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Economics 201

Microeconomics

Economic Inequality
http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/ind01/l3_3868_2812-eng.htm?hili_famil105

Statistics Canada measures inequality using income:

 Market income (wages, interest, rent and profit)

 Total income (market + government payments such as welfare/disability payments)
 After tax income (total – taxes)

We can also use a Lorenz Curve - it shows how far away we are from equality.

45 degree line is equality (10% of the people have 10% of the wealth, 60% have 60% etc). The further
the Lorenz Curve is away from this line, the more unequal the distribution is.

(Max Otto Lorenz 1880 – 1962, US. Curve in 1905).

Internationally the Gini coefficient is widely used. It is a ratio of area between the curve and the 45 0
line (area A) and the whole area under the 450 line.

100
Cumulative %
income

100
Cumulative % households

The lower the Gini coefficient the more equal is the distribution of income. Sometimes the coefficient
is multiplied by 100 to give a Gini index.

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2172rank.html

Distribution of wealth

Wealth is much less equally distributed than income. Where income is measured over time (earnings
per year or per week), wealth is what is owned at a point in time. For example if you have savings in
a bank that is wealth, the interest you earn in it per year is income.
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The top 10% of Canadians accounted for almost half (47.9%) of all wealth in 2012. This group saw
their median net worth rise by 41.9% since 2005 (to $2.1 million). Compare this to a 150% drop in the
median net worth of the bottom 10% (to negative $5,100).

Distribution of wealth in Canada by decile, 2012 Other forms of wealth are stocks, bonds,
investments and real estate etc. We would expect this to be more unequally distributed than income as
poorer people are much less likely to be able to afford investments, real estate etc.

Statistics Canada data from the Survey of Financial Security of the distribution of assets, debts and
net worth of Canadians.

In the USA, the wealthiest 50 individuals have more wealth than 155 million of their compatriots.

Reasons for inequality

We can use the tools of analysis from labour markets to look at inequality in two ways:

Human capital

Discrimination

Human capital gives some justification to inequality in income.

Demand for labour

We know that the demand for labour depends on the value of the marginal product, and higher skilled
labour has a higher value of marginal product. It follows that a higher skilled worker will be paid a
higher wage therefore.

It is simplistic to assume however that a firm will know the marginal product of each extra hours
work – it may be possible in a regimented production line (such as a fast food restaurant) but how is it
possible in a college, hospital or in management?
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A further problem particularly in the low wage market as we have seen already, is the market power
of firms is greater than that of unskilled workers. As a result they may be underpaid relative to their
productivity.

Education and technology are certainly the way to increase incomes in the long term (by increasing
MPL) but this can take time and so measures to mitigate inequality in the short term (like minimum
wages) are important.

Supply of Labour

Skills are costly to acquire (costs of education and the opportunity cost of lost income while a person
is in education/training). It seems reasonable then that higher skilled labour would be supplied at a
higher price as compensation for the cost of education/training and lost earnings while in education.
The acquisition of skills and training also limits supply so the skilled labour curve (S H) shifts back
from SL the low skilled supply curve.

W$ SH

SL

DH
DL

QL

Also higher incomes are justified for other reasons for example:

 Big responsibility (risk of big loss if you make a mistake).

 Dangerous jobs

There is an explanation (at least in part) as to why income has become less equally distributed based
on skills/education – this is linked to technology and globalisation.

Technology

Technology changes capital and makes it more productive and more widely substitutable for labour
(new machines to do the work of people). This is an ongoing historical process (Google the term
‘Luddite’ for example). However the rate of technological change over the past 30 years has been
huge and many of the applications of technology have been substitutes for lower skilled labour. At
the same time, the operation, installation and maintenance of sophisticated technology require skilled
labour (they are complements rather than substitutes).

As the marginal revenue product of capital increases more if it is substituted for lower skilled labour,
while the higher skilled labour that used the technology has increased its MRP. As a consequence
demand for low skilled labour has decreased while that of high skilled labour has increased.
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In terms of income, the returns to labour have fallen and returns to capital have increased. This makes
for more inequality as those who rely more on returns to capital (investors and owners of capital) have
gained more over the past 40 years than those who rely on wages.

Globalisation

Economically, globalisation means the integration of economies. The result is that companies face
more competition as they are in a world rather than a domestic market. In particular China, India and
Brazil have developed industries with a comparative advantage in labour costs for lower skilled
labour. Many manufactured goods have fallen in price therefore reducing the MRP of labour and so
reducing demand for their labour.

