19 ECONOMIC INEQUALITY

Transcription

1 19 ECONOMIC INEQUALITY Beta May 2016 version (c) Tuca Vieira ECONOMIC DISPARITIES ARE MOSTLY A MATTER OF WHO YOUR PARENTS ARE; WELL-DESIGNED POLICIES AND INSTITUTIONS CAN REDUCE INEQUALITIES WITHOUT LOWERING AVERAGE LIVING STANDARDS Your income depends on who your parents are because this will determine the country in which you are born, your ethnic group and your first language. It will also influence the amount and quality of your education, inherited wealth and social networks Our model of the labour market helps explain the way that policy choices and new technologies alter inequality as measured by the Gini coefficient Income inequality declined within most countries during most of the 20th century, a trend that has reversed in many of them since the 1980s Income inequality among the citizens of the world increased between the early 19th century and the end of the 20th century, and has declined since because of the rapid economic growth of China and India Economic inequalities arising from discrimination based on race, gender, or religion are considered by many people to be unfair, as are inequalities arising from other forms of unequal opportunity While inequalities may provide incentives for hard work and risk-taking, they may also bring with them costs that impair economic performance The trade-offs that a society faces in addressing inequality can be modelled using the standard framework of feasible sets and indifference curves Well-designed and implemented government policies can limit economic inequality without reducing average living standards See for the full interactive version of The Economy by The CORE Project. Guide yourself through key concepts with clickable figures, test your understanding with multiple choice questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements, watch economists explain their work in Economists in Action and much more.

2 2 coreecon Curriculum Open-access Resources in Economics It is On a collective farm in China, Yichen Li and Renfu Bo, both 17, live under Communist Party rule. Renfu is the child of a local Communist Party leader who is close to Deng Xiaoping, the soon-to-be leader of China. In 10 years he will attend Tsinghua University, an elite engineering university in Beijing, and will join the Communist party himself. In 20 years he will run a state-owned enterprise. In 30 years he will be CEO of the company after it is privatised, and be highly ranked within the Party. Yichen, however, will not go to university, but instead will work the land alongside her parents who have no party connections until she is 16, then will try working at a state-owned enterprise making car parts for export to the US and Europe. When she is 30 years old she will hear about an opportunity to work in the new Motorola factory opening in nearby Guangdong, paying three times her current wage. She will decide to go there, but will not be able to obtain a hukou (internal passport) to migrate legally to Guangdong. She will travel anyway, giving up access to health care and to public education for her daughter. She will live in barracks with the other workers, missing her family. Yichen and Renfu are hypothetical. We could have inserted a disclaimer: All characters appearing in this work are fictitious. But that would not be entirely true they illustrate the divergent real life histories of real people alive today. Let s also consider two other hypothetical people, living in the US, also in Mark and Stephanie, also 17, live in Gary, Indiana. Mark is about to finish high school and start working in the local unionised steel mill with his father, where the pay is good and he doesn t have to spend four years in further education before earning a wage. In the 1981 recession Mark will lose his job. He will try to use his mechanical ability to open a car parts business. With little collateral and high interest rates, he will not be able to obtain a bank loan. Given the competition the car parts industry will be facing from east Asia in 1981, the expected profits of the business would have been too low for a bank to make a loan to help launch the project. He will move south to another factory. This one is non-union, and he will make less money than he did in Gary. He will stay there, despite the erratic shifts that mean he will sometimes have to work all night, and despite the increasing pain in his shoulders. In 2008, during the recession, his factory will replace him with a KUKA Robotics Corporation Titan industrial robot. In 1975 Stephanie, both of whose parents are doctors, decides she will attend Indiana University Bloomington, majoring in psychology. Afterwards she will work for a large financial corporation in Chicago and, after a series of promotions, will become a vice president for human resources. She will invest her savings in the stock market, which will yield an average return of more than 10% for many years, and will benefit from government tax cuts that favour high earners.

3 UNIT 19 ECONOMIC INEQUALITY 3 These four people had very different life outcomes. Is there anything wrong with that? Each of the four made good choices knowing what they could have known at the time, everybody worked hard, and yet they had very different lives. We might say that in the card game of life they simply drew different hands. Their parents are an important difference in the hands that they drew. This starts with the fact that Yichen and Renfu were born in China, and Mark and Stephanie in the US. The parents of the two in China were likely to be equally poor, although Communist party members enjoyed a higher level of social prestige and education. The gap in wealth between the two sets of American parents would probably have been larger. If Mark had been African American the gap would have been greater still, but his family would still have been far better off in material terms than both the Chinese families. In 2010 the children of Stephanie and Renfu, who have been relatively successful in each country, will have access to a variety of opportunities not available to the kids of Yichen and Mark. In China, Renfu s children will attend better schools and have better job prospects because of their father s connections. With luck, they may even attend a US university, gain valuable work experience in the university-trained, English-speaking global labour market, return to China with salaries many times those of the average Chinese citizen, and be able to join the Communist Party. Yichen s daughter will not obtain a high-quality primary or secondary education, and she may not see her mother for many years at a time. This is because the hukou restrictions mean she must go to school in Yichen s rural home district and not in the city where her mother works. Nevertheless, most likely she will be better off over her lifetime than her parents, and will certainly be better off than her grandparents. In the US Stephanie s children will attend either a public school in her expensive neighbourhood, well funded by local property taxes, or an expensive private school. They will get early access to a much larger vocabulary, form lifelong friendships with other kids from their privileged background, and engage in a variety of interesting extracurricular experiences that help their educational performance and will help them get admission to elite universities. If they are admitted to university, the contacts, credentials and skills they will gain at the university will translate into average lifetime earnings of close to $800,000 greater than the earnings of those whose education finishes at high school level. Mark s children will have to deal with poorly-funded public schools, the absence of union jobs, a minimum wage that will be worth less in real terms than it was in their parents generation, and changes in technology and trade that will amplify the effects of these problems. The life trajectories of these four people illustrate just a few of the global changes in the distribution of income that have occurred in the past 40 years.

4 4 coreecon Curriculum Open-access Resources in Economics Figure 19.1 shows the distribution of income across and within countries. The height of each bar in the chart varies along two axes: the first, from left to right of the figure, is a ranking of countries from the poorest in gross domestic income per capita (the Democratic Republic of Congo) on the left of the figure to the richest (Norway) on the right; the second, from the front to the back of the figure, shows the distribution of income from poor to rich within each country. The width of each country s bars represents the population of the country. The distance marked x on the top left of the figure is equivalent to a population of 200 million. For example, you can estimate that the US has a population of around 300 million, because its bar is about 1.5 times the gap between vertical lines. Richest 10% in Japan Stephanie Gross Domestic Income per capita (2007 US$ at PPP) 120, ,000 80,000 60,000 40,000 20,000 0 Scale: x = population size of 200 million x Poorer to richer people within a country Nigeria Congo, Dem. Rep. Richest 10% in Indonesia India Renfu Indonesia Yichen Richest 10% in Botswana Richest 10% in Brazil China Poorer to richer countries Brazil Mark Japan US Botswana Norway Figure 19.1 The distribution of income in the world in Height of the bars is the gross domestic income per capita (measured in purchasing power parity dollars) of the population decile indicated. Source: Bob Sutcliffe designed the representation of global inequality in this figure and supplied the data. A first version was published in: Sutcliffe, Robert B Ways of Seeing an Unequal World. London: Zed Books. The skyscrapers (the highest columns) at the back of the right-hand side of the figure represent the income of the richest 10% in the richest countries. The tallest skyscraper is the richest 10% in the US. This exclusive group has gross domestic income per capita of a little more than $125,000. Although Norway has the highest gross domestic income per capita and is therefore the country at the right-hand end of the figure, it does not have a particularly tall skyscraper for the richest 10% (our view is almost entirely blocked by the US skyscraper) because income is more evenly distributed in Norway than in some other rich countries.

5 UNIT 19 ECONOMIC INEQUALITY 5 We have marked the positions of Renfu, Yichen, Stephanie and Mark in the world income distribution on the Figure Their stories also illustrate that inequality in economic dimensions such as wealth and income are often associated with disparities in education, in health, and in the scope of choices open to a person. While both Stephanie and Mark face trade-offs in pursuing their life objectives, Stephanie s feasible set is a larger than Mark s. The size of her feasible set is an indicator that Stephanie is better off than Mark. For example, she could have both more income and more free time than Mark if she decided that s what she wanted to do. Because she has more choices, she is freer than Mark. While inequalities in freedom are an important subject, in this unit we will focus on inequalities in wealth and income TECHNOLOGY, ENDOWMENTS, INSTITUTIONS AND INEQUALITY The inequalities among the four people whose stories we told are partly the result of the choices they made, and their individual capacities and objectives. But many of the differences are not really about them as individuals, but instead about where, when and to whom they were born. Stephanie, for example, might have done well had she been born in China, but she almost certainly would have ended up earning less than Mark did in the US until he was laid off. In short, inequalities depend not only on the people, but also on their circumstances. The factors influencing the extent of economic inequality can be understood using a simplified model representing the cause-and-effect relationships (which we show by arrows from cause to effect) in Figure The figure shows that both technology and institutions influence economic inequality directly, but also indirectly through their effect on endowments. Technology and institutions also affect each other as we saw for example in Units 1 and 2, where the competition for innovation rents that is a part of the institutions of a capitalist economy accelerated the rate of adoption of new technologies. We will return to this model and provide examples of each of the arrows as a summary at the end of the unit. Changes in inequality can feed back to affect technology, institutions, and endowments (though we do not show these arrows). As the lives of our four hypothetical characters illustrated, an increase in economic inequality in one generation affects the endowments of the next and, in turn, inequality in the generation to follow.

