Economic Inequality

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CHAPTER
Economic Inequality
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After studying this chapter you will be able to

• Describe the inequality in income and wealth in
  the United States and the trends in inequality
• Explain the features of the labor market that
  contribute to economic inequality
• Describe the scale of income redistribution by
  government

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Rags and Riches

• Homelessness and abject poverty exists alongside
  extreme wealth.
• What determines the distribution of economic
  well-being?
• How much redistribution does government do to
  limit extreme poverty?

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Measuring Economic Inequality

• The census bureau defines a households income as
  money income, which equals market income plus
  cash payments to households by the government.
• Market income equals wages, interest, rent, and
  profit earned by the household in factor markets,
  before paying income taxes.

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Measuring Economic Inequality
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Measuring Economic Inequality

• The Distribution of Income
• Figure 18.1 shows the distribution of income
  across the 113 million households in the United
  States in 2005.

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Measuring Economic Inequality

• The mode income is the most common income and was
  about 13,000.
• The median income is the level of income that
  separates the population into two groups of equal
  size and was 46,326.
• The mean income is the average income and was
  63,344.

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Measuring Economic Inequality

• A distribution in which the mean exceeds the
  median and the median exceeds the mode is
  positively skewed, which means it has a long tail
  of high values.
• The distribution of income in the United States
  is positively skewed.

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Measuring Economic Inequality

• Figure 18.2 shows the distribution of income
  shares for the United States in 2005.

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Measuring Economic Inequality

• In 2005
• The poorest 20 of households received only 3.4
  of the total income.
• The middle 20 received 14.6 of total income.
• The richest 20 received 50.4 of total income.

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Measuring Economic Inequality

• The Income Lorenz Curve
• The income Lorenz curve graphs the cumulative
  percentage of income earned against the
  cumulative percentage of households.
• Figure 18.3 shows the income Lorenz curve for the
  income shares in Figure 18.2.

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Measuring Economic Inequality

• The vertical axis of a Lorenz curve is the
  cumulative percentage of total income.
• The horizontal axis is the cumulative percentage
  of households.

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Measuring Economic Inequality

• If everyone has the same income,
• the income Lorenz curve is a 45 degree line from
  the lower left corner to the upper right corner.
  This line is called the line of equality.
• The Lorenz curve shows the cumulative
  distribution of income.

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Measuring Economic Inequality

• The Distribution of Wealth
• A households wealth is the value of all the
  things that it owns at a point in time.
• The distribution of wealth is another way of
  examining the degree of economic inequality.

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Measuring Economic Inequality

• A wealth Lorenz curve measures the distribution
  of wealth in the same way an income Lorenz curve
  measures the distribution of income.
• The distribution of wealth is even more unequally
  distributed than income.

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Measuring Economic Inequality

• Wealth Versus Income
• Wealth is a stock of assets and income is a flow
  of earnings that result from a given stock of
  wealth.
• The reason that wealth is more unequally
  distributed than income is that wealth does not
  measure the quantity of human capitalonly income
  reflects the quantity of human capital.
• Because wealth does not reflect potential for
  income from human capital, income is a more
  accurate measure of economic inequality.

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Measuring Economic Inequality

• Annual or Lifetime Income and Wealth?
• A households income and wealth change over time.
• A household headed by a young person starts out
  with moderate income and accumulates wealth for
  retirement years.
• A middle-age headed household is in its highest
  earning years and enjoys the highest level of
  wealth.
• A households headed by an older, retired person
  has lower earning and is consuming, rather than
  accumulating, its wealth.

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Measuring Economic Inequality

• Trends in Inequality
• To measure inequality as an index number, we use
  the Gini ratio, which equals the ratio of blue
  area to the red area in the two figures below.

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Measuring Economic Inequality

• With perfect equality, the Lorenz curve is the
  line of equality and the Gini ratio is zero.

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Measuring Economic Inequality

• With the most extreme inequalityone person has
  all the incomethe Lorenz curve runs along the
  axes and the Gini ratio is one.

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Measuring Economic Inequality

• The closer the Gini ratio is to one, the more
  unequal is the distribution of income. In 2005,
  the U.S. Gini ratio was 0.47.

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Measuring Economic Inequality

• Figure 18.5 shows the U.S. Gini ratio from 1970
  to 2005.
• The Gini ratio shows that the distribution of
  income in the United States has become more
  unequal.
• Despite the change in the definition in 1992, the
  trend is still visible.

