978-0133872293 Chapter 19 Lecture Note

Unlock access to all the studying documents.

View Full Document

W H AT I S E C O N O M I C S ? 2 1 1

T h e B i g P i c t u r e

Where we have been:

Chapter 18 explained how factor markets allocate income based on demand

and supply for land, capital, and labor. Chapter 19 examines how the factor

market outcomes in(uence the distribution of income and wealth in society.

This chapter explains how we measure the degree of inequality, the

characteristics of households at di+erent places in the distribution, trends in

inequality, and redistribution policies. A theme of the chapter is the role played

by human capital and the resulting increase in productivity in a+ecting the

distribution of income.

Where we are going:

The following chapter is the last of the microeconomic theory chapters. It

focuses on risk and uncertainty and market e-ciency in the face of

uncertainty.

N e w i n t h e Tw e l f t h E d i t i o n

More data and analysis about inequality in the distribution of wealth have been

included. The introduction and conclusion consider the high pay packages that

have been awarded to female executives in technology industries. A new Worked

Problem section has been added. Using data from Norway and South Africa, the

Worked Problem takes the students through the creation of a Lorenz curve. Then it

shows the students how to use Lorenz curves to compare economic inequality and

what would be necessary to make the distribution of income more equal. To

include the new Worked Problem without lengthening the chapter, some problems

have been removed from the Study Plan Problem and Applications. These

problems are in the MyEconLab and are called Extra Problems.

19ECONOMIC

INEQUALITY

C h a p t e r

211

L e c t u r e N o t e s

Economic Inequality

 Incomes are distributed unequally.

 In large part, features of the labor market account for the unequal distribution of

income.

 Other factors also a+ect income inequality.

 The government has policies that redistribute income.

I. Economic Inequality in the United States

Money income equals market income plus cash payments to households by the

government. Market income equals wages, interest, rent, and pro3t earned in

factor markets before paying income taxes. In the United States in 2012, the median

income was $51,017, and the mean income was $71,274.

Where are you in the income distribution? Ask the students to place themselves in

the U.S. income distribution by estimating their household income. Be sure to remind them

to add together the income of both of their parents if they live with both and both earn

income. Many students will be surprised that they are from upper-middle income families,

even if they suspected that they were middle income to lower middle income families.

The Distribution of Income

 The distribution of income in the U.S. is positively skewed, so that the distribution of

incomes has a long tail of high income households. In 2012,

 the poorest 20 percent of households received 3.2 percent of total income

 the middle 20 percent of households received 14.4 percent of total income

 the richest 20 percent of households received 51.1 percent of total income.

The Income Lorenz Curve

 An income Lorenz curve graphs the cumulative percentage of income earned

against the cumulative percentage of

households.

 The table below has the (approximate)

income shares for the United States and

the 3gure graphs the resulting Lorenz

curve.

Households

(percentage)

Income

(percenta

ge)

Income

(cumulativ

percentage

)

Lowest 20 3 3

Second 20 9 12

Middle 20 15 27

Next highest

23 50

Highest 20 50 100

 The “Line of Equality” shows what the distribution of income would be if incomes

were equally distributed. The closer the Lorenz curve to the line of equality, the more

equal is the distribution of income and the farther away the Lorenz curve from the

line of equality, the less equal is the distribution of income.

Interpreting the Lorenz curve. Emphasize that the Lorenz curve measures economic

equality within a given population. Ask: which is more unequal, the distribution of income

in the United States or the distribution of income among the 849 major league baseball

players? After a minute or two of discussion, you can provide the data in the table below.

Make the point that although income is much more unequally distributed among major

league baseball players, in 2009 the poorest earned $400,000 a year, which is more than

twice the average of the 3fth quintile in the United States, $180,000. Relate this reality to a

comparison of countries to the United States. Get the students to consider the fact that the

average income person living in the poorest quintile in the United States is still enjoying a

higher level of income than the median income individual living in any of a majority of

other countries around the world.

Quintile U.S. Households Major league baseball players

percentage of income percentage of income

Lowest 3.2 1.8

Second 8.3 2.8

Middle 14.4 8.2

Fourth 23.0 24.0

Highest 51.1 63.3

The Distribution of Wealth

 Wealth is the value of all the things that are owned by a household at a given point

in time. The distribution of wealth can be examined with a Lorenz Curve. Because

human capital is not included in measured wealth, the distribution of wealth is more

unequal than the distribution of income and the income distribution is a more

accurate measure of economic inequality.

