CHAPTER 18

Income Distribution and Poverty

 EQUITY AND FAIRNESS
 We already know from the previous reporters what actions the
government do in order to improve market efficiency.
 Even if we achieved markets that are perfectly efficient, would
the result be fair? We now turn to the question of equity, or
fairness. Somehow the goods and services produced in every
society get distributed among its citizens.
 Why do some people get more than others? What are the
sources of inequality? Should the government change the
distribution generated by the market?
SOURCES OF HOUSEHOLD
INCOME
Why do some people and some families have
more income than others?
Households derive their incomes from
three basic sources:

(1) from wages or salaries received in

exchange for labor;

(2) from property—that is, capital, land,

and so on;

(3) from government.

 WAGES AND SALARIES
 Perfectly competitive market theory predicts that
all factors of production (including labor) are paid
a return equal to their marginal revenue
product—the market value of what they produce
at the margin.
 There are reasons why one type of labor might be
more productive than another and why some
households have higher incomes than others.
 REQUIRED SKILLS, HUMAN CAPITAL,
AND WORKING CONDITIONS

 Some people are born with attributes that

translate into valuable skills. LeBron James and
Kevin Garnett are great basketball players,
partly because they happen to be very tall. They
did not decide to go out and invest in height; they
were born with the right genes.
 Some people have perfect pitch and beautiful
voices; others are tone deaf. Some people have
quick mathematical minds; others cannot add 2
and 2
6’8”

6’11”
 The rewards of a skill that is in limited supply
depend on the demand for that skill. Men’s
professional basketball is extremely popular, and
the top NBA players make millions of dollars
 HUMAN CAPITAL
 Not all skills are inborn. Some people have
invested in training and schooling to improve
their knowledge and skills, and therein lies
another source of inequality in wages. Human
capital, the stock of knowledge and skills that
people possess, is also produced through on-the-
job training.
People learn their jobs and acquire “firm-specific”
skills when they are on the job. Thus, in most
occupations, there is a reward for experience. Pay
scale often reflects numbers of years on the job, and
those with more experience earn higher wages than
those in similar jobs with less experience.
 Some jobs are more desirable than
others. Entry-level positions in
“glamour” industries such as media
tend to be low-paying. Because
talented people are willing to take
entry-level jobs in these industries at
salaries below what they could earn
in other occupations, there must be
other, nonwage rewards. It may be
that the job itself is more
personally rewarding or that a low
paying apprenticeship is the only way
to acquire the human capital
necessary to advance.

KELSEY MERITT,
first ever Filipina
Victoria Secret
Model (2018)
 COMPENSATING DIFFERENTIALS
Non monetary differences between jobs where higher
or lower wages are paid because of differences of the
desirability of the job itself
  Compensating differentials are also required when a
job is very dangerous. Those who take great risks are
usually rewarded with high wages.

High-beam workers on
skyscrapers and bridges
command premium wages.

Firefighters in cities that

have many old, run-down
buildings are usually paid
more than firefighters in
relatively tranquil rural or
suburban areas
 MULTIPLE HOUSEHOLD INCOMES
Another source of wage inequality among
households lies in the fact that many households
have more than one earner in the labor force.
 THE MINIMUM WAGE
 One strategy for reducing wage inequity that has
been used for almost 100 years in many countries
is the minimum wage. A minimum wage is the
lowest wage firms are permitted to pay workers
 Effect of Minimum Wage
Legislation

If the equilibrium wage in

the market for unskilled
labor is below the
legislated minimum wage,
the result is likely to be
unemployment. The
higher wage will attract
new entrants to the labor
force (quantity supplied
will increase from L* to
LS), but firms will hire
fewer workers (quantity
demanded will drop from
L* to LD).
 UNEMPLOYMENT
 People earn wages only when they have jobs.
Unemployment hurts primarily those who are
laid off, and thus its costs are narrowly
distributed. For some workers, the costs of
unemployment are lowered by unemployment
compensation benefits paid out of a fund
accumulated with receipts from a tax on payrolls.
 INCOME FROM PROPERTY

Another source of income inequality is that some

people have property income—from the ownership
of real property and financial holdings—while
many others do not. Some people own a great deal
of wealth, and some have no assets at all.
 The amount of
property income that a
household earns
depends on

 (1) how much

property it owns and
 (2) what kinds of
assets it owns.