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Measuring Economic Inequality

• Who Are the Rich and the Poor?
• Figure 18.6 on the next slide identifies the five
  characteristics that appear to influence the
  amount of income earned by a household.
• These characteristics are
• Education
• Type of household
• Age of householder
• Race

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Measuring Economic Inequality
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Measuring Economic Inequality

• Poverty
• Poverty is a situation in which a households
  income is too low to be able to buy the
  quantities of food, shelter, and clothing that
  are deemed necessary.
• Poverty is a relative concept.
• In 2005, the poverty level calculated by the
  Social Security Administration for a four-person
  family was 19,971.
• 37 million Americans lived in households with
  incomes below this poverty level12.6 percent of
  the total population in 2005.

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Measuring Economic Inequality

• The distribution of poverty by race is unequal
• In 2005, 8.5 percent of white Americans lived in
  poverty compared to 22 percent of Hispanic-origin
  Americans and 25 percent of African Americans.
• Poverty is also influence by household status
• More than 31 percent of households in which the
  householder is a female with no husband present
  had incomes below the poverty level.

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The Sources of Economic Inequality

• Inequality arises from unequal labor market
  outcomes and from unequal ownership of capital.
• Two significant features of labor markets create
  income differences among individuals
• Human capital differences
• Discrimination

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The Sources of Economic Inequality

• Human Capital
• The more human capital a person possesses, the
  more income that person likely earns, other
  things remaining the same.
• On the demand side of the labor market,
  high-skilled workers generate a larger marginal
  revenue product than low-skilled workers.
• So firms are willing to pay a higher wage rate
  for high-skilled labor.

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The Sources of Economic Inequality

• Figure 18.7(a) shows the difference in demand
  curves for high-skilled versus low-skilled labor.

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The Sources of Economic Inequality

• On the supply side of the labor market,
  high-skilled workers incur a cost of acquiring
  their skillsmoney costs as well as time costs.
• So high-skilled workers are willing to supply
  labor only at wage rates that compensate them for
  those costs, which exceed the wage rates at which
  low-skilled workers are willing to supply labor.

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The Sources of Economic Inequality

• Figure 18.7(b) shows the difference in supply
  curves for high-skilled versus low-skilled labor.

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The Sources of Economic Inequality

• Figure 18.7(c) shows the difference in
  equilibrium wage rates.
• The higher demand and lower supply for
  high-skilled workers relative to low-skilled
  workers creates a higher equilibrium wage rate
  for those workers with greater human capital.

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The Sources of Economic Inequality

• Figure 18.8 shows how technological change and
  globalization combined with skill differences
  have widened the income gap between low-skilled
  and high-skilled labor.
• The demand for low-skilled labor has decreased
  and the wage rate has fallen.

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The Sources of Economic Inequality

• The demand for high-skilled labor has increased
  and the wage rate has risen.

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The Sources of Economic Inequality

• Discrimination
• Human capital differences can explain some of the
  economic inequality we observe.
• Discrimination is another possible source of
  income inequality.
• If the marginal revenue product of one race or
  one sex is perceived to be higher than that of
  another race or another sex, the equilibrium wage
  rates will vary across each racial or gender
  group, despite holding the level of human capital
  constant.

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The Sources of Economic Inequality

• Suppose that firms perceive white males to be
  more productive workers than black females.
• Then the perceived marginal revenue product
  (which is also the labor demand curve) for white
  men would be higher than that for black women.

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The Sources of Economic Inequality

• Figure 18.9 shows the potential effect of
  discrimination of the wage rates of white men and
  black women.
• If black women are discriminated against, the
  perceived MRP is lower and their wage rate and
  employment level decrease.

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The Sources of Economic Inequality

• If white men are discriminated for, the perceived
  MRP is higher and their wage rate and employment
  level increase.

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The Sources of Economic Inequality

• Economists disagree to the extent that
  discrimination pervades the labor market.
• One line of reasoning states Firms that
  discriminate would have higher production costs
  (pay higher wages for the same marginal revenue
  product) than those that do not.
• If this line of reasoning is correct,
• 1. The profit margins for the firms practicing
  discrimination will be lower.
• 2. The market prices of their goods and services
  would be higher than non-discriminating firms.

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The Sources of Economic Inequality

• Either way, the market pressures increase the
  opportunity cost to firms (and the consumers who
  buy their product) for practicing discrimination,
  eventually eliminating these practices.
• Another line of reasoning is that claims of sex
  discrimination can be explained by differences
  between the men and women regarding their
  willingness, on the average, to specialize in
  providing income generating labor versus
  providing non-income generating labor in the home.