6 6 coreecon Curriculum Open-access Resources in Economics Technology Differences in endowments Economic inequality Institutions Figure 19.2 The causal relationships among technology, institutions, endowments and inequality. Endowments The first set of factors determining the extent of economic inequality among people is the differences in what they have or what they are differences in their wealth and in their skills and other capacities. Facts about an individual that may affect his or her income are called endowments. Endowments are the basis of wealth. ENDOWMENT Facts about an individual that may affect his or her income: The physical wealth a person has is a component of that person s endowment A person s CV is a partial list of the individual s endowment, because it shows schooling, special training, work experience in internships, the person s citizenship and whether the individual has a visa (or green card) allowing employment in a particular labour market When race or social class background affect the probability of getting a job, it means they are endowments for that applicant The nonmaterial aspects of the broader definition of wealth, such as schooling and training, are sometimes called human capital

7 UNIT 19 ECONOMIC INEQUALITY 7 DISCUSS 19.1: TECHNOLOGY, INSTITUTIONS, ENDOWMENTS AND INEQUALITY Choose a particular country and time period that you know well. For your chosen country and time, replicate Figure 19.2 above, with specific examples of each of the boxes and arrows, to show the effect of technology and institutions on differences in endowments (be as specific as possible about examples of endowments) and inequality. You can use the table in Figure to help you. Employers scour CVs of job applicants for evidence of endowments: nationality, gender, even the person s race or social class. Social networks now allow employers to research other endowments, including a person s appearance and connections. To see how inequalities may arise because of who one interacts with, and on what terms, think back to the interactions you have studied in the previous units, summarised in Figure In the table we present the cases in the first column, starting with the interaction in Unit 5 between Bruno, the landlord, and Angela, the farmer. Recall that how much Bruno got depended on: The fact that Bruno owned the land: He could exclude Angela from working it (Bruno s endowment). Angela s productivity as a worker: This is determined by Angela s endowment and the available technology. Angela s reservation option: What Angela would get if she were to refuse to work for Bruno or he refused to hire her. It is determined by her endowments and the institutions or policies in place. Endowments and classes The endowments of the pairs of individuals in Figure 19.3 appear in the second column of the figure, starting with Bruno owning the land and Angela owning only her time and capacity to work. This inequality in land ownership matters because it determines who has to work for whom, and who can earn income from allowing others to work with their capital good or their land. Endowments matter in another way, because they change Angela s reservation option (in this case, what she would get if her employment relationship with Bruno ended). If Angela owned land that she could work herself, then Bruno would need to pay her at least enough that she would rather work for him than work on her own land.

8 8 coreecon Curriculum Open-access Resources in Economics SITUATION, ACTORS AND UNIT ENDOWMENT RESERVATION OPTION CONFLICT OVER? INSTITUTIONS AND POLICIES (EXAMPLES) TECHNOLOGY (EXAMPLES) LANDLORD AND FARMER: BRUNO AND ANGELA UNIT 5 Bruno owns the land Angela has 24 hours of potential labour Bruno: rent to another farmer Angela: government support Rent paid by Angela to Bruno and the hours that Angela works Angela s reservation option and legislation limiting work hours Angela s increased productivity due to an improvement in seeds allows Bruno a larger surplus when he has all the bargaining power BORROWING, LENDING AND INVESTMENT: JULIA AND MARCO UNIT 11 Julia: $100 next year Marco $100 now Julia: consume nothing now, $100 later Marco: consume some now, store and consume some later Julia benefits from a low interest rate and Marco benefits from a high interest rate Competition among lenders and interest rate regulation An improvement in storage technology makes it easier for Marco to move his goods forward in time, and also raises the rate of return on his investments SPECIALISATION AND TRADE: GRETA AND CARLOS UNIT 16 The skills and resources of each that determine their feasible consumption set in the absence of specialisation and trade Both: the utility they would enjoy if they did the best possible without trading Price at which they exchange the good in which they specialise Price-setting power by either Greta or Carlos An improvement in the technology of the good in which one specialises will benefit both countries, the larger gains going to the person with price-setting power FIRM: OWNER AND EMPLOYEES UNIT 6 Owner: ownership of the firm Employee: capacity to work given her skills Owner: hire some other employee Employee: unemployment insurance and job search Wage, working conditions, effort on the job Level of unemployment insurance, employment level and legislation regulating work conditions A new technology may increase the productivity of the employee s effort, transferring a greater surplus to the employer (short run) and increasing employmentand the real wage (long run). It may also affect how easily the employer can monitor the employee s effort BANANA PLANTATION: OWNERS AND DOWNSTREAM FISHING COMMUNITIES UNIT 10 Owners: the land and other capital goods of the plantation. Fishing communities: their boats and capacity to catch fish Owners: raise bananas without using Weevokil pesticide. Fishers: convert to farming Use of polluting chemical, possible compensation for destruction of fisheries or commitment not to use Weevokil Regulations governing the use of pollutants and enforcement of private agreements made between the parties A new pesticide technology could reduce or increase the conflict between the two groups depending on its external effects Figure 19.3 Inequality: Endowments, reservation options, conflicts, institutions and technologies.

9 UNIT 19 ECONOMIC INEQUALITY 9 Differences in endowments also explain why Julia and Marco are on the opposite sides of the credit market. Marco has a sum of money now and Julia has none, so Julia will borrow from Marco and repay him with interest. Similarly, the owner and employees of a firm are on different sides of the labour market. If the workers owned the buildings, machinery and other assets making up the firm, they would most likely not be employees. We say that Julia and Marco, or the owner and employees are in different classes. CLASSES Groups of people who, because of their differing endowments, engage in asymmetric economic interactions with members of other groups, such as: Owners and employees Landlords and tenants Borrowers and lenders Economic inequality exists both between classes (as in these examples) and also within classes, as when employees with distinct skills or differing by ethnic group are paid different wages or for whatever reason are out of work. We call these interactions asymmetric because the actions open to one party the employer for example are not open to the other the employee. The employer, for example, sets the wage and the tasks that a worker is directed to perform, and can also fire the worker. The worker chooses how to go about her work within limits that the employer sets. These interactions differ from those we studied in Unit 4, for example, where the actions open to all parties were identical for example, use integrated pest management or chemical fertilizers, learn C++ or Java. Asymmetric relationships among classes are based on the different endowments that the members of different classes possess, and are associated with differences in income, but also in power. The employer can fire the worker and deprive her of the employment rent she would otherwise receive. The fear of losing this rent is an important reason for the worker to carry out the employer s wishes. (The worker could, of course, quit. But this does not make the relationship symmetrical. If she is receiving a rent she would penalise herself by quitting, and her employer would just replace her with someone currently unemployed.) Interactions between members of different classes are not only economic involving mutual gains through exchange and conflicts over their distribution they are also political involving the exercise of power by one party over the other.

10 10 coreecon Curriculum Open-access Resources in Economics DISCUSS 19.2: CLASSES, ASYMMETRY AND CONFLICT Consider the first (landlord and farmer) and last (banana plantation owner and downstream fishing communities) relationships listed in Figure Identify the classes on either side of the relationship and the asymmetries in their economic interactions. 2. For each of the institution/technology examples listed in the last two columns, explain how the relationship would be affected. Yichen, Renfu, Stephanie and Mark illustrate these differences in power: At the top of large corporations, both Renfu and Stephanie regularly give orders to others with the expectation that they will be obeyed. When Yichen works at the Motorola plant, and when Mark worked at the factory until he was replaced by a robot, they would have little choice but to carry out the directives of the owners and managers who employed them. Wealthy individuals Borrowers become Lenders lend to Successful borrowers Credit market excluded become become become hire Employers Employees Employed Unemployed Figure 19.4 The credit and labour markets shape the relationships between classes. Figure 19.4 illustrates how the credit and labour markets together influence the relationships among the classes of lenders and borrowers and employers and employees. The credit market allows those without wealth to smooth consumption (as we have described in Unit 11 and Unit 12), and also to acquire money to purchase capital goods to become an employer. In this model, those who are wealthy enough

11 UNIT 19 ECONOMIC INEQUALITY 11 to have substantial endowments in the form of capital goods (either by owning them outright or by borrowing) become employers. Those who are not wealthy become employees or unemployed. Institutions and technology The value of a particular endowment, say a programming skill or ownership of a 3D printer, depends on both technology and institutions. Being physically strong was a valuable endowment in agriculture at least until mechanisation made it less important in determining earnings. In that case a change in technology reduced the demand for a particular kind of skill, and so its value (relative to other skills) fell. The wage that a farm worker received may have been decided in three ways: It could have been decided by supply and demand for the worker s endowments. It might have been set by law. It might have been decided by the bargaining power of a trade union. Therefore, institutions matter in this case. We saw another example of how institutions affect the value of a person s endowment in Unit 11 and Figure Recall that Julia s endowment is $100 next year. Her wealth now (what would be measured in the bathtub) depends on the institutions determining whether she can borrow, and the interest rate at which she can borrow. If her only option is the village moneylender in Chambar, she faces a high interest rate and her wealth (now) is much lower than $100; if she can borrow at a low interest rate, her wealth is quite close to $100. If she can t borrow at all, then there is nothing in the bathtub: her wealth now is zero. If your endowment is a scarce machine that you own, which produces something that many people (and even better, many rich people) want, then many firms will want to rent that machine from you, and so it will command a high price. In the last column of Figure 19.3 we consider the role of changes in technology in affecting the degree of inequality. In the row concerning the firm s owners and employees, a laboursaving technology, as we saw in Unit 15, can at least initially reduce the number of workers a firm needs, making employees more vulnerable to job loss and reducing the likelihood of getting another job at the same wage for those who have been fired. Recall that a change in institutions can change Angela s reservation option. Before the rule of law, the institutions were such that Bruno could simply coerce her to work, and the only thing that constrained the size of the surplus he could get was the need to keep Angela healthy enough to work the next day. The institutional change, which gave her the right to say no, changed this reservation option: Bruno had to offer Angela a deal that would make her better off working for him than not working. Institutions can also alter the set of allocations that were allowed (for example, by restricting the maximum length of Angela s working day).