Similarly, because capital can move more freely internationally, firms find it more profitable to
relocate to places with lower labour costs. This has also lead to reduction in the demand for labour,
particularly in labour intensive industries. Communications technology has had the same effect. It is
now possible for telemarketers to be located overseas where the cost of labour is lower because the
cost of international phone calls has fallen so much in real terms.

This means that the returns to less skilled labour (the wages earned) would fall, leading to more
unequal distribution of income.

Discrimination

Systematic discrimination also explains economic inequality – whether by race, religion, gender etc.
This is beyond the scope of our analysis to explain why this happens but we certainly recognise that it
does. The Black Lives Matter movement is the most recent example of the long struggle against
systemic racism and its effects. First Nations in Canada face similar systematic discrimination and
India’s caste system is one of countless examples of historic and continuing injustice. Economic and
income inequality are symptoms of wider discrimination and income redistribution alone would not
solve these problems

http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/labor01a-eng.htm

Is inequality a problem or not?

Redistribution of income

Income is redistributed through taxation and using the money to fund welfare programmes and
services (such as health care and education). Redistribution shifts the Lorenz curve closer to the 45 0
line.

A famous analogy by Arthur Okun1 was that,

“Money can only be carried from the rich to the poor in a ‘leaky bucket. Some of it doesn’t make it to
the poor” (p91).

1
“Equity and efficiency; the big tradeoff”; Arthur Okun, 1975 Washington DC; Brooking Institution.
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Okun argued that here is a trade- off between equity and efficiency when income is redistributed.
Economic efficiency means no loss of consumer or producer surplus, but in fact, there will be some
loss of efficiency in this case. Canada Revenue Agency (which collects taxes) and the welfare
agencies are expensive to run, using skilled labour, so some of the taxes are used just to pay for
running the tax system - an opportunity cost.

He further argued that the downside of redistribution is reduced incentives to work/earn as tax payers’
income is reduced. If people work and save less (the demand and supply of labour show that income
taxes shift the supply curve back – less labour is supplied) this is a deadweight loss. There is less
consumer demand and less income to tax. People will also find ways to avoid taxation and the time
and effort going into tax avoidance is another opportunity cost.

He also argued that there is a disincentive due to welfare – people may be less motivated to work, get
training or to invest in education.

This is the basis for those economists who believe that inequality is a necessity and that redistribution
can slow down economic growth.

The argument can be taken too far (reductio ad absurdum) – suggesting that trying to have complete
equality is doomed to fail as it did in the old style communist countries. However many economists
are not suggesting that we have complete equality but that we have less inequality – it is a question of
how much inequality we accept.

A recent study by the IMF2 typifies those economists who believe that inequality itself can inhibit
economic growth (the opposite to Okun). It argues that more equality is correlated to faster and longer
lasting growth and that only in extreme cases of redistribution (too much redistribution) are there
negative effects on growth. There does not seem to be any statistical evidence of a trade off between
growth and equality (in other words, increased equality does not lead to lower economic growth).
The problem is that inequality leads to poor outcomes in health and access to education/training (key
factors in growth) and a lack of social consensus (there is hostility between the advantaged and
disadvantaged - unions and employers, skilled and unskilled, rich and poor, employed and
unemployed, included and excluded, etc). Wealthier people/large corporations have greater political
influence and are more likely to get governments that benefits them. This leads to political and
economic instability (strikes for example), which hinders long term growth. Currently, Thomas
Piketty is a leading economist who would favour this argument.

Redistribution of income

In order to look at the way in which income is distributed and whether or not it should be
redistributed, we have to look at the philosophical underpinnings of economic systems. How do we
decide what is best for society?
An early notion of distribution was utilitarianism, sometimes expressed in the term “The greatest
happiness of the greatest number”. The concept of diminishing marginal utility would tell us that
income taken from the wealthy and given to the poor would increase overall utility (happiness). The
increase in utility of the poor person is greater than the decrease in utility of the rich person.

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IMF Research Department: Redistribution, Inequality, and Growth
Jonathan D. Ostry, Andrew Berg, Charalambos, G. Tsangarides; April 2014
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Utility Utility

Utility Function Utility Function

Income
Income

The total utility would increase as the gain for the lower income person is greater than the loss for the high
income person.
The idea was that we should move towards equality of wealth. A problem with this is that taking
income from the wealthy to give to the poor affects incentives. Wealthy entrepreneurs would be less
likely to want to invest in their business (capital investment falls) and high wage earners are less
likely to want to work so much (labour supply falls). In effect there would be less GDP which would
mean that there would be lower incomes for all, including the poor.
There are further problems with utilitarianism, which we will see later.

The work of John Rawls3 addresses this exact question. He formulates two basic principles: There
should be:
1. Equality in rights and duties
2. Equality in wealth unless allowing some person or group to be wealthier than others,
will benefit the whole society.

