needs to be provided by government as compulsory social insurance from which people cannot exit.


• Third reason why voluntary insurance fails – Voluntary insurance requires means of

objective verification of outcomes against which insurance is sought.

– Challenges to objectively verify (third reason why voluntary insurance fails).


Public Insurance: Solving Moral-Hazard

• The moral-hazard problem is solved if the EU from choosing high effort exceeds the expected utility from choosing low effort


• Solving the moral hazard problem also solves the adverse selection problem.

• If incomplete insurance has made choosing high effort everyone’s best choice, no one has an incentive to leave the insurance pool.

• With incomplete insurance providing incentives for everyone to choose high effort, any person observed to have low income has been genuinely unlucky and so is a victim of fate who deserves help.


• Impediments to helping people who deserve help:– Incomplete insurance limits the assistance that is

given to people who experience bad outcomes (might want to help more those who exerted high effort to be self-reliant but were unlucky).

– If help could be given as a surprise after a person has experienced an adverse personal outcome, there would be no moral hazard.

– In a repeated game, moral hazard is re-introduced as people take advantage of asymmetric information to choose low effort in response to the high social insurance benefits – which are no longer a surprise.


• The social dilemma of resolving the moral-hazard problem:– Non-generous income transfers of incomplete insurance

eliminate moral hazard.– Because of the non-generous income transfers for people who

experience bad outcomes, everyone chooses high effort.– However, some people nonetheless experience random

unfortunate outcomes through no fault of their own.– High income transfers to the people who experienced the

genuinely random unfortunate outcomes cannot be made without reintroducing moral hazard.

• Note as Bentham social insurance in incomplete, moral hazard is alleviated.


• The two cases for incomplete insurance1. Behind a veil of ignorance where people have no

information about their future selves2. Moral hazard when, after emergence from behind

the veil of ignorance, information is asymmetric, because people have private information about whether they have chosen high or low effort to be self reliant

• How incomplete should social insurance be, when the no-information and asymmetric-information cases for incomplete insurance are combined?


• The answer depends on Type-1 and type-2 errors and political sensitivities– A type-1 error: People in genuine need

through no fault of their own are insufficiently helped by social insurance.

– A type-2 error: People who could be self-reliant choose low effort at self-reliance and benefit from the income transfers of social insurance.


• Sensitivity to type-1 errors can expand insurance beyond Bentham’s incomplete insurance

• Sensitivity to type-2 errors can make choice of social insurance more incomplete than Bentham.– The left is less willing to make a type-1 error– The right may be less willing to make a type-2

error


• We have viewed luck and effort at self-reliance as separate influences on a person’s income. Could effort at self-reliance also be consequence of luck?

• Do people choose low effort at self-reliance or do they have no choice?1. The left:

• Through unequal opportunities in life, people with low incomes are victims of fate and unfairness

2. The right:• Low incomes in the presence of insurance are the consequence of

moral hazard. • Overly generous social insurance creates low incomes through

moral hazard


Describing the level of redistribution

• Gini Coefficient: ratio of the area between the Lorenz Curve and the line of absolute equality (numerator) and the whole area under the line of absolute equalityy (denominator).

• The extreme values of the Gini Coefficient are 0 and 1, although they are often presented as percentages, between 0 and 100 per cent respectively.

73

SOCIAL JUSTICE: DISTRIBUTION, POVERTY AND POLICY RESPONSES

11

data for a particular country, the Lorenz curve will bow away from the line of absolute equality down to the right. The more unequal a society is, the further it will deviate away from the line of absolute equality. Changes in the Lorenz curve over time illustrate the evolution of inequality in a country. Figure 8.2