12 12 coreecon Curriculum Open-access Resources in Economics While this outcome was Pareto-inefficient, as we saw in Unit 5 (Figure 5.10), it also reduced inequality. We will examine a variety of policies at the end of this unit, and discuss how they influence equality and efficiency. DISCUSS 19.3: YICHEN, RENFU, MARK AND STEPHANIE Consider the economic situation of Yichen, Renfu, Mark and Stephanie, discussed at the start of this unit. Give examples of how technology, institutions and differences in endowments explain any differences in economic success between these actors INEQUALITY BETWEEN EMPLOYERS, THE EMPLOYED AND THE UNEMPLOYED To study inequality between employers and employees we return to the model of the labour market introduced in Units 6, 9 and 15. Remember there are two classes employers and employees and, among the second class, some are typically unemployed. In Unit 6 we used the wage curve to explain the relationship between employment (the fraction of the labour force that is employed) and the wage rate offered by firms, and how this relationship is affected by changes in the employees reservation option (for example, changes in the unemployment benefit). In Units 9 and 15 we showed how the wage curve and the profit curve determine the level of employment and the wage rate in the economy taken as a whole. As we did in Unit 1, we can construct the Lorenz curve and calculate the Gini coefficient for the economy in this model. Read the Einstein sections called Inequality as differences among people and The Lorenz curve, the Gini coefficient and a small population bias that explain how to calculate the Gini coefficient with different kinds of information about a population. In Figure 19.5a we see an economy with 80 employees of 10 firms. Each firm has a single owner. There are also 10 unemployed people. Because the unemployed people receive no income (we will introduce an unemployment benefit shortly), the Lorenz curve (the solid blue line) begins on the horizontal axis to the right of the left-hand corner. In total, the 80 employees receive 60% of the income as their wages, while

13 UNIT 19 ECONOMIC INEQUALITY 13 the firm owners receive the remaining 40%. The size of the shaded area measures the extent of inequality, and the Gini coefficient is To learn how to calculate the Gini coefficient from information like this on the composition of the population and the wage rate, see the Einstein section called The Lorenz curve and the Gini coefficient in a class-divided economy with a large population. 100 Cumulative share of income (%) 60 Gini coefficient: Unemployed Employed Owners Cumulative share of the population from lowest to highest income (%) Figure 19.5a The Lorenz curve among employers, employed and the unemployed. The Lorenz curve is made up of three line segments with the beginning point having coordinates of (0, 0) and the endpoint (1, 1). The first kink in the curve occurs when we have counted all the unemployed people, so everyone else has some income. The second is the interior point, whose coordinates are (fraction of total number of employees, fraction of total output received in wages). The fraction of output received in wages, sometimes called the wage share in total income, s, is s = wage per hour output per hour of labour Therefore the shaded area in the figure and hence the Gini coefficient will increase if: A larger fraction of the employees is without work Wages fall and nothing else changes Productivity rises and nothing else changes (wages do not rise) We now study how changes in the three factors influencing inequality of income in Figure 19.3 institutions, endowments and technology result in changes in the distribution of income represented by the Lorenz curve and the degree of inequality as measured by the Gini coefficient.

14 14 coreecon Curriculum Open-access Resources in Economics Institutions In Unit 5, you studied how a change in institutions a reduction in the maximum allowable rent charged by landlords in the Indian state of West Bengal can affect the Lorenz curve and the Gini coefficient. Differences in institutions governing the relationship between employers and workers will be associated with differences in the degree of inequality. Recall that, among the incentives that firms provide for workers to work hard and well, is the payment of a wage higher than the worker would be able to get if she was fired, and the threat that inadequate effort or care on the job may result in the workers becoming unemployed. But trade unions often resist what are called for cause firings, and national legislation often makes dismissing employees a costly process for firms. Figure 19.5b depicts the effects of a change in legislation that has made it easier for a firm to fire a worker who is not conforming to management s requirements for the pace of work. The greater likelihood that a shirking worker would be fired under the new legislation makes it cheaper for the employer to get his employees to work, as we saw in Unit 6. If output remains unchanged (no new firms enter), the employers now find they can get workers to work for a lower wage. The combination of a lower wage for the workers and higher incomes for the owners means the Gini coefficient rises from 0.36 to Cumulative share of income (%) Wage share = s Effect of legislation making it easier to fire workers Initial Gini coefficient: 0.36 Gini coefficient after legislation making it easier to fire workers: Unemployed Employed Owners Cumulative share of the population from lowest to highest income (%) Figure 19.5b The effect of making it easier to fire workers on inequality among employers, employees and the unemployed (immediate effect, assuming output constant).

15 UNIT 19 ECONOMIC INEQUALITY 15 In the model introduced in Unit 15, however, this effect will not be permanent because a higher rate of profit will motivate firms to hire more, lowering the unemployment rate and raising wages (due to the upward-sloping wage curve), and reducing inequality. DISCUSS 19.4: UNEMPLOYMENT INSURANCE Start with the initial situation in Figure 19.5a. Now suppose that following a change in policy, the unemployed receive unemployment insurance equal to 50% of the wage. 1. Assuming that output and unemployment remain unchanged, and that the Gini coefficient before the change in policy was 0.36 as in Figure 19.5a, calculate the Gini following the introduction of unemployment insurance. 2. Draw the Lorenz curves before and after the policy was enacted. 3. Provide an explanation of why the introduction of unemployment insurance reduces inequality. 4. Suggest why the assumption that output remains unchanged may not hold. Endowments The employee s primary endowment is a capacity to work rather than physical wealth, so now consider a case in which workers have acquired more schooling, which increases productivity (a unit of effort now produces more goods). This means that, at the previous wage, the greater productivity of workers now produces a higher profit for the firms. Figure 19.5c shows what happens if, with higher profits, firms enter. Production expands, which reduces the rate of unemployment. Because this increases the workers reservation position, it raises the wage. Note that because total output has increased (more workers are employed and they are more productive), the fact that owners of the firms now receive a smaller share of the total output is consistent with their profits having risen.

16 16 coreecon Curriculum Open-access Resources in Economics 100 Cumulative share of income (%) Effect of increased schooling Initial Gini coefficient: 0.36 Gini coefficient with increased schooling: Unemployed Employed Cumulative share of the population from lowest to highest income (%) Owners Figure 19.5c The effect of a more educated workforce on inequality among employers, employees and the unemployed. Technology To see how changes in technology affect the degree of inequality, consider what happens if a labour-saving technology is introduced and 10 of the employed people are no longer needed in production, so they join the unemployed. As a result of the reduction in employment (the increase in unemployment) the reservation position of the remaining workers has deteriorated: if they were to lose their job they would remain unemployed for longer. Knowing this, the firms can now pay a lower wage, so the remaining 70 employees now receive only 42% of the output, the firms gaining the rest. The lower wage of the employed workers is indicated by the flatter dashed Lorenz curve for the portion relating to the employed workers. The increased income of the owners is reflected in the steeper line indicating their income. The resulting Gini coefficient has risen from 0.36 to The effect will not be permanent, however; as we saw in Unit 15, improvements in technology result in job creation as well as job destruction. In that model, firms will enter, production will expand and some of the unemployed will get jobs.

17 UNIT 19 ECONOMIC INEQUALITY Cumulative share of income (%) Effect of increased unemployment Initial Gini coefficient: 0.36 Gini coefficient with increased unemployment: Unemployment rises from 10% to 20% Cumulative share of the population from lowest to highest income (%) Figure 19.5d The immediate effect of a labour saving technological change on inequality (no increase in output) INEQUALITY AMONG LENDERS, BORROWERS, AND THOSE EXCLUDED FROM CREDIT MARKETS Long before there were employers, employees and the unemployed, there were lenders and borrowers. The class of borrowers includes those excluded entirely from the credit market. Differences in income between those who lend and those who borrow people like Marco and people like Julia remain an important source of economic inequality today. We can analyse inequalities between these classes (and among the borrowing class) using the same Lorenz curve and Gini coefficient model. Here is an illustration. An economy is composed of 90 farmers who borrow from 10 lenders and use the funds to finance the planting and tending of their crops. The harvest (on average) is sold for an amount greater than the farmer s loan, so that for every euro borrowed the farmer gains income of 1+ρ, where ρ is called the rate of profit. Following the harvest, the farmers repay the loans with interest, at rate i. We simplify by assuming that all of the loans are repaid and that all lenders lend the same amount to the farmers at the same interest rate.

18 18 coreecon Curriculum Open-access Resources in Economics Because for each euro borrowed, total revenue is 1+ρ and the cost of inputs is 1, it follows that income (revenue less costs) in the total income of the economy is proportional to ρ. Income is divided between the lender who receives an income of i for every euro lent, and the borrower who receives the remainder, namely i-ρ. The share of the total output received by the lender is i/ρ and by the borrower is 1 - i/ρ. Thus, if we have i = 0.10 and ρ = 0.15 then the lender s share of total income is 2/3 and the borrower s is 1/3. Inequality in this economy is depicted Figure 19.5e. The Gini coefficient is Recall that in Unit 11 we showed why some would-be borrowers those unable to post collateral or lacking their own funds to finance a project may be excluded entirely from borrowing even if they would be willing to pay the interest rate. How does this affect the Lorenz curve and the Gini coefficient? To explore this, imagine that 40% of the prospective borrowers are excluded (and since they cannot borrow, they receive no income at all) and that nothing else in the situation changes (i and ρ remain unchanged). The new situation is shown by the dashed line in Figure 19.5e. The new Gini coefficient is 0.70, showing an increase in inequality as the result of the credit market exclusion of the poor. 100 Cumulative share of income (%) (1-i/ρ) = 1/3 Gini coefficient: 0.57 Gini coefficient with excluded borrowers: Credit market excluded Borrowers Lenders Cumulative share of the population from lowest to highest income (%) Figure 19.5e Inequality in a borrowing and lending economy. Note: The Gini coefficient when there are no borrowers excluded is 0.57; when 40 are excluded it is 0.70.