Equality in rights and duties. The problem is how a society would choose the rights, duties,
distribution of wealth and power in a society in an unbiased way.
People whose income/wealth was above average would not want any redistribution of wealth as it
would make them worse off. People who were below average income would want redistribution as it
would make them better off.
Rawls used a thought experiment (what philosophers do when you can’t do a real life experiment). He
imagined what would happen if people had to decide on the distribution of wealth, power and access
to education or health services etc. without knowing their own place in society. People would not
know their talents, academic ability, health, the advantages or disadvantages of family connections or
ethnic group etc. Rawls called this the veil of ignorance, it meant that people couldn’t try to influence
the distribution of wealth for their own benefit.
Given that people would face a higher probability of being disadvantaged (there are many more poor
people than rich people), they are more likely to opt for a society that had some kind of redistribution
of income to and limits to power to ensure a reasonable quality of life for all – people don’t want to
risk living in poverty. Rawls called this the minimum position.

...Unless
This might have suggested a sort of communist distribution of income with total equality, like the
utilitarian position, however Rawls did recognise the importance of incentives and rewards in
increasing overall economic and income growth. For example, entrepreneurs are likely to be in a more
economically advantaged position (wealthier) but this would be accepted if it increased the position of

3
John Rawls Theory of Justice 1971
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all people in society (particularly the most disadvantaged) and not just the entrepreneur. This could
happen if the entrepreneurs were creating jobs, inventing new, useful technologies or finding cures for
diseases etc. So there could be some inequality of income, the entrepreneur would be allowed to have
a higher income as an incentive to make everyone better off.
The role of government would be to ensure equal opportunities to education, freedom of choice of
occupation, determine the social minimum, deal with market failures and prevent the concentration of
wealth and power.

The counter argument

A problem with the redistribution is whether or not one group in society has the right take income
away from another group. This is exactly the issue that was addressed by Robert Nozick4.
He argued that redistribution doesn’t take into account how the distribution of wealth came to be in
the first place. If a person gains their wealth through free, voluntary exchange or through freely given
gifts, we have what he called, Justice of Acquisition. There was nothing illegal or inherently wrong
in the way that they came by their wealth. The sum of all these free exchanges must therefore result in
a fair distribution of wealth.5 If the existing distribution of wealth is fair, then no one has the right to
alter it.
He argued therefore that the role of government should be minimal and limited to enforcing contracts,
preventing fraud etc and not otherwise redistributing wealth or providing services.
He is against the utilitarian principle of redistribution as it only shares out wealth based on the status
quo, that is, it starts from the existing distribution of wealth and doesn’t consider if that initial position
was gained fairly. He argues that we cannot accept this – if people have justly gained their wealth, it
cannot be taken from them; if some people have unjustly gained their wealth there should be
recompense.
Nozick argues strongly that Rawls’ original position can only ever result in choosing equality as this
is the way in which the experiment set up. People were bound to choose to redistribute wealth if they
faced the probability of poverty. However, this thought experiment ignores the reality that people do
know their position and it may have been attained fairly and legally.

There are problems with Nozick’s analysis:

 Are economic interactions free and voluntary? Someone who is socially disadvantaged (poor,
unskilled or part of an excluded group) does not have a choice about the work that they do or
the wages that they are paid – it is not a free or voluntary exchange of labour for wages. The
profits that a business makes in this respect would not come under Justice of Acquisition.
 Similarly, wealthy, powerful nations and corporations have often built their position
historically on colonialism and slavery, with the help of military power. Again, this would
not come under Justice of Acquisition. Furthermore, how would it be possible to compensate
people (or nations) for a process that may have begun in the 16th or 17th century?

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Anarchy, State and Utopia 1974
5
An interesting result of this is that if wealth is gained through unjust acquisition, retribution should be made.
This applies not only to individuals but to governments.
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Veil of Ignorance game

There is a compulsory course for which you will be assigned a grade. You do not know what the
subject is (so you do not know how good or bad you are in this area of study) – this is the veil of
ignorance. It could be Italian Renaissance poetry, dance, welding, inorganic chemistry or anything
else and it is selected randomly. It will affect your GPA.

There are 36 students.

The options are:

1. All students are given an equal grade, everyone would get a B-.
2. Alternatively you can take the unknown course and earn a grade in the usual way. Here are
the probabilities for each grade

Grade #Students Proby

A+ 1 3%
A 1 3%
A- 1 3%
B+ 1 3%
B 5 14%
B- 1 3%
C+ 1 3%
C 6 18%
C- 3 9%
D 3 9%
F 11 32%

This grade distribution is taken from previous results for Econ 201