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

5.2 Institutions and power

Nowhere else in the world during the late seventeenth and early eighteenth century did ordinary workers have the right to vote, to receive compensation for occupational injuries, or to be protected by the kinds of checks on arbitrary authority that were taken for granted on the Royal Rover. The Royal Rover’s articles laid down in black and white the understandings among the pirates about their working conditions. They determined who did what aboard the ship and what each person would get. For example, the size of the helmsman’s dividend compared to that of the gunner. There were also unwritten informal rules of appropriate behaviour that the pirates followed by custom, or to avoid condemnation by their crewmates.

Institutions

institution

An institution is a set of laws and informal rules that regulate social interactions among people, and between people and the biosphere; sometimes also termed ‘the rules of the game’.

incentive

An economic reward or punishment, which influences the benefits and costs of alternative courses of action.

These rules, both written and unwritten, were the institutions that governed the interactions among the pirates on the Royal Rover.

The institutions provided both the constraints (no drinking after 8 p.m. unless on deck) and the incentives (the best pair of pistols for the lookout who spotted a ship that was later taken). In the terminology of game theory from Unit 4, we could say that they were the ‘rules of the game’, specifying, as in the ultimatum game, who can do what, when they can do it, and how the players’ actions determine their pay-offs.

In this unit, we use the terms ‘institutions’ and ‘rules of the game’ interchangeably.

Experiments in Unit 4 demonstrate that the rules of the game affect:

• how the game is likely to be played
• the size of the total pay-off available to those participating
• how this total is divided.

ultimatum game

A game in which the first player proposes a division of a ‘pie’ with the second player, who may either accept, in which case they each get the division proposed by the first person, or reject the offer, in which case both players receive nothing.

allocation

In an economic interaction, an allocation is a particular distribution of goods or other things of value to all participants.

For example, in the ultimatum game, the rules (institutions) specify the size of the pie, who gets to be the Proposer, what the Proposer can do (offer any fraction of the pie), what the Responder can do (accept or refuse), and who gets what (the allocation) as a result.

Changing the rules of the game changes the outcome. In particular, when there are two Responders in the ultimatum game, they are more likely to accept lower offers because each is not sure what the other will do. And this means that the Proposer can make a lower offer, and obtain a higher pay-off. (Section 4.12.)

power

The ability to do (and get) the things one wants in opposition to the intentions of others.

Since institutions determine who can do what, and how pay-offs are distributed, they determine the power individuals have to get what they want in interactions with others.

Power

Power in voluntary economic interactions takes two forms:

• Structural power: When two people voluntarily engage in buying or selling something, or one employs the other, the deal they strike must give each of them an outcome that is an improvement over what they could get if they ended the relationship and took their next best alternative. When we consider conflicts over how something of value will be divided, a person’s structural power is the value of their next best alternative. Having structural power means being able to walk away from a bad deal. A person’s structural power is limited by the structural power of the other: the most a person could get is the amount that would make the other no better off than her next best alternative. Getting more than that is not feasible because, in that case, the other would refuse to engage in the interaction and instead take their next best alternative.
• Bargaining power: The structural power of two parties to a voluntary interaction determines both the most and the least that a person can get in order for the interaction to take place. What each person gets between these two extremes is determined by their bargaining power. A person exercising bargaining power may:
  • set the terms of an exchange, for example by making a take-it-or-leave-it offer (as in the ultimatum game)
  • impose or threaten to impose heavy costs unless the other party acts in a way that benefits the person with power.

Institutions and power in the ultimatum game and in history

The rules of the ultimatum game affect the pay-offs that the players will get—the extent of their advantage when dividing the pie. The power to make a take-it-or-leave-it offer gives the Proposer more bargaining power than the Responder, and usually results in the Proposer getting more than half of the pie. The Proposer can get at least half the pie because 50-50 offers are almost always accepted. Still, the Proposer’s bargaining power is limited because the Responder has the power to refuse. If there are two Responders, the power to refuse is weaker, so the Proposer’s bargaining power is increased. A seemingly small change in the rules of the game—two Responders rather than one—makes a difference in bargaining power.

Suppose that, instead, we allow the Proposer simply to divide up a pie in any way, without any role for the Responder other than to take whatever they get (if anything). Under these rules, the Proposer has all the bargaining power and the Responder none. There is an experimental game like this, and it is called (you guessed it) the dictator game. These are all ways that institutions—the rules of the game—affect bargaining power.

A change in structural power could also affect the distribution of pay-offs in the ultimatum game. Suppose the rules of the game were changed to improve the Responder’s next best alternative: if they rejected the Proposer’s offer, they would get a certain pay-off from some other source equal to 40% of the ultimatum game pie, rather than zero. The Responder would then reject any offer less than 40%, and knowing this, the Proposer would not offer less than 40% of the pie.

In experiments, the assignment of the role Proposer or Responder, and hence the assignment of bargaining power, is usually done by chance. In real economies, the assignment of power is definitely not random and has significant implications for the final outcome in any strategic interaction and how it is shared.

In the labour market, the power to set the terms of the exchange typically lies with those who own the business: they are the ones proposing the wage and other terms of employment. Those seeking employment are like Responders, and since usually more than one person is applying for the same job, their bargaining power may be low, just as in the ultimatum game with more than one Responder. Also, because the place of employment is the employer’s private property, the employer can exclude the worker by firing them unless their work meets the specifications of the employer. This is why employers have substantial bargaining power. But if employees are able to gain structural power by convincing the government to provide them with income support if they lose their job, then this will place a lower limit on the wages that the employer can offer and still retain their workers.

Figure 2.18 shows that the productivity of labour started to increase in Britain around the middle of the eighteenth century. But it was not until the middle of the nineteenth century that the demand for labour and new institutions such as trade unions and the right to vote for workers, gave wage earners both structural and bargaining power sufficient to raise their wages substantially.

In Unit 6, we explain how the labour market, along with other institutions, gives employers bargaining power: they both set the wage and other terms of the exchange, and then direct what the employees do, and are able to fire them if they do not comply. If employees are members of a trade union, they too will have some bargaining power.

In Units 7 and 8, we explain how prices that firms charge depend on the structural and bargaining power of both firms and consumers. A firm with few competitors has bargaining power (it can set the price). But if there are many sellers of similar products, firms will have to charge lower prices because the consumer has structural power: their next best alternative is just to switch brands. In Unit 9, we explain how the credit market gives power to banks and other lenders over people seeking mortgages and loans.