19 UNIT 19 ECONOMIC INEQUALITY INEQUALITY ACROSS THE WORLD AND OVER TIME Economists and statisticians use Lorenz curves to estimate Gini coefficients so that they can measure inequality in wealth, income, earnings (income from work in the form of salaries and wages), years of schooling, and other indicators of economic or social success. Figure 19.6 presents data on three dimensions of inequality wealth, wages, and disposable income in three economies. Recall that disposable income is the income that a family can spend after paying taxes and including any monetary transfers from the government such as unemployment insurance and old age pensions. Two things stand out: Wealth is much more unequally distributed than earnings, which in turn are much more unequally distributed than disposable income: Though the differences among the three are much smaller in Japan than in Sweden and the US. The remarkable equality of Sweden s disposable income: This is due to its modest inequality in earnings and system of taxes and transfers, not to relative equality in its distribution of wealth, which is similar to that of the US. Gini coefficient United States Sweden Japan Wealth inequality Earnings inequality (before taxes) Disposable income inequality Figure 19.6 Inequality in wealth, earnings and disposable income: US, Sweden and Japan. Source: Fochesato, Mattia, and Samuel Bowles Wealth Inequality from Prehistory to the Present: Data, Sources and Methods. Dynamics of Wealth Inequality Project, Behavioral Sciences Program, Santa Fe Institute; Fochesato, Mattia, and Samuel Bowles Technology, Institutions and Wealth Inequality in the Very Long Run. Santa Fe Institute; Wang, Chen, and Koen Caminada Leiden Budget Incidence Fiscal Redistribution Dataset. Version 1. Leiden Department of Economics Research.

20 20 coreecon Curriculum Open-access Resources in Economics DISCUSS 19.5: INEQUALITIES AMONG YOUR CLASSMATES 1. Using this Gini coefficient calculator, calculate the degree of inequality of height among your classmates. 2. Why is this Gini so much smaller than it was for wealth in the data above? 3. Now use the calculator to compute the Gini for another measure (for example, age, weight, commuting time to university, number of siblings or grade in the last exam). 4. Explain any differences between this Gini and that for wealth. Another way to measure inequality focuses on the very rich, providing an answer to the question: what fraction of total income or wealth is accounted for by the richest 1% or 10% of the population? This indicator has the advantage that it can be measured over hundreds of years, because the very rich have long been required to pay taxes, and hence we have reasonably good information on their incomes and wealth. Figure 19.7 shows the fraction of all wealth held by the richest 1%, for all countries on which data is available. A: US independence: 1776 B: French Revolution: C: Voting rights for all males, France: 1884 D: Bolshevik revolution, World War I and voting rights for all males (except US): E: World War II: F: Golden age of capitalism: A B C D E F Wealth share of the top 1% Denmark Norway Finland United States France Sweden United Kingdom Figure 19.7 Share of total wealth held by the richest 1%: Source: Adapted from Figure 19 of Waldenström, Daniel, and Jesper Roine Long Run Trends in the Distribution of Income and Wealth. In Handbook of Income Distribution: Volume 2a, edited by Anthony Atkinson and Francois Bourguignon. Amsterdam: North-Holland. Data.

21 UNIT 19 ECONOMIC INEQUALITY 21 There appear to be three distinct periods: the 18th and 19th centuries up to about 1910 show increasing wealth inequality (excepting Norway and Denmark), the 20th century until 1980 shows decreasing wealth inequality, and the period since shows a modest increase in wealth inequality. Figure 19.8 presents similar data but for the share of income before taxes and transfers (rather than wealth) received by the top 1% of income earners. As in Figure 19.7 there are country differences: in recent years the US is much more unequal than China, India, or the UK for example. But there are also common trends, similar to the second and third periods in the distribution of wealth: a trend towards less inequality in much of the first three quarters of the 20th century followed by an increase in inequality since about We will see later that this U-turn did not occur in all countries, including most of the major economies of the continent of Europe. 30 End of WWI: 1918 Start of Great Depression: 1929 End of WWII: 1945 End of golden age of capitalism: 1973 Start of global financial crisis: Income share of the top 1% Argentina United States South Africa United Kingdom India China Figure 19.8 The share of total income received by the top 1%: (for an interesting comparison look ahead to Figure 19.18). Source: Alvaredo, Facundo, Anthony B Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman The World Wealth and Income Database (WID). We used data created by Thomas Piketty and his collaborators to create Figures 19.8 and He is an economist and author of the bestselling economics book Capital in the 21st century. In this Economist in Action video, he examines economic inequality from the French Revolution to the present, and explains why careful study of the facts is essential.

22 22 coreecon Curriculum Open-access Resources in Economics 19.5 GROUP INEQUALITY From Figure 19.1 it appears that that the most important determinant of income is the country in which you were born. If you doubt this, try the following thought experiment. All you care about is income. Do you choose option 1 or option 2? 1. You can choose the decile you are to be in, but not the country. 2. You can choose the country you are born and live in, but not the decile. If you chose option 1, you would of course choose to be in the top decile, so you would be at the back of Figure But you have an equal chance of being on the left-hand side or the right-hand side. If you chose option 2, you could select one of countries at the right-hand end with the highest average income. You are as likely to be in the lowest decile, at the front of the figure, as in the highest decile. Figure 19.9 shows the income inequality among the world s population irrespective of the country they live in (the blue dots) as measured by the Gini coefficient (income is measured before taxes and transfers). Also shown is the amount of income inequality that would result if, hypothetically, everyone in each country had the same income the average for that country. If this were the case, then the only source of inequality in the world would be inequality between countries. You can see in 1986 the Gini coefficient for all families in the world (the first blue dot) was 0.68, and this number would have been 0.60 had there been absolutely no inequality within each country (the red line). As a result, we see that 88% of global inequality in income is accounted for by our measure of inequality between countries (that is because 0.60/0.68 = 0.88, or 88%). The figure also shows that between-country inequality has been falling rapidly: by 2008, 74% of global inequality was between-country inequality (0.51/0.69 = 0.74). At the beginning of Unit 1 we wrote that, prior to the emergence of capitalism: The prospects of a daughter or a son depended on where their parents were on the economic ladder. It mattered much less in which part of the world the son or daughter was born. The economic take-off of the first capitalist economies changed this for North Americans and Europeans, as even the poor in these countries became richer than even the rich elsewhere. This is now changing again, as we have seen, as a result of the economic take-off of India and China.

23 UNIT 19 ECONOMIC INEQUALITY Global inequality 0.70 Inequality: Gini coefficient Inequality between countries Within-country inequality Global inequality (1986 to 2008) The blue dots show income inequality among all families in the world. It is, effectively, the world s Gini coefficient. The hypothetical inequality between countries falls... The red curve shows the between-country income inequality between 1952 and To calculate it we assume everyone in a given country had the same income. It started to decline rapidly the 1980s.... and within-country inequality rises The decline in between-country inequality accelerated as the growth of the world s largest poor countries, China and India, increased. In 1986, 88% of global inequality was between countries. By 2008, this was 74%. Figure 19.9 Group inequality: Global and between-country income inequality ( ). Source: Milanovic, Branko Global Income Inequality by the Numbers: In History and Now -an Overview-. Policy Research Working Papers. The World Bank. It is still the case, however, that the greater source of inequality in the world today is the group inequality based on country of citizenship. Passports and borders limit the economic opportunities people from different countries face. People with the same level of education, intelligence and ambition, but born on different sides of a national border, face very different life chances, whether that is the border between Mexico and the US, North and South Korea, or the Mediterranean Sea that divides North Africa from Europe. Even where migration is allowed, migrants are often denied access to political and labour rights, as occurs in the Gulf and some East Asian countries.

24 24 coreecon Curriculum Open-access Resources in Economics Group inequality also exists within countries. Vast disparities in life chances in India, for example, follow from 2,000-year-old hereditary caste boundaries. South African apartheid formalised inequality with a complex system of racial barriers. Many countries, for example Australia, the US and much of Latin America, have high inequality between descendants of colonists and indigenous people. Some countries have been endorsing equal rights for hundreds of years, but have not eliminated economic inequalities between men and women. Figure 19.10a shows the expected lifetime earnings (labour income) of men and women assuming that they work full time from the time they leave school until retirement. As a result, any differences in Figure 19.10a are not due to women on average having more time out of the labour force because of child-rearing. Because the quality of schooling does not differ between males and females on average (and girls tend to do as well on most tests) the gender differences in pay are not due to differences in cognitive ability, or quality of schooling. Yet for every level of schooling women can expect to earn less than men. Expected lifetime earnings ($m) Male Female 0 Less than secondary school Secondary school Some postsecondary/ no degree Bachelor's degree Master's degree Doctoral degree Professional (law, medicine, etc) Figure 19.10a Group inequality: Schooling and lifetime earnings for men and women in the US. Source: Adapted from Figure 5 in Carnevale, Anthony P, Stephen J Rose, and Ban Cheah The College Payoff. Georgetown University Center on Education and the Workforce. The figure also shows, however, that additional schooling contributes to higher lifetime incomes, and that those women who complete university (a bachelor s degree) earn much more than men who ended their schooling after secondary school. But for most of the people of the world, investing in four years of education after secondary school will have a smaller payoff than investing in a new passport by gaining citizenship of a higher-income country.

25 UNIT 19 ECONOMIC INEQUALITY 25 In many parts of the world girls receive considerably less schooling than boys but, as Figure 19.10b shows, girls go to school for the same time as boys in both the US and France, and longer in Brazil. China and Indonesia have virtually eliminated the gender gap in years of schooling, and India is rapidly closing it. 1.2 Ratio of girls' to boys' years of schooling Brazil France US Indonesia China Tanzania India Figure 19.10b Group inequality: Average years of schooling, girls relative to boys ( ). Source: The World Bank IIASA/VID Educational Attainment Model. Dataset Produced by the International Institute for Applied Systems Analysis (IIASA) in Laxenburg, Austria and the Vienna Institute of Demography, Austrian Academy of Sciences. Educational Attainment Statistics. To understand why some societies end up highly segregated by race or some other group characteristic, take two minutes to play the online game The Parable of the Polygons. A final example of the way that institutions can influence inequality is what is termed the segmented labour market. Until now we have assumed that all workers receive the same wage in a single labour market, but in reality there are many distinct labour markets. In the primary labour market workers are typically represented by trade unions, and enjoy high wages and job security. Workers in the secondary labour market might be primarily young, or discriminated against by race or ethnic group, or simply workers on short-term contracts with limited wages and job security. Figure shows the effect of labour market segmentation, with a low-wage segment and an equal number of high-wage primary segment workers. The owners are not segmented because they can easily invest their wealth in firms in either or both sectors and, as a consequence, the rate of return will be the same in both sectors.