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The Sources of Economic Inequality

• More women than men work at home for a portion of
  their adult life while engaged in child rearing
  and/or running the household.
• This allocation of time means that womens wages
  will be lower, on the average, than mens wages.
• Accounting for this difference in labor
  specialization has been found to explain much of
  the wage differentials between men and women.

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The Sources of Economic Inequality

• Unequal Wealth
• The inequality of wealth (excluding human
  capital) is much greater than the inequality of
  income.
• This inequality arises from savings and wealth
  transfers between generations.
• There are two significant aspects of
  intergenerational wealth transfers that increase
  economic inequality
• 1. Debt cannot be transferred across generations
• 2. Marriage concentrates wealth

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Income Redistribution

• The three main ways governments in the United
  States redistribute income are
• Income taxes
• Income maintenance programs
• Subsidized services

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Income Redistribution

• Income Taxes
• The U.S. federal government and most state
  governments tax incomes.
• By taxing incomes of different levels at
  different tax rates, economic inequality can be
  decreased.
• A progressive income tax is one that taxes income
  at an average rate that increases with income.
• The U.S. income tax system and all state income
  tax systems are progressive income tax systems.

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Income Redistribution

• A regressive income tax is one that taxes income
  at an average rate that decreases with income.
• A proportional income tax (also called a
  flat-rate income tax) is one that taxes income at
  a constant average rate for all income levels.

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Income Redistribution

• Income Maintenance Programs
• Three major types of programs provide direct
  payments to individuals
• Social security programs
• Unemployment compensation
• Welfare programs

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Income Redistribution

• Subsidized Services
• A great deal of redistribution takes the form of
  subsidized servicesservices provided by the
  government at prices below the cost of
  production.
• An example is primary and secondary public
  education, as well as state colleges and
  universities.
• The students at these institutions generally pay
  tuition and fees that range from 20 to 25 of the
  actual cost of educating a college student.
• The families of these students enjoy a sizeable
  subsidy for acquiring human capital.

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Income Redistribution

• The Scale of Income Redistribution
• Market income tells us what a household earns in
  absence of redistribution.
• Start with market income then subtract taxes and
  add the amounts received from the government.
• In 2001, the 20 percent of households with lowest
  incomes net benefits that increase their share of
  total income from 0.9 percent to 4.6 percent.
• In 2001, the 20 percent of households with
  highest incomes paid net taxes that decreased
  their share of income from 55.6 percent to 46.7
  percent.

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Income Redistribution

• Figure 18.10 shows the scale of government
  redistribution in 2001.
• The blue curve show the distribution of market
  income distribution.
• The green curve, the distribution after taxes and
  benefits, is
• more equal than the distribution of market
  income.

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Income Redistribution

• The three lower income groups gain
• and the highest income group loses.

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Income Redistribution

• The Big Tradeoff
• Redistributing income leads to a tradeoff between
  equity and efficiency, known as the big tradeoff.
  Programs to redistribute income are inefficient
  for three reasons
• The process of income redistribution uses up
  resources that could have otherwise been used for
  producing goods and services.
• Redistribution of income requires taxes to be
  imposed on the economy, which was shown in an
  earlier chapter to generate a deadweight loss in
  the markets that are taxed.

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Income Redistribution

• Income redistribution decreases the incentives
  for
• 1. Taxpaying workers to provide labor when
  leisure is a normal good (by decreasing income
  from work) and
• 2. Income assistance recipients to provide labor
  and earn income.
• A major challenge in the U. S. today is finding
  ways to assist the poorest identifiable group
  young minority women who have not completed high
  school, have dependent children, and live without
  a spouse in the household.

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Income Redistribution

• The long-term solution to their plight is
  education and job trainingacquiring human
  capital.
• The short-term solution is enforcing child
  support payments from absent fathers and former
  husbands, and providing welfare assistance. But
  it must be designed to minimize the disincentive
  to become self-sufficient.

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Income Redistribution

• Welfare reform occurred in 1996 when the
  Temporary Assistance for Needy Families (TANF)
  program was implemented.
• TANF is a block grant to the states, not an
  open-ended entitlement program for individuals.
• An adult member of a family receiving assistance
  must either work or perform community service and
  there is a five-year limit for receiving
  assistance.

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THE END