The Lorenz Curve

A related measure of inequality is the Gini coefficient. It is calculated as the ratio

of the area between the Lorenz Curve and the line of absolute equality (numerator) and the whole area under the line of absolute equality (denominator). The extreme values of the Gini Coefficient are 0 and 1, although they are often presented as percentages, between 0 and 100 per cent respectively. A low Gini coefficient indicates greater equality in society, with absolute equality represented by a Gini of zero. Conversely, a Gini of 100 per cent means that the top 10 per cent of income earners enjoy 100 per cent of all income in society. The Lorenz curve is most often used to depict the distribution of income; if data are available it can also be used to illustrate the distribution of wealth. Ireland’s Income Distribution How does Ireland perform using these different measures of inequality? Table 8.2 provides the data necessary to draw Lorenz curves for Ireland for different years. The table shows the distribution of disposable household income after taxation and transfers in Ireland between 1980 and 2010. Overall, there is a remarkable degree of consistency with the percentage of disposable income earned by each decile of the population remaining broadly constant over the 25 year period.

When the income shares of the top 20 per cent to the bottom 20 per cent are compared over time a number of points are worth noting. The ratio fell during the economically depressed 1980s but rose through the economic expansion of the 1990s. This can be attributed to an increase in the share of income enjoyed by the top 20 per cent of earners. After 2004, however, the income share of the bottom 20 percent increased as the welfare state expanded, and as a result the ratio fell. The ratio fell


Extent of Redistribution

74


Early Crisis Change in Inequality

75

SOCIAL JUSTICE: DISTRIBUTION, POVERTY AND POLICY RESPONSES

13

Table 8.3 European Comparison of Gini Coefficients

(after taxes and transfers)

Country 2005 2009

2011 Change

2005-2011 Portugal 38.1 35.4 35.4 -2.7 Denmark 23.9 27 35.4 11.5 Spain 31.8 32.3 34.5 2.7 Greece 33.2 33.1 33.5 0.3 UK 34.6 32.4 33 -1.6 EU 15 29.9 30.3 30.9 1.0 France 27.7 29.8 30.8 3.1 Ireland 31.9 28.8 29.8 -2.1 Germany 26.1 29.1 29 2.9 Netherlands 26.9 27.2 25.8 -1.1 Finland 26 25.9 25.8 -0.2 Sweden 23.4 24.8 24.4 1.0

Source: Eurostat Online database (2011) Regional and Life-Cycle Inequalities Regional inequalities exist within Ireland, although these have fallen since 2000. According to the Central Statistics Office, data for 2010 shows that residents of Dublin enjoy disposable income (after taxes and transfers) that is 11 per cent higher than the national average while residents of the southern and eastern regions enjoy disposable income that is 3 per cent higher than the national average. This is balanced by 8.3 per cent lower than average disposable income in the border, western and midland regions.

At county level, Donegal and Offaly are the counties with the lowest levels of average disposable income whereas Dublin, Cork, Kildare, and Limerick are the only four counties with disposable income above the national average. Differences in standards of living are likely to be smaller when differences in the cost of living between the counties are taken into consideration. There is also a rural/urban dimension to inequality with extensive rural development policies in place to deal not only with this but also to avoid the decline of rural areas due to migration

Inequalities can emerge at different points in the life cycle. For children, students in full-time education and the elderly, opportunities to earn money are limited and consumption is financed by parental support or the drawing down of accumulated financial wealth such as pensions. It has been shown that in Ireland and around the world, low income households tend to have more children. This can lead to the situation where a small number of children have access to significant resources when growing up, while more modest resources are spread more thinly over a larger number of children. Such inequality is likely to lead to very real differences in education and


3. Social Justice without Government: Altruism and charity

• Can social justice be achieved without government?– Altruistic income transfers are voluntary.– There are no efficiency losses because of leaks in the

bucket of redistribution.– Altruism and charity do not eliminate moral hazard.– Adam Smith in his book Theory of Moral Sentiments

(1759) observed that human nature led people to be altruistically concerned about the well-being of others.

• Lets look at some simple models…..


• Interdependent utilities

• At point A, person 1 has all the income Y=y1

• After point B, the personal loss from giving exceeds the personal gain from seeing person 2 better off.