26 26 coreecon Curriculum Open-access Resources in Economics 100 Cumulative share of income (%) Effect of labour market segmentation Initial Gini coefficient: 0.36 Gini coefficient in segmented labour market: Unemployed Secondary labour market Primary labour market Cumulative share of the population from lowest to highest income (%) Owners Labour market segmentation This divides employees equally into low-wage and high-wage groups. In this new setting, the Gini coefficient is higher than before. Figure The effect of labour market segmentation (or a model of inequality in the world economy). We can also use Figure as a simplified way to view the world economy. Instead of two labour market segments in the same country, there are two countries, a poor one with low wages and a high-wage country, a little like China and Germany in Unit 16. Just as it is not easy for workers to move up from the secondary to the primary labour market within a country, the global economy has nationally segmented labour markets because of the barriers facing workers who would like to relocate from one country to the other. And, just as in the national economy, owners are not segmented. They invest their wealth wherever it will get the highest return. (International capital mobility is high: money does not need a green card or a work visa to be allowed to work in a country.)

27 UNIT 19 ECONOMIC INEQUALITY INHERITED INEQUALITY In addition to differences in group membership such as your nation, sex, race, or ethnic group, a second source of economic inequality within a nation is inherited: you are rich or poor because your parents were rich or poor. In most countries 200 years ago it was taken for granted that somebody should expect a life of poverty simply because her parents had been poor, or that someone else should inherit the ownership of his father s company and social status, without having to prove that he was the best person for the job. But this has changed with the spread of public education and, in many countries, with the decline in discrimination against poor people due to their race, religion, or simply their origins. The economic status of one s parents is now not automatically transferred to the next generation. The expression intergenerational mobility refers to the fact that parents status does not determine the status of the child (when mobility is low, we say that the intergenerational transmission of wealth or any other measure of economic status is high). Economists and sociologists measure social mobility by ranking parents by their incomes or wealth, and then looking at what income or wealth their kids end up with when they become adults. High mobility implies that two kids from two different families, whose parents had different economic status, would both have the potential to succeed as adults. Knowing how rich the parents were would not tell us much about the likely income or wealth of the adult children. However, if mobility is low, then kids whose parents had a high income are likely to grow up to have high incomes themselves, and kids from low-income families are likely to have low incomes as adults. This is what we see in Figure 19.12, which gives measures of the intergenerational mobility of men, based on their labour earnings in the US (top panel) and Denmark (the bottom panel). The tall bar on the left in the top panel means, among men whose fathers were in the bottom fifth of the earnings distribution, 40% were themselves in the poorest fifth, while 7% ended up in the top fifth of the earnings distribution. By contrast, 36% of the men born to the richest fifth were themselves in the richest fifth the tall purple bar on the right.

28 28 coreecon Curriculum Open-access Resources in Economics UNITED STATES Proportion of children in earnings quintile conditional on father's earnings quintile Poorest 20% Richest 20% Richest 20% Children's earnings Poorest 20% quintile Father's earnings quintile DENMARK Proportion of children in earnings quintile conditional on father's earnings quintile Poorest 20% Richest 20% Richest 20% Children's earnings Poorest 20% quintile Father's earnings quintile Figure Intergenerational transmission of earnings: US and Denmark. Source: Table 14 in Jäntti, Markus, Bernt Bratsberg, Knut Røed, Oddbjørn Raaum, Robin Naylor, Eva Österbacka, Anders Björklund, and Tor Eriksson American Exceptionalism in a New Light: A Comparison of Intergenerational Earnings Mobility in the Nordic Countries, the United Kingdom and the United States. Discussion Paper Series Institute for the Study of Labor. One of the reasons that children of the rich tend to be richer than the children of the poor is the financial support that rich parents give to their children, both during the parents lifetimes and at death in the form of bequests. The data in Figure 19.12, however, is based on labour earnings, not inherited wealth. The earnings of parents and their children appear to be similar in the US, partly because children of well-off parents receive more, higher-quality, schooling. They also benefit from the networks and connections of their parents, which improve access to the labour market. Highearning parents may also pass on to their children the personalities and habits that

29 UNIT 19 ECONOMIC INEQUALITY 29 contributed to their high earnings. There may be other genetic explanations, but, other than race, it is difficult to document any genetically heritable traits that make a substantial contribution to intergenerational transmission of economic status. There is a significant genetic element in performance on cognitive tests such as IQ, for example, but this explains very little of the fact that parents and their offspring have similar incomes. The data from Denmark in the lower panel suggests a more level playing field: the advantage of being born in a rich family is relatively small, and the disadvantage of being born poor is smaller than in the US. A summary measure that tells us the overall rate of economic mobility in a society is called the intergenerational elasticity for some indicator of economic success such as wealth or income. To see what this measures, consider two pairs of fathers and sons: the father in the first pair is richer than the father in the second. The intergenerational elasticity measures how much richer the son of the richer father will be than the son of the poorer father. An elasticity of 0.5, for example, means that if one father is 10% richer, then his son on average will be 5% richer than the other son. The higher the intergenerational elasticity, the lower the mobility in the society, and the greater the degree of intergenerational transmission of economic status. We use this elasticity to measure what we term intergenerational inequality as distinct from what we usually refer to as inequality, which is measured between people, or groups of people, at a particular time. INTERGENERATIONAL MOBILITY, ELASTICITY, INEQUALITY Be careful not to confuse these three terms: Intergenerational mobility: Changes in the relative economic or social status between parents and children. When this is high, the parents status does not determine the status of the child. Intergenerational elasticity: For parents and grown offspring, the percentage difference in the second generation s status that is associated with a 1% difference in the adult generation s status. Intergenerational inequality: The extent to which differences in parental generations are passed on to the next generation, as measured by the intergenerational elasticity or the intergenerational correlation. Figure presents evidence on the intergenerational elasticity for earnings and earnings inequality at a particular time, which is called cross-sectional inequality. Cross-sectional inequality is measured using the Gini coefficient for income. Note that we do not include the effects of taxes and government transfers in Figure when we measure both income inequality and intergenerational transmission of

30 30 coreecon Curriculum Open-access Resources in Economics earnings, because we are interested in how these two dimensions of inequality move together independent of government policy. You can see the differences between measures of inequality in earnings, income and disposable income for a few countries in Figure Inequality: Gini coefficient Canada Norway Finland Denmark Australia Germany Italy United States United Kingdom Spain France Correlation coefficient = 0.53 Switzerland Intergenerational inequality Figure Intergenerational and cross-sectional inequality. Source: Corak, Miles Inequality from Generation to Generation: The United States in Comparison. In The Economics of Inequality, Poverty, and Discrimination in the 21st Century, edited by Robert S Rycroft. Santa Barbara, CA: Greenwood Pub Group; Chen, Wen-Hao, Michael Förster, and Ana Llena-Nozal Globalisation, Technological Progress and Changes in Regulations and Institutions: Which Impact on the Rise of Earnings Inequality in OECD Countries? Working Paper Series 597. LIS. The figure shows that, for the countries considered, inequality in earnings at a given point is greater where high-earning fathers have high-earning sons, and the sons of low-earning fathers also receive low wages or salaries. But countries differ in which type of equality is most pronounced: compare, for example, Canada and Switzerland. Does inequality cause intergenerational transmission of economic status, or the other way around, or both, or neither? We know that societies with a strong culture of fairness and equal treatment such as Denmark adopt policies to reduce inequality among people at a given moment, and at the same time attempt to improve intergenerational mobility by providing equal opportunities for high-quality education, by reducing the importance of inherited wealth, and through other policies that would reduce intergenerational transmission of economic status. We assume this is part of the explanation of the contrast between Denmark and the US in Figure Another likely source of the correlation in Figure is that, in any period (a generation for example), some individuals experience good luck and others bad, for example from serious illness of themselves or a family member, unplanned

31 UNIT 19 ECONOMIC INEQUALITY 31 pregnancy, business failure or because technological change or shifts in demand make their skills less valuable. Where intergenerational inequality is high, for example in the US, Italy and the UK, high or low earnings resulting from good luck or bad luck are passed on to the next generation, and added to whatever shocks the next generation experiences. As a result, intergenerational inequality contributes to inequality at a specific moment WHAT (IF ANYTHING) IS WRONG WITH INEQUALITY? Michael Norton, a professor of business administration, and Daniel Ariely, a psychologist and behavioural economist, asked a large sample of Americans how they thought the wealth of the US should be distributed: what fraction of it, for example, should go to the top 20%? They also asked them to estimate what they thought the distribution of wealth actually was. Figure gives the results, with the top three bars showing the distribution that different groups of respondents considered would be ideal, and the fourth bar the wealth distribution that they thought actually existed in the US. This bar (labelled Estimated ) shows that they thought that the richest 20% owned about 60% of the wealth. The bottom bar shows the actual distribution. In reality the richest fifth owns 85% of the wealth. Even more surprising than the public s underestimate of wealth inequality is what they think a fair distribution should be. The top bar shows that Americans thought that, ideally, the richest 20% should own a little more than 30% of total wealth. Top 20% 2nd 20% Middle 20% 4th 20% Bottom 20% Ideal Ideal (Income > $100K) Ideal (Income < $50K) Estimated Actual % wealth owned by the indicated decile Figure Americans ideal, estimated and actual distribution of wealth. Source: Adapted from Figures 2 and 3 in Norton, Michael I, and Daniel Ariely Building a Better America-- One Wealth Quintile at a Time. Perspectives on Psychological Science 6 (1): 9 12.