Such income generally

takes the form of
profits, interest,
dividends, and rents.
 INCOME FROM THE GOVERNMENT
 Transfer payments are payments made by
government to people who do not supply goods or
services in exchange. Some, but not all, transfer
payments are made to people with low incomes
precisely because they have low incomes.
Transfer payments thus reduce the amount of
inequality in the distribution of income.
 Not all transfer income goes to the poor. The
biggest single transfer program at the federal level
is Social Security. Transfer programs are by and
large designed to provide income to those in need.
They are part of the government’s attempts to
offset some of the problems of inequality and
poverty.
 THE NET COSTS OF IMMIGRATION
Based on the recent study of Borjas, Freeman and Katz takes issue with much
of the work done to date. They argue that immigrants do not stay in the cities at
which they are arrive but rather move within the United States in response to
job opportunities and wage differentials. Thus, they argue that the effects of
immigration on wages and unemployment must be analyzed at the national
level, not the city level.
Technological change also appears to play a role in increase in
inequality. More work is conducted with the aid of computers and less work
requires large inputs of unskilled labor. The important role of technology in
driving inequality suggests that going forward, education may be key to
reducing inequality in the United States and across the world.
 POVERTY
Poverty is a very complicated word to define. In simplest terms, it means the
condition of people who have very low incomes. Another definition term
simply as lack of money or material possesions.
Poverty should be measured by determining how much it costs to buy the
“basic necessities of life” Urban poverty is very different from rural poverty.
If poverty is a related concept, the definition of it might change significantly
as a society accumulates wealth and achieves higher living standards.
 THE DISTRIBUTION OF WEALTH
The distribution of wealth is more unequal than the distribution of
income. Part of the reason is that wealth is passed from generation to
generation and accumulates. Large fortunes also accumulate when
small business becomes successful.
 THE UTILITY POSSIBILITIES FRONTIER
 In discussing distribution, we should talk not
about the distribution of income or goods and
services, but about the distribution of well-being.

 In the nineteenth century, philosophers used the

concept of utility as a measure of well-being.
People make choices among goods and services on
the basis of the utility those goods and services
yield. People act to maximize utility
Suppose society consisted of two people, I and J. Next, suppose that
the line PP in Figure 18.3 represents all the combinations of I’s utility
and J’s utility that are possible, given the resources and technology
available in their society
Any point inside PP , or the utility possibilities frontier, is inefficient
because both I and J could be better off. A is one such point. B is one
of many possible points along PP that society should prefer to A
because both members are better off at B than they are at A

In practice, however, the market solution leaves some people out.

The rewards of a market system are linked to productivity, and
some people in every society are simply not capable of being very
productive or have not had the opportunity to become more
productive.
All societies make some provision for the very poor. Most often, public
expenditures on behalf of the poor are financed with taxes collected from
the rest of society. Society makes a judgment that those who are better off
should give up some of their rewards so that those at the bottom can have
more than the market system would allocate to them.
THE REDISTRIBUTION DEBATE
Debates about the role of government in correcting for inequality in the
distribution of income revolve around philosophical and practical issues.

o Philosophical issues- deal with the “ideal.” What should the distribution of
income be if we could give it any shape we desired? What is “fair”? What is
“just”

oPractical issues- deal with what is and what is not possible. Suppose we wanted
zero poverty.

How much would it cost, and what would we sacrifice? When we take
wealth or income away from higher-income people and give it to lower-income
people, do we destroy incentives?
ARGUMENTS AGAINST REDISTRIBUTION
 This argument rests on the proposition that “one is entitled to the
fruits of one’s efforts.

oThe argument against redistribution also rests on the principles behind

“freedom of contract” and the protection of property rights.

When you agree to sell your labor or to commit your capital to use, you do so
freely. In return, you contract to receive payment, which becomes your
“property.”
The more common arguments against redistribution are not philosophical.
Instead, they point to more practical problems. First, it is said that taxation and
transfer programs interfere with the basic incentives provided by the market

o Taxing higher-income people reduces their incentive to work,

save, and invest

oTaxing the “winners” of the economic game also discourages risk

taking

oFurthermore, providing transfers to those at the bottom reduces

their incentive to work as well

All of this leads to a reduction in total output that is the “cost” of redistribution