Annual or Lifetime Distribution of Wealth?

 Household income varies over the life cycle, typically starting out low, growing to a

peak at retirement, and then falling after retirement. Wealth follows a similar

pattern.

 Inequality in annual income and wealth data overstates life time inequality because

households are at di+erent stages in their life cycles.

Trends in Inequality

 The Gini ratio is based on the Lorenz curve and equals the ratio of the area

between the line of equality and the Lorenz curve to the entire area beneath the line

of equality. The larger the Gini ratio, the more unequal the distribution. The Gini ratio

shows that since 1970 the distribution of income in the United States has become less

equal.

Economics In Action considers the growing inequality of U.S. incomes. It notes the steady

increase in income share for the richest Americans. In 2012 67 percent of Americans

surveyed said that incomes were too unequal when in 1991 only 21 percent said this. The

Economics in Action feature also presents data on the impact of education, type of

household, age, race, and region on incomes.

Poverty

Poverty is a situation in which a household’s income is too low to be able to buy the

quantities of food, shelter, and clothing that are deemed necessary. In 2012, the

poverty level calculated by the Social Security Administration for a four–person

family was $23,492.

 In 2012, 46 million Americans, 15 percent of the population, lived below the poverty

level..

 Race: In 2012, 13 percent of white Americans lived in poverty compared to 26

percent of Hispanic-origin Americans and 27 percent of black Americans.

E C O N O M I C I N E Q U A L I T Y 1 9 1

 Age: Poverty rates are 22 percent for children and 9 percent for seniors over age

65.

 Work Experience: The poverty rate for those with jobs is 7 percent or for those

without 33 percent.

 Physical Ability: 29 percent of people with disabilities are poor.

 Household Status: 28 percent of households headed by women with no husbands

present experience poverty.

The Economics in Action considers whether the American Dream is still alive. It uses data

to examine mobility up and down the income distribution. The analysis concludes that

between 2007 and 2009 most households did not move from one quintile to the next. But

there is still mobility, to both higher and lower quintiles.

II. Inequality in the World Economy

Income Distribution in Selected Countries

 Countries such as Brazil and South Africa have more unequally distributed incomes,

with the average person in the highest quintile receiving 32.5 times the income of

the average person in the lowest quintile. The United States lie somewhere in the

middle globally, with the average person in the highest quintile receiving 10 times

the income of the average person in the lowest quintile. Finland and Sweden have

more equally distributed incomes, with the average person in the highest quintile

receiving 4.4 times the income of the average person in the lowest quintile.

 Brazil and South Africa are somewhat extreme and have relatively small and rich

European populations and relatively large and poor indigenous populations.

 Finland and Sweden are also somewhat extreme, but less unusual. They are

similar in income distribution to many European countries where governments

pursue aggressive income redistribution policies.

Global Inequality and Its Trends

 The global distribution of wealth is much more unequal than the distribution within

any one country.

 Many nations are still pre-industrial and very poor, while others are sophisticated

industrial producers and accordingly quite rich.

 3 billion people or 50 percent of the world’s population live on $2.50 per day or less.

2 billion people or 30 percent of the world’s population live on more than $2.50 and

less than $10 per day. That means 5 billion people or 80 percent of the world’s

population live on $10 per day or less.

 An average person in the United States has an income of $115 per day. The average

person in the highest quintile in the industrialized countries has $460 per day. The

average American earns 46 times the income of half the world’s population and 11.5

times the income of 80 percent of the world’s population.

 The world Gini ratio in 2009 is about .64. The U.S. Gini ratio is about .47. These Gini

ratios mean the world’s Lorenz curve lies much farther to the right (away from the

line of equality) than the U.S. curve.

 Over time, incomes have become more unequal in the United States and the same

trend can be found in most economies. But while incomes are more unequal within

countries, the world distribution of income as a whole is becoming less unequal. The

average incomes in poor countries are rising faster than the average incomes in rich

countries, narrowing the gap across countries.

Is capitalism heartless? Emphasize that there are no societies where income or wealth

is equally distributed. Society has two main concerns: prosperity and equality. Private

enterprise (capitalist) societies are, in general, more prosperous, and in most cases (but

not all) have no less equal an income distribution than socialist societies. Ask which is

1 9 2 C H A P T E R 1 9

better for a family, to be the poorest in a rich but unequal society or equal with everyone

else in a poor society.