32 32 coreecon Curriculum Open-access Resources in Economics Different groups largely agree on the ideal distribution of wealth. Americans with an annual income greater than $100,000 thought that the share going to the top 20% should be slightly larger than those who earned less than $50,000 thought it should be; Democratic party voters wished for a more equal distribution than Republican party voters; and women preferred more equality then men did. The differences between these groups, however, were small. DISCUSS 19.6: ESTIMATED, IDEAL AND ACTUAL DISTRIBUTIONS OF WEALTH Use this Gini coefficient calculator to determine the Gini coefficients for wealth ownership given by the estimated, ideal, and actual distributions in Figure (Note: you will have to estimate the data visually from the chart.) Although there seems to be a consensus on the ideal outcome in the US, policies that would redistribute income are controversial and debated passionately as they are in most countries. Differences in self-interest contribute: richer Americans, for example, tend to oppose redistribution that favours the poor, while poorer Americans support it. But, as the experiments in Unit 4 would lead us to expect, self-interest is just part of the explanation. People differ also because they hold different beliefs about why the poor are poor and how the rich became rich. In laboratory settings, people often express strong feelings of fairness, and give up considerable sums of money to ensure outcomes that are consistent with ideas of economic justice. For example, responders in the ultimatum game reject what they consider an unfair offer, preferring to receive nothing and to impose the same fate on the proposer than to agree to being treated unfairly. Both rich and poor may think that high levels of inequality are unfair and that the government should reduce economic disparities, even if it means voting for policies that would reduce the disposable income of the voter. Christina Fong, an economist, found that a person who thinks that hard work and risk-taking are essential to economic success is much less likely to support redistribution to the poor than one who thinks that the key to success is inheritance, race, your connections, or who your parents are. The results of her study are in Figure Notice that white people who think that race (more precisely, being white) is important to getting ahead strongly support redistribution to the poor evidently because they think that the process by which economic success is determined is unfair.

33 UNIT 19 ECONOMIC INEQUALITY Extent of support or opposition to redistribution Support for redistribution Opposition to redistribution Gender matters (male) Race matters (white) Education matters Parents matter Connections matter Luck matters Dishonesty matters Inheritance matters Race matters (black) Gender matters (female) Risk-taking matters Hard work matters Beliefs about what it takes to get ahead in life Figure How Americans beliefs about what it takes to get ahead predict their support or opposition to government programs to redistribute income to the poor. Source: Figure 5.3 in Bowles, Samuel The New Economics of Inequality and Redistribution. Cambridge: Cambridge University Press. This suggests that the question how much inequality is too much? cannot be answered unless we know why a family or person is rich or poor. If income depends substantially on what we call an accident of birth your race, your sex or your country many people think this group inequality is unfair. We saw large group inequalities based on where you are born in Figure 19.1: have another look. DISCUSS 19.7: A LEVEL PLAYING FIELD When people think about too much inequality, some think about the Gini coefficient measuring inequality at a point in time, while others are more interested in intergenerational inequality. 1. Use an example of two fictional families in each country to explain the combination of cross-sectional and intergenerational income inequality in Canada and Switzerland in Figure Rank the countries in Figure according to your own values: which do you think is the fairest, the second fairest, and so on?

34 34 coreecon Curriculum Open-access Resources in Economics Now think about the indifference curves that you could draw in this figure that would indicate the combinations of inequality and intergenerational inequality that would be equally fair in your judgement. 3. If you cared only about a low Gini coefficient, what would they look like? 4. If you cared only about the intergenerational elasticity, what would your indifference curves look like? 5. If you cared about both, what would they look like, and why? 6. Use your rankings of the countries to draw a set of your own indifference curves (the curves implied by the ranking you have given in part 2, above). 7. Did drawing your own indifference curves lead you to revise your rankings? 19.8 HOW MUCH INEQUALITY IS TOO MUCH (OR TOO LITTLE?) We have considered a range of policies that affect the degree of inequality and we will consider some more policies below. When we evaluate these policies, we ask two questions: What is the level of economic inequality that we would like our society to have? What are policies that will implement that level of inequality for the lowest cost? This is exactly what we did in Unit 18. Given the trade-offs we face, we first determined the level of environmental quality that we would like to achieve, and then considered which policies would best implement the abatement that this implies. The veil of ignorance as a lens for viewing inequality Suppose your income depends substantially on what we call an accident of birth, whether that be your race, your sex, a physical disability or your country. Many people would regard any substantial differences in income between people arising from accidents of birth as unfair. People would be less likely to think of inequality as unfair if there was a level playing field, so that economic success is entirely a result of hard work.

35 UNIT 19 ECONOMIC INEQUALITY 35 This is what Fong s research in Figure showed: those who think that hard work matters for getting ahead were opposed to the government redistributing income to the poor, while those who think that parents, connections, or inheritance matter held the opposite view. But even if the playing field were level, we still would face a question: how rich should the winners be compared to the losers? To think about this question, transport yourself to a hypothetical world in which you (perhaps along with other fellow citizens) are asked to design your model society. There will be two classes of equal size, one called richer and the other poorer. You will get to live in the society you design after you have answered the question how rich should the richer class be and how poor should the poorer class be? But there is a hitch: which class you get to be in will be determined by the flip of a coin. This thought experiment is what the American philosopher John Rawls, who we encountered in Unit 5, termed choosing a social contract from behind a veil of ignorance: we would not know which positions we would occupy in the society we were considering. Behind the curious device of the veil is an important concept: Rawls fundamental idea is that justice should be impartial. It should not favour one group over another, and the veil of ignorance invites you to think this way (because you do not yet know which group you are going to be in). Rawls asked us to think about justice if: [N]o one knows his place in society, his class position or social status; nor does he know his fortune in the distribution of natural assets and abilities, his intelligence and strength, and the like. John Rawls, A Theory of Justice (1971) This does not tell us the answer to how much inequality there should be, but it does suggest a way to look at it. Feasible inequality Is this question just about philosophical statements of our values, or can economics help? Economics is useful, because it gives us tools for studying what combinations of the income of the rich and the poor are feasible, and how we might reason about which ones are preferable to others. Let s try one way to answer how rich should the richer class be and how poor should the poorer class be? : let s say there should be no difference between the incomes of the rich and the poor. Suppose that, in this case, both classes would receive $100,000 annually (per adult). This is shown by point E in Figure where the 45-degree line gives all of the points of equal income among the two classes. The figure shows the annual income per adult of the poor and the rich along the axes.

36 36 coreecon Curriculum Open-access Resources in Economics Maximum feasible income of the rich Maximum average income Slope = -1 D F A Indifference curve of an inequality averse citizen Slope : MRS Income of rich Income of both classes with complete equality Feasible frontier (Slope: MRT) Feasible set E B R Rawls ideal Rich and poor equal along this line 45 Minimum feasible income of the poor Maximum feasible income of the poor Income of poor Figure Choice among feasible income distributions. Would this be your choice? In this version of an ideal society, you would not run the risk of ending up poorer than others after the coin flip. But as an economist you might think that complete equality in the society would mean that there were insufficient incentives for people to work and study and take risks, so that at least a little bit of inequality could actually be better for everyone. In the figure points between E and R show possible combinations, in which the rich are richer than the poor, but where the poor also are richer than they would be under complete equality. Comparing the two points you can see that E is Pareto-inefficient because both rich and poor are better off at R than at E. The income distribution at R is also the one at which the poor are as rich as they can possibly be in the economy in question. This is the point that Rawls favoured (and why we called it point R). The upward sloping part of the line between E and R is similar to a part of the feasible environment-consumption frontier in Figure in which at very low levels of abatement, increased environmental quality is possible along with increased consumption. Would you choose R? Notice that above R, the frontier is very steep. This means that it s possible to make the rich richer at very little reduction in the income of the poor. The blue curved line made passing through R and E (and the other points above R) is the frontier of the feasible set of income distributions for the economy in question. As with all feasible frontiers, the slope is a marginal rate of transformation, in this case transformation of income losses of the poor into income gains for the rich.

37 UNIT 19 ECONOMIC INEQUALITY 37 slope of the feasible frontier = = MRT income gains for the rich income losses for the poor If the point R had been proposed, would you want to consider other points higher up on the feasible frontier? Remember, after the coin flip, you will get either the income of the rich or that of the poor with equal probability (one half), so you know that: expected income = 0.5 (income of the rich) (income of the poor) So as long as income gains for the rich come at little expense of income losses for the poor, you would definitely do better to move above point R. If you were interested in maximising your expected income then you would choose point A, where the income gains of the rich are exactly offset by income losses by the poor, so the marginal rate of transformation is equal to one. But, after point A, the inequalities would become so severe that the average income would fall, and the rich would be getting a larger slice of a smaller pie. This might occur if the poor were insufficiently well fed to work hard, or sufficiently angry about their condition to motivate the rich to employ people to guard their gated communities, rather than producing goods and services. By looking ahead to Figure 19.19c, you will see data showing that more unequal societies (such as the US, UK and Italy) devote more resources to workers employed in private and public security activities than do other more equal countries with similar GDP per capita. You can also see that if you could rig the coin flip so that you knew you would end up rich (and you had no concern about fairness) you would select point F. Like the feasible set when Angela and Bruno were bargaining, there is a minimum level of income that the poor can get. This minimum could be set by their biological needs, or perhaps by the fact that were income to fall below this level they would revolt. Notice that if the poor were to be even poorer than at point F, the rich would themselves suffer. So like point E (maximal equality), point D (minimal income of the poor) is not Pareto-efficient. In the figure we have considered the following income distributions: E: complete equality R: the distribution with the highest income for the poor A: the highest average income of rich and poor F: the maximum income of the rich D: the distribution in which the poor are at their minimum feasible living standard

38 38 coreecon Curriculum Open-access Resources in Economics A preference for fairness Which would you choose? Points between D and F are easy to eliminate from the running as they are all inferior for both classes to point F. And the same goes for points between E and R. The same idea eliminate from consideration all Paretoinefficient distributions means that no points interior to the feasible set would be considered: like points between D and F and between E and R, they are all Paretoinefficient. That leaves points between F and R. How will you choose among them? To answer this, you need to consult your indifference curves. In this case an indifference curve gives combinations of the incomes of the two classes that are equally valued by you. Curves further away from the origin are preferred (more income for both is always better). The slope of these indifference curves is the marginal rate of substitution between income for the rich and income for the poor. slope of the feasible frontier = = MRS marginal value of poor income marginal value of rich income You would then maximise your utility by finding the point on the feasible frontier at which the marginal rate of transformation is equal to the marginal rate of substitution. If you wished to maximise your own expected income, then you would place an equal value on the income of the rich and the poor because you are equally likely to be one or the other. But you might care about the condition of the poorer class even were you to have the good luck to be assigned to the richer class in the coin flip (remember you have to make your choice before you know your assignment). That is, you might be inequality averse, caring about your own payoffs but also disliking inequality per se. In this case you would have an indifference curve like the red one shown in the figure. You would choose point B, somewhere between Rawls ideal (the highest feasible income of the poor) and point A, the highest average income ADDRESSING UNFAIR INEQUALITY Where inequalities are seen as unfair, government policies can limit economic inequality in four ways: Using taxes and transfers: They reduce disparities in disposable income.