• Transfers are pareto improving up until point B (or C for person 2).


• A three-person society

• The income of the unfortunate person y3has the characteristics of a public good.


• The prisoners’ dilemma of private income transfers when each person prefers that the other give.

• Nash Equilibrium is that no person gives. • Free rider problem is introduced.


• Public policy because of the prisoners’ dilemma: taxation and publicly financed income transfers.

• When preferences of donors differ, there is asymmetric information.– A government can only take a best guess about the taxes

to levy on the two donors to finance an income transfer.

• Through expressive voting, people derive utility from confirmation of identity:– It may be sufficient to vote in favor of income transfers to

obtain the benefit of utility from feeling generous.


• Charity when the act of giving increases utility and highest utility is achieved by being the sole donor

• The dominant strategy is to give


• Charity when the act of giving increases utility and highest utility is obtained by giving together with others


Exploitation of charitable intentions

• We have been considering interactions among donors.

• We now consider the interaction between a donor and a beneficiary of income transfers who does not have a work ethic.– There is no moral hazard because there is no

asymmetric information: the donor can observe whether the recipient is making an effort to be self-reliant.


• The exploitation of charitable feelings

• The Nash equilibrium is (3, 4)• The donor is unhappy with the outcome• What can the donor do?


• Misrepresented preference: – Donor declares that she has the highest utility 4 when recipient makes no effort

and the donor does not give. – Donors new preferences give utility 3 when the recipient makes the effort and

money given. • The recipient starves at 4,1 and wants to avoid it.

• No dominant strategy for donor or the recipient and no Nash equilibrium in pure strategies

• The recipient does not want to die of starvation and recipient adopts a maxi-min strategy (makes the decision that results in the least potential self-harm)

• The outcome is at (3,3)• For the change in outcome, the recipient must believe that the donor will indeed let

him starve. In repeated game he might learn that (4,1) is not possible. Rules, not discretion can help.


• Social status: Conspicuous giving to charity displays wealth

• The contest for status has social benefits when status is achieved by visible charitable activities

• The amount of private charity depends on how many people are prepared to actually give, rather than expressively declaring that “something should be done to help the needy”

• People are unwilling to give if they perceive moral hazard


Experimental evidence on norms of fairness

• The ultimatum game– Sum of money is made available between two people. – One person is chosen as the donor and the second as the

recipient. – Identities of the two people are hidden. Donor is asked to

propose a division of the money. – If recipient does not accept neither person keeps the money.

• Outcomes of the ultimatum game indicate how conceptions of fairness influence behaviour in a society

• In general, donors propose that they keep 60 percent and offer 40 percent to the recipient.


• Outcomes of the ultimatum game in different locations

• Standards of fairness as near-equal division are universal.• An interpretation: people chosen to be donors should understand that luck

could have gone the way.• We see the relation to the veil of ignorance.


• The aberration: a tribe in Peruvian Amazon– Lower feeling of obligation to share

• In an experiment in China: – Chinese middle school students were concerned that they were

being offered money that they had done nothing to deserve.– The usual response among the students was to divide the

money equally because no one deserved the money and certainly no one deserved more money than anyone else.


• The dictatorship game– Recipient does not have a decision to make now– Less in general is given in dictatorship games than in ultimatum

games but still some (self-image and social approval)• People are prepared to incur a personal cost in order to

punish perceived selfish behavior (two stage game)• Anonymous situations: there is less sharing when no

one, including the experimenter, observes their behavior• A collective decision by a group usually results in more

generous sharing than an individual decision• People are less generous when they feel they have

earned the money rather having received as a gift


• Comparisons between the ultimatum and dictatorship games.– In the ultimatum game, people fear retribution.– In the dictatorship game, there is no fear of

retribution and donors give less to recipients.• The role of social justice therefore

changes between the two games.


Intergenerational economic mobility

• High economic mobility in general requires equal opportunities for personal improvement – or ex-ante equality.