III. The Sources of Economic Inequality

Human Capital

In labor markets, di+erences in human capital as well as discrimination can lead to

di+erences in incomes.

 In general, people with more human capital are high-skilled workers. Skills a+ect

both the demand and supply side of the labor market:

 High-skilled workers have a larger

VMP than low-skilled workers, so the

demand for high-skilled workers

exceeds the demand for low-skilled

workers.

 High-skilled workers must incur the

cost of acquiring their skills, so the

supply of high-skilled workers is less

than the supply of low-skilled workers.

 As the 3gure shows, the combination

of higher demand (DH compared to

DL) and lower supply (SH compared to

SL) for high-skilled workers versus

low-skilled workers leads to a higher

wage rate for high-skilled workers.

 The wage di+erential between

high-skilled and low-skilled workers has widened over time because technological

changes and globalization have increased the demand for high-skilled workers and

decreased the demand for low-skilled workers. (Technological change has been a

complement for high-skilled workers and substitute for low-skilled workers.)

Discrimination

 Discrimination is another possible source of income inequality. The VMP of the group

being discriminated against is less than the VMP of the other group, so

discrimination can lower the wage rate of the group being discriminated against.

Economists disagree to the extent that discrimination actually a+ects wage rates.

 One line of reasoning states that those 3rms that practice discrimination face higher

costs than those 3rms that do not. As a result, the pro3ts of the discriminating 3rms

will be lower and the market price of their goods and services will be higher so that

these 3rms cannot survive in competitive markets.

 How much workers choose to specialize primarily in a career versus spending more

time and energy on home life a+ects wages. This factor explains part of the wage

gap between married men and other types of workers. When the wages of never

married men and never married women with the same amount of human capital

were compared, wages of the two groups were the same.

Contests Among Superstars

 Some of the really large di+erences in wages cannot be accounted for by di+erences

in human capital. Contests among superstars can explain this di+erence.

 Contests with prizes do a good job of allocating scarce resources e-ciently when the

e+orts of participants are hard to monitor and reward directly. This describes the

case for CEOs and other stars.

 The prizes are so di+erent because they need to induce enough e+ort.

E C O N O M I C I N E Q U A L I T Y 1 9 3

 In sports, globalization has increased the total revenue generated by sports. The

total prize money has increased and, to generate enough e+ort amongst all the

players, the share going to winner has increased.

 In business, more businesses are global in nature so the number of executives

vying for the top positions has increased. To generate enough e+ort amongst all

the executives, the salary paid the CEO—the “winner” of the “contest”—has

increased.

What demographic characteristics are correlated with household income? List the

demographic characteristics that tend to be correlated with household income: level of

education, size of household, and marital status, for example. These result from individual

choices and not from characteristics outside the individual’s control (age or race).

Emphasize that not all who are living in the lowest (or highest) income quintile will remain

in that same economic situation in the long term. Emphasize that private enterprise

democracies create dynamic socio-economic pathways for their citizens. Investing in

human capital today (deferring current consumption) ensures a much more prosperous life

for tomorrow. Advise your students that this investment is much harder to implement after

reaching middle age than as a young adult.

Unequal Wealth

Greater wealth inequality arises from two sources: life cycle saving patterns and

transfers of wealth from one generation to the next.

 Life-Cycle Saving Patterns: Wealth is built over one’s lifetime, so much of the wealth

is owned by people in their sixties.

 Intergenerational Transfers: Households that inherit wealth are likely to transfer that

wealth to the next generation.

 Marriage and Wealth Concentration: Assortive mating (“like attracts like”) implies

that wealthy people seek wealthy partners, so wealth becomes concentrated in a

small number of families.

IV. Income Redistribution

 Governments in the United States use three main ways to redistribute income: taxes,

income maintenance programs, and subsidized services.

Income Taxes

 All levels of government collect income taxes. Income taxes may be progressive,

regressive, or proportional. A progressive income tax is one that taxes income at

an average rate that increases with income. A regressive income tax is one that

taxes income at an average rate that decreases with income. A proportional

income tax (also called a (at income tax) is one that taxes income at a constant

average rate, regardless of income.

The U.S. federal income tax is progressive. Ask the students if they think they know the tax

burden paid by the richest 1 percent, 5 percent, and 10 percent of taxpayers. The students

usually underestimate how progressive the income tax rate system is. IRS 3gures based on

income tax returns collected for the year 2008 reveal that:

 The richest 1 percent paid 38 percent of all income taxes collected.