39 UNIT 19 ECONOMIC INEQUALITY 39 Reducing individual differences in endowments: Maybe reduce the difference in wealth, or the determinants of success in the labour market. Change the relative value of endowments: Adopt policies to increase the value of endowments held by poorer people. Insuring citizens against some economic losses: This would reduce the impact of bad luck, such as job loss or ill health, on economic status (see Unit 6 to remind yourself about this). Using taxes and transfers In Figure 19.5b we saw that inequality in wealth and before-tax labour earnings is much greater than the inequality of disposable income the buying power of a family after paying taxes and receiving any government transfers such as unemployment insurance. The equalising effect of taxes and transfers is particularly high in Sweden (where wealth is unequally held, compared to most countries) but lower in Japan (where both earnings and wealth are not very unequally distributed, at least compared to the US). We also saw in Unit 1 that some other countries (Belgium and Germany) create low levels of income inequality using taxes and transfers. Giving money directly to poor people is one possible transfer: Conditional transfers: In Latin America, governments give money to poor households that comply with certain actions such as sending their kids to school (measured by attendance records) or having them vaccinated. Conditional cash transfer programs such as Oportunidades in Mexico and Bolsa Familia in Brazil have gained support from middle class voters, and transferred substantial income to the poor. Economic researchers have found that Oportunidades has yielded long-term improvements in children s schooling; children have entered the workforce later and are more likely to be in non-agricultural work. Unconditional transfers: In South Africa, cash transfers given as pensions have had significant effects on child nutrition and schooling achievement because the pension goes primarily to the grandmother, who is often the person responsible for the care and schooling of her grandchildren. We know that unconditional cash transfers like this increase the autonomy poor people have in deciding what to do with their resources, and are relatively cheap to administer. Greater equality of endowments Other countries (South Korea and Taiwan for example) are more like Japan, experiencing limited levels of inequality without a major role of taxes and transfers because endowments are more equally distributed. After the second world war, all three redistributed the property of large landowners among landless or landpoor farmers and have also invested heavily in providing high-quality education to citizens.

40 40 coreecon Curriculum Open-access Resources in Economics These countries have focused on redistributing endowments, rather than taxing well-off citizens to raise the incomes of the less well-off through transfers from the government or adopting policies to raise the value of endowments held by poor people. James Heckman, a Nobel prizewinning economist, shows how economists can learn from experiments and other data how to level the playing field for children growing up poor in our Economist in Action video. Raising the value of the endowments of the poor Governments can also intervene in market processes directly by creating, protecting or breaking up monopolies or by employing large numbers of workers directly. Using the legal system, governments can also alter which property rights are protected, for example banning slavery, establishing trading rights in emissions (Unit 18), or setting the duration of intellectual property rights and patents. All of these measures can change which groups have bargaining power and their reservation options, which will change the distribution of income. Finally, governments can also change the set of contracts that are allowed or enforced, and this alters the distribution of the income as we saw in Unit 5, when we saw the effect of legislation to enforce maximum hours of work. Another example is a statutory minimum wage, which prohibits contracts with wages below a certain level. Figure shows how a minimum wage can affect the Lorenz curve and the Gini coefficient. We begin with the segmented labour markets economy in which half the workers, those in the secondary labour market, make just one-third of what the primary segment workers earn (the solid Lorenz curve). Now we consider a minimum wage that doubles the wages in the secondary market. The immediate impact of this change is that the 40 workers making up the secondary labour market now receive 20%, rather than 10%, of the total income. The result is that the Gini coefficient falls from 0.62 to To MINIMUM WAGE The statutory minimum wage is a tool used in advanced economies: It eliminates labour contracts where wages are too low It reduces inequality between the middle and the bottom of the income distribution assess the longer-run effects of the minimum wage we would have to consider the effects on the profits of their employer, the greater spending of the secondary labour market workers and other indirect effects on the level of employment.

41 UNIT 19 ECONOMIC INEQUALITY Cumulative share of income (%) Effect of a minimum wage Initial Gini coefficient: 0.62 Gini coefficient with the minimum wage: Unemployed Secondary labour market Primary labour market Cumulative share of the population from lowest to highest income (%) Owners Figure The effect of a minimum wage in a segmented labour market economy. The costs of the minimum wage could be unemployment, although recent evidence suggests that this is small for minimum wage rises in the US and UK. A study of different changes in minimum wages in areas in the US, when that area was next to a similar location in which the minimum wage did not rise, showed that raising the wage more than offset the decrease in employment. Therefore, on average, raising the minimum wage increased the income of poor workers. Legislation may also rule out particular kinds of contracts, such as those that prohibit employees from leaving their firm to work for a competitor. The justification offered for these non-compete contracts is that workers leaving a firm may take with them industrial or trade secrets that would benefit the competition. But in the US non-compete contracts are now being imposed even on fast food workers. This suggests employers have a different motive: to reduce the reservation option of employees by making it more difficult to find work should they be fired. This lowers the wage. Or, to put it in policy terms: prohibiting non-compete contracts would raise the wage. A third policy is illustrated by the Indian state of West Bengal where a tenancy reform, Operation Barga (discussed in Unit 5) gave local bargadars (sharecroppers) the right to keep three-quarters of their crop rather than handing over half of the crop to the landowner, as had been the previous custom. They also received protection from eviction by landowners as well as rights to their product.

42 42 coreecon Curriculum Open-access Resources in Economics EQUALITY AND ECONOMIC PERFORMANCE The success of Operation Barga in raising productivity in farming, of Oportunidades in Mexico, and of pensions in South Africa in raising school achievement and child health may help explain a fact that some people find surprising: more equal countries do as well, or better, in terms of standard economic performance than unequal countries. We saw in Unit 17 (Figure 17.15) that the low levels of inequality, the power of trade unions, and the growth of pro-poor tax and transfer policies during the golden age of capitalism were associated with the most rapid growth of income per capita in modern history. Investment, too, occurred at levels not seen before, raising the capital stock at an unprecedented rate of growth. Earlier in this unit (Figure 19.8) we showed the centuries-long U-turn of top incomes in many countries including the US and the UK. By this measure, late 20th-century inequality had risen to levels not experienced since before the Great Depression. But this U-turn pattern is far from universal, as Figure shows. 30 End of WWI: 1918 Start of Great Depression: 1929 End of WWII: 1945 End of golden age of capitalism: 1973 Start of global financial crisis: Income share of the top 1% Germany Italy Japan France Sweden Netherlands Denmark Figure Declining share of the top 1% in some European economies and Japan. Source: Alvaredo, Facundo, Anthony B Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman The World Wealth and Income Database (WID).

43 UNIT 19 ECONOMIC INEQUALITY 43 DISCUSS 19.8: THE U-TURN COUNTRIES Look again at the difference between the U-turn countries in Figure 19.8, which showed a trend towards greater equality in the first three quarters of the 20th century followed by an increase in inequality since about 1980, and the countries in Figure 19.18, in which inequality did not increase significantly, or at all. Make a list of possible explanations as to why countries in the two groups took such different courses since 1980, making sure to check (you can use the internet) that any technological or institutional changes you refer to are historically accurate. Most of the countries in Figure are high performers when we look at countries that achieved both rapid growth in income per capita and modest levels of inequality of disposable income, as you can see in Figure 19.19a. We measure inequality in income after taxes and transfers (disposable income) here because this is the best measure of the inequality in living standards that people experience. Differences between measures of inequality in earnings, income and disposable income can be seen for a few countries in Figure 19.5b. Figure 1.14 in Unit 1 shows that, in some countries, government policies result in disposable income being considerably less unequal than income. The most evident conclusion from Figure 19.19a is that most countries grow at similar rates and there is no relation to the level of inequality. 3.0 Annual average GDP per capita growth, (%) Luxembourg Norway Finland Austria High performers Belgium Germany Sweden France Netherlands Italy Denmark Canada Australia Switzerland United Kingdom United States Low performers Long term average inequality in disposable income (Gini coefficient) Figure 19.19a The cost of inequality: Inequality and growth in living standards among rich countries. Source: Wang, Chen, and Koen Caminada Leiden Budget Incidence Fiscal Redistribution Dataset. Version 1. Leiden Department of Economics Research.

44 44 coreecon Curriculum Open-access Resources in Economics DISCUSS 19.9: HIGH AND LOW PERFORMERS We have drawn a line in Figure 19.19a to distinguish high from low performers, but what counts as high performance depends on your preferences. 1. Rank the countries in Figure 19.19a from the most to the least preferable from your standpoint (for example, would you prefer less inequality and a slower rate of growth as in Switzerland, or more inequality and a higher rate of growth as in the US?). 2. Use your rankings to sketch your indifference curves in the space given by Figure 19.19a (hint: is the slope of the indifference curve positive or negative?). There have also been high and low performers among the catch-up countries. Figure 19.19b shows that South Korea and Taiwan were able to achieve high growth with relatively low inequality over the past 30 years, whereas the performance of Latin American economies along these dimensions was typically much worse. 6 Korea Annual average GDP per capita growth, (%) Taiwan Uruguay Mexico Peru Brazil Colombia Guatemala Average inequality in disposable income (Gini coefficient) Figure 19.19b The cost of inequality: Inequality and growth in living standards among catch-up countries. Source: Wang, Chen, and Koen Caminada Leiden Budget Incidence Fiscal Redistribution Dataset. Version 1. Leiden Department of Economics Research; OECD; International Monetary Fund World Economic Outlook Database: October 2014.