• Social justice can be defined as high intergenerational economic mobility

• How do people fare in life relative to their parents?


• Estimates of intergenerational economic mobility

• When incomes are in logarithms, the coefficient b is an elasticity

• If the variances of the distributions of Ychild and Yparent are equal, b is the correlation coefficient between children’s and parents’ incomes

• If b = 0, there is complete economic mobility• If b = 1, there is complete social immobility


• If 0 < b < 1, there is regression to the mean in income inequality– Parents with high incomes do not necessarily have children who

will have high incomes– Parents with low incomes do not necessarily have children who

will have low incomes• Francis Galton (1822 – 1911) who studied inherited

human characteristics (Galton, 1889), predicted an equalizing process through regression to the mean of the population

• Studies for different countries suggest convergence of incomes to the mean over a small number of generations


• Comparisons of economic mobility• fathers and sons, value of b


• Should economic mobility be maximized?– Income consequences of inherited traits

would have to be neutralized– Inheritances would have to be taxed

completely or all wealth and income would need to be collectivized


• Characteristics other than income• U.S. intergenerational economic

characteristics (Mulligan 1999)


• Assortative mating occurs when there are systematic rather than random tendencies when males and females sort themselves into couples– Tendencies for inequality arise, and reversion to the

mean does not take place– Reversion to the mean is within subgroups of the

different sorted groups• Assortative mating decreases economic mobility• Social immobility increases, if high-ability, high-

income women have fewer children


• Economic mobility requires meritocracy in labour markets. – There is no point in investing in education and indeed

being one of the most successful of students, if jobs are obtained on the basis of privileged family connections.

• Economic mobility promotes social stability.• Economic mobility does not end the demand for

social insurance – because of different time dimensions.


• Income distribution and economic mobility• 2 people have incomes of 100 and 200.• The children switch incomes.

– No change in income distribution but there has been perfect high economic mobility.

• For economic mobility, it matters whose incomes changed.

• Income distribution is independent of the identities of the people who have the different incomes.


• If b>1 inequality between generations increases.

• If b<1, inequality declines and converges to a constant level

• Economic mobility is a means of achieving a more equal income distribution – without the need for taxation and public spending on income transfers


Global social justice • Global social justice = Social justice

without government. • Behind the veil of ignorance we

would want a global insurance contract that applies wherever we would be.q Child born in rural Chad is likely to live to 50 without

the opportunity to become truly literate and survive with life time earnings of $40,000. Assuming child mortality has been negotiated.

q European child born into a middle to high income family will most likely enjoy third-level education of some kind, have an opportunity to live into their 80s and enjoy life earnings of approximately €3,000,000.


• The World Bank, other international aid agencies, and governments provide aid to governments in poor countries.

• Insurance in principle compensates for random adverse events.

• The foreign assistance provided because of adversity has not been random.

• Aid has been given systematically to the same countries over the course of time.


Moral Hazard in Aid

• The ineffectiveness of aid: The balance of the data shows that aid has been ineffective in promoting growth and economic development in poor countries

• The hostage problem: Governments in poor countries keep the poor in their countries poor so that aid will continue


• The dilemma of foreign aid

• The dominant strategy of the donor is to give• The government of the poor country has a dominant

strategy of not helping the poor• The Nash equilibrium is at (3, 4)• The aid is given and is appropriated.


• Why does the donor persist in giving the aid, given that that the dominant strategy of the government is to not use aid resources to help the poor?– Aid may not inspire growth but leads to longer

life expectancies and immediate improvements in quality of life.

– The donor feels obligated to be a donor and to give.

– The aid is expressive.


• Global government could in principle implement a global social insurance contract.

• The United Nations is the closest institution to global government.

Date post:	04-Jan-2022
Category:	Documents
Upload:	others
View:	2 times
Download:	0 times

EC3161 Spring 2020 - Michael King

Documents