 The richest 5 percent paid 58.7 percent of all income taxes collected.

 The richest 10 percent paid 69.9 percent of all income taxes collected.

 The lowest 50 percent paid 2.7 percent of the total income tax collected.

Clearly the progressive nature of the federal tax system redistributes income away from

richer households.

Income Maintenance Programs

There are three major types of programs that redistribute income by making direct

payments to people in the lower part of the income distribution:

1 9 4 C H A P T E R 1 9

 Social security programs: Old Age, Survivors, Disability, and Health Insurance

(OASDHI) makes monthly cash payments to retired or disabled workers or their

surviving spouses and children.

 Unemployment compensation: Every state government has established an

unemployment compensation program that taxes all workers in the state and gives

unemployed workers in the state a periodic cash bene3t for a speci3ed period of

time.

 Welfare programs: Welfare programs provide incomes for people with incomes below

a speci3ed level and who do not qualify for social security or unemployment

programs. These programs include the Supplementary Security Income (SSI)

program, the Temporary Assistance for Needy Households (TANF) program, the Food

Stamp program, and Medicaid.

Subsidized Services

 A great deal of income redistribution takes place in the United States through the

provision of subsidized services, services provided by the government at prices

below the cost of production. Examples include primary and secondary public

education, as well as state colleges and universities. Medicare and Medicaid are

other examples of subsidized services.

An Economics in Action feature presents data that shows how government taxes and

bene3t programs redistribute income and make the distribution more equal.

The Big Tradeof

 Redistributing income leads to a tradeo+ between equity and e-ciency, known as

the big tradeof. Programs to redistribute income lead to ine-ciency because the

process of income redistribution uses up resources and, more importantly, because

redistribution decreases the incentives for the taxpaying workers to provide labor

and decreases the incentives for the bene3t recipients to provide labor.

What are the costs of redistributing income? Emphasize that there is an opportunity

cost to redistributing income in any society: when a dollar is taken from a rich person, a

poor person receives less than a dollar. The size of the economic pie shrinks because:

Productive resources are consumed to implement the program rather than produce

goods and services,

 Redistribution requires taxation of income or exchange, which imposes a dead weight

loss to society, and

 The incentives facing the recipient of supplemental income are altered, delaying

re-entry into the work force.

Economics in the News: Using a recent hire by Apple as its launching point, the

application considers trends in incomes of the superrich and why the prizes may be larger

for the winners than they were in the past.

E C O N O M I C I N E Q U A L I T Y 1 9 5

A d d i t i o n a l P r o b l e m s

1. How does the minimum wage a+ect the distribution of income?

2. Compared to the United States, managers in Hong Kong and Malaysia are

paid much more than the low-skilled factory workers that they supervise.

What accounts for this di+erence in relative pay?

3. Many pets in rich nations eat better than people in poor nations. To equalize

the international distribution of income, do you think that rich nations should

tax their citizens and give the income to the poor of very poor nations? Would

this policy be fair?

S o l u t i o n s t o A d d i t i o n a l P r o b l e m s

1. The minimum wage a+ects the distribution of income in several ways. First, workers

who without the minimum wage would be paid less, receive a higher income than

otherwise with the minimum wage. Because these workers are low-income workers,

the minimum wage makes the distribution of income a bit more equal. Second, some

workers lose their jobs when a minimum wage is imposed. These workers’ incomes fall

and the minimum wage makes the distribution of income less equal. Finally, the

minimum wage probably decreases some 3rms’ pro3ts and so decreases their owners’

incomes. Because owners are generally higher–income earners, the minimum wage

makes the distribution of income more equal.

2. The di+erence in pay is a result of the fact that managerial skills are in much smaller

supply in Hong Kong and Malaysia. There are many low-skilled factory (oor workers in

Hong Kong and Malaysia. There are few high-skilled managers. As a result, the

equilibrium wage rate paid to the few high-skilled managers in Hong Kong and

Malaysia is many times greater than the wage rate paid to the many low-skilled

factory (oor workers.

3. It is indeed the case that people in rich nations are much better o+ than people in poor

nations. Rich nations are better o+ because their citizens are more productive because

they have immensely greater amounts of physical and human capital. The question of

redistributing income from one nation to another has a big tradeo+ associated with it.