45 UNIT 19 ECONOMIC INEQUALITY 45 Figures 19.19a and 19.19b are initially surprising because economists have often claimed that high taxes and transfers depress incentives for people to work hard and take the kinds of risk necessary for innovation to occur. Explanations of why egalitarian countries such as Japan, South Korea, and Taiwan in Asia, and Nordic and other northern European countries have done so well economically include: Cooperation and trust: this helps to create high-quality, knowledge-intensive goods, but it may be difficult to sustain when inequalities within a firm or a nation are large. Policies that enhance the endowments of the poor: High-quality health services, education, and land ownership by the person who works on the land contribute to the more productive use of an economy s resources. This is also true of policies that raise the value of the endowments of the poor, as illustrated by Operation Barga. Guard labour: Nations characterised by high levels of inequality divert a substantial portion of their resources away from productive uses and into the construction of secure environments for the rich, such as gated communities. Figure 19.19c illustrates this last point: the US, Italy and the UK are countries with highly unequal disposable incomes that hire three times as many guards (public and private security personnel, excluding armed forces) than do the more equal nations of Finland, Denmark and Sweden. An unequal society may expend a lot of resources on protecting property rights and enforcing the rule of law. More unequal societies may have more of their workforce devoted to repressing, persuading, or otherwise managing potential conflicts. Number of protective services employees per 10,000 in Denmark Norway Belgium Luxembourg Austria Germany Finland Switzerland Netherlands Sweden Ireland Spain Greece Italy Inequality in disposable income: Gini coefficient United States (2000) United States (1979) United Kingdom Figure 19.19c The cost of inequality: Economic disparity and the fraction of workers employed as guards. Source: Jayadev, Arjun, and Samuel Bowles Guard Labor. Journal of Development Economics 79 (2):

46 46 coreecon Curriculum Open-access Resources in Economics CONCLUSION What have we learned about the people that we represented by the hypothetical Mark, Yichen, Stephanie and Renfu, and how their economic lives turned out differently? Their starting conditions were shaped by their families, which set them up with differing initial upbringing, skills and physical wealth (endowments) and opportunities. The scarcity or abundance of those endowments on markets and hence the value of their endowments then shaped their opportunities. Globalisation (trade between China and the US) and technology (the Titan robot and the Motorola plant) reduced the value of Mark s skills as a machinist. China US trade had the opposite effect on Yichen s fortunes: her factory job at Motorola paid much more than she ever would have made as a farmer, and it would not have existed had the plant not exported its products to the US. Differences in the endowments that the four developed in schooling (university against high school), as well as institutions (unions, taxes, and hukou passports), all played a role in driving their lifetime incomes. Economists interested in the study of inequality spend a lot their time trying to untangle the interactions and relative importance of these forces. We can summarise much of this Unit, and earlier ideas about inequality, using the model in Figure 19.20, adding examples of each of the arrows, now numbered in the figure. Think about arrow number 1: this is a direct channel from institutions to economic inequality exemplified by: Greater competition in markets: Opening of the economy to more imports will reduce the markup on costs, and redistribute income from owners of firms to consumers, making the endowments of the owners less valuable than before. Minimum wages and immigration: A minimum wage raises the value of the endowments of some workers, immigration lowers it. Direct effects of technology on economic inequality (arrow 2) include labour-saving innovations that reduce demand for, and hence the value of, the endowments of workers with skills that can be replaced by machines. Figure has examples for the other numbered arrows.

47 UNIT 19 ECONOMIC INEQUALITY 47 Technology Differences in endowments 5 Economic inequality 4 Institutions 1 Arrows Example Units 1 The degree of competition in markets, bargaining power of employers and employees, taxes, government transfers, property rights, provision of public goods, change in immigration policy affects value of one s nationality or one s skill, minimum wage, tariffs 10, 16, 7 2 Displacement of workers by labour saving innovations, new 2, 15 technologies that require more skills or increase the productivity of some endowments 3 A new technology may make a previously useless skill a source of income (e.g. in code-writing); or remove a handicap (such as blindness) from limiting sources of income, or country of residence a source of income (e.g. analysing radiology results remotely) 2, 20 4 Inheritance tax, land reform, educational opportunities, intellectual 5, 10 property rights, rule of law, role of force in acquiring endowments 5 6 Changes in supply and demand affect rates of return on endowments Digital revolution affects intellectual property rights, extent of increasing returns affects degree of competition in markets 7, Intellectual property rights, degree of competition among firms, 20 education, FDI policy, rule of law Figure Institutions, technologies and differences in endowments as causes of economic inequality. The numbered arrows in the top panel refer to the numbered rows in the bottom panel. But there is something missing from Figure 19.20: change. You know from Unit 1 that a capitalist economy is constantly changing and changing the world. From Figures 19.7, 19.8, 19.9 and in this unit you know that the level of wealth and income inequality changes over time. This is partly a result of the changes in technology and in institutions due to the dynamism of capitalism. In Figure we extend the model to make it less like a snapshot and more like a film. Think of the earlier figure as a frame in a film. When you run the film you see that the story does not end with the three arrows representing effects on economic inequality. Economic inequality is both an effect of other influences and a cause of institutions, technologies and endowments in the future.

48 48 coreecon Curriculum Open-access Resources in Economics Technology Technology Differences in endowments Economic inequality Differences in endowments Institutions Institutions Inequality in the current generation It is not only the case that technology, institutions and differences in endowments affect economic inequality Inequality in the next generation but also that inequality in turn affects technology, endowments and institutions and hence, economic inequali Figure Determinants of inequality in this and future generations. Figure (the earnings of fathers and their children in the US and Denmark) showed that although economic status is not automatically transmitted to the next generation, the earnings of fathers helps predict the earnings of children. It s a much better predictor in some countries than others, as we saw in Figure A high level of inequality may, even in a democratic society, allow the rich to affect laws that are adopted. In this way they control the institutions that shape the lives of the next generation. An example is laws that weaken trade unions. On the other hand, a lower level of inequality may produce institutional change in the school system that makes the playing field more level for the next generation of children. CONCEPTS INTRODUCED IN UNIT 19 Before you move on, review these definitions: Gini coefficient Lorenz curve Endowment Technology Institution Classes Labour market segmentation Group inequality Intergenerational elasticity Inequality aversion Minimum wage Labour market segmentation

49 UNIT 19 ECONOMIC INEQUALITY 49 The arrow from inequality to technology captures the way in which high inequality creates market incentives for innovation activities to be focused more on serving the cosmetic needs or extending the longevity of the rich than on the needs of the poor. In the next unit we continue this theme of the dynamism of the capitalist economy, focusing on innovation and technical change in the production and distribution of knowledge. Among other questions, we will look into the possible effect on inequality of new technologies capable of replacing human cognition with artificial intelligence, and substituting robotic systems for human labour. Key points in Unit 19 Lorenz curve, Gini coefficient, intergenerational elasticity The Lorenz curve and the Gini coefficient provide summary measures of the degree of inequality; the intergenerational elasticity is a measure of the transmission of economic success from parents to children. Technology and institutions influence inequality Both influence the level of inequality directly, and also through their effects on inequalities in endowments. Credit and labour markets, and wealth, influence inequality Markets in credit and labour, alongside the distribution of wealth, influence inequality in income by affecting the relationships among classes including lenders and borrowers (and the credit-excluded), and employers and employees (and those without work). Global inequality For the world population, most inequalities in income today are the result of accidents of birth, the most important of which are one s nation, parents, gender, or ethnic or cultural group. Government policies to reduce inequality Policy can reduce inequalities by affecting technology, institutions and the distribution of endowments. How much inequality? Judgements about how much inequality a society should have involve trade-offs that can be analysed using a feasible frontier of combinations of inequality and average income, with indifference curves for values such as inequality aversion and self-interest.

50 50 coreecon Curriculum Open-access Resources in Economics The optimum level of inequality When we do this type of analysis, many economies appear to be well inside the feasible frontier. Costs and benefits of economic equality Policies to reduce inequality may have adverse effects on incentives. But countries and historical periods characterised by greater economic equality have also experienced higher growth of productivity and living standards, and low unemployment EINSTEIN Inequality as differences among people The Gini coefficient, g, is often calculated as the area between the Lorenz curve and the complete equality line divided by the area under the equality line. This, however, is an approximation (see the note on small population bias, below). It is more precisely defined mathematically as half of the relative mean difference in incomes among all pairs of individuals in the population. We can calculate g easily using this definition when we know the income of every person in a small population. So, to calculate g when we know the incomes of every member of a population: 1. We find the difference in income between every possible pair in the population 2. Then we take the mean of these numbers 3. We divide this number by the mean income of the population. This statistic is the relative mean difference 4. g = relative mean difference divided by two Thus, if there are just two individuals in the population and one has all of the income, we can assume their incomes are 0 and 1: 1. The difference between the incomes of the pair = 1 2. This will be the mean difference because there is just one pair 3. Mean income = 0.5, so the relative mean difference = 1/0.5 = 2 4. g = 2/2 = 1 (as we would expect)

51 UNIT 19 ECONOMIC INEQUALITY 51 Now think about two people dividing a pie. The Gini coefficient is a measure of how unequal their slices are. For example: 1. If the smaller slice of the pie is 20% of the pie, the other person s slice is 80%, so the difference is 60% (0.60) 2. This is the mean difference (there are only two incomes, as before) 3. Divide this by the mean slice size (which is 50% or 0.50), to get Half of this is 0.60, which is the Gini that measures the inequality between the two pie eaters when the unfortunate one gets only 20% of the pie In the illustration below, this division of the pie is the third picture. In each case we show the Gini coefficient when two people share a pie: g = 0 g = 0.2 g = 0.6 g = 1 Now suppose there are three people, one of whom has all of the income, which we assume is an income of 1 unit. 1. The differences for the three possible pairs would be 1, 1 and 0 2. The mean difference = 2/3 3. The relative mean difference = (2/3)/(1/3) = 2 4. The Gini coefficient g = 2/2 = 1 Again, g = 1, as we would expect. As an exercise, show that in the two-person case, where the size of the smaller slice is σ, we can write: σ = 1 g 2 (Hint: rearrange the equation so that g is on the left-hand side.) To make sure you understand the four steps in this method, take the three-person case and show that g = 0 if the incomes are equal, and calculate g if one person has zero, another has 1/3 and the third person has 2/3.