In particular, while the transfer of income to poorer nations equalizes income among

nations, it lessens the poor nations’ incentives to develop and so slows their economic

growth. In addition, the issue of fairness comes into play. The “fair results” approach

to fairness argues that it is de3nitely fair to transfer resources to poor nations. But the

“fair rules” approach to fairness suggests that these transfers aren’t fair. Taking tax

revenue from people in rich nations to transfer the funds to poor nations is not a

voluntary exchange and so is unfair.

A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s

1. What is the di erence between poverty and an unequal income

distribution? Ask the students to consider each of these measures of

economic inequality by asking the following set of questions:

How would you de”ne poverty? Get the students to realize that poverty is a

relative measure, rather than a positive measure of economic inequality. The

minimum quantity of food, clothing, and shelter to a U.S. student is likely to be

considered as abundant riches to the average citizen of developing countries.

1 9 6 C H A P T E R 1 9

Does an unequal income distribution imply that poverty exists? Does

poverty imply that an unequal income distribution exists? The

upper-income people in some developing countries have annual incomes that

are less than the monthly income of the typical unskilled laborer living in the

U.S. Because poverty is a relative measure, there is little direct relationship

between unequal income distribution and the incidence of poverty.

Is it necessarily a bad thing for the Gini Ratio to increase over time?

Ask the students what the implications are for a society in which: 1) workers

are rewarded based on merit, 2) most workers make good decisions over their

lifetime, (invest in human capital, maintain a good work ethic, etc.) some

workers make bad decisions (drop out of school, waste their life on drugs,

crime, etc.), and 3) those that make good decisions in life become more

productive and earn higher wages than those that make bad decisions in life.

Point out that even in a “perfect world” where race or gender discrimination

was completely absent, and no “bad luck” situations were to ever a+ect

anyone, the Gini Ratio would still increase over time as this merit-based

economy continues to reward those who make good decisions more highly

than those who make bad decisions. This implies that an increasing Gini Ratio

is not necessarily a bad indicator for those concerned about equity as well as

e-ciency.

2. If you were a benevolent dictator, how would you deal with the Big

Tradeo ? Ask the students to choose a degree of economic inequality they

think should be the maximum that our society must endure (in terms of lost

e-ciency). Have them justify this level of economic inequality by using the

economic concepts of marginal bene3t and marginal costs:

How would you measure the marginal cost to society of an unequal

income distribution? Point out that before we embark on a program to

rectify the problem of economic inequality, we 3rst must assess the degree of

the problem: How should we measure the social cost of unequal economic

opportunities? Many economic studies have attempted to do this, but without

much success in gaining wide acceptance of the methodology.

How would you measure the marginal cost to society of implementing

an income redistribution program? Once we are comfortable with our

measure of the social cost of economic inequality, we turn to the alternative:

What amount of prosperity would we all be willing to give up as a society to

increase economic equality in our society (how much smaller would we want

the economic pie to be)? More importantly, what cost would we be willing to

impose on others in society to rectify economic inequality? How should this

decision be made? Help the students to see how complex the issue of

economic inequality really is in the world. There are no simple solutions.

3. If two di erent but equally “important” occupations in society were

to earn very di erent levels of income, is this necessarily re,ective of

discrimination? Remind students that while it is true that 3rms’ demand for

labor is partially derived from society’s demand for the product generated

from the occupation’s labor force, the wages that 3rms pay for that labor is

also determined by the households’ willingness to supply labor to that

occupation. Much of the observed di+erences in wages across equally

“important” occupations can be attributed to the relative unwillingness of

households to supply as much labor for the higher paid occupation as for the

lower paid occupation. This is a di+erent reality than assuming that 3rms’ are

largely unwilling to pay a wage equal to the value of the true VMP of labor to a

certain class of laborers that tend to dominate the lower paid occupations.

E C O N O M I C I N E Q U A L I T Y 1 9 7

4. Are prizes on shows like American Idol unfair? Discuss whether the

unevenness in the rewards for shows induces more e+ort or are unfair.

5. Are there fewer women CEOs and do women CEOs make lower wages

because they are not giving enough to their careers as they try to

maintain family responsibilities? Recently the CFO of Facebook wrote a

book that garnered a lot of press and sparked conversation about what

women need to be giving to the labor market to succeed. Supportive and

critical opinion pieces on this topic are widely available and might spark a

good classroom conversation.

1 9 8 C H A P T E R 1 9