Twelfth Edition, Global Edition ECONOMICS Twelfth Edition, Global Edition Michael Parkin 1

19 ECONOMIC INEQUALITY Notes and teaching tips: 29, 49, 54, and 59. To view a full-screen figure during a class, click the expand button. To return to the previous slide, click the shrink button. To advance to the next slide, click anywhere on the full screen figure. Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action. (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining. (2) Once or twice a semester, set an assignment, for credit, with the following instructions: (a) Find a news article about an economic topic that you find interesting. (b) Make a short bullet-list summary of the article. (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article. Use the Economics in the News features in your textbook as models. ECONOMIC INEQUALITY 2

After studying this chapter, you will be able to: Describe the distributions of income and wealth and the trends in economic inequality in the United States Describe the distributions of income and the trends in inequality in selected countries and the world Explain the sources of economic inequality and its trends Describe the scale of government income redistribution in the United States 3

Economic Inequality in the United States The Census Bureau defines a household’s 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. 4

Economic Inequality in the United States The Distribution of Income Figure 19.1 shows the distribution of income across the 122 million households in the United States in 2012. 5

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Economic Inequality in the United States The mode income is the most common income and was between $15,000 and $20,000. The median income is the level of income that separates the population into two groups of equal size and was $51,017. The mean income is the average income and was $71,274. 7

Economic Inequality in the United States 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 U.S. distribution of income is positively skewed. 8

Economic Inequality in the United States Figure 19.2 shows the distribution of income shares for the United States in 2012. The lowest quintile of households received only 3.2% of the total income. The second lowest quintile of households received 8.3% of the total income The third quintile received 14.4% of total income. 9

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Economic Inequality in the United States The fourth quintile of households received 23% of the total income. The highest quintile received 51.1% of total income. 11

Economic Inequality in the United States The Income Lorenz Curve The income Lorenz curve graphs the cumulative percentage of income against the cumulative percentage of households. The vertical axis plots the cumulative percentage of income. The horizontal axis is the cumulative percentage of households. 12

Economic Inequality in the United States If everyone has the same income, the income Lorenz curve would be shown by the line of equality. 13

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Economic Inequality in the United States The Lorenz curve shows the distribution of income. 15

Economic Inequality in the United States The further the Lorenz curve is from the line of equality the more unequal is the distribution of income. 16

Economic Inequality in the United States The Distribution of Wealth A household’s 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. 17

Economic Inequality in the United States Wealth is even more unequally distributed than income. 18

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Economic Inequality in the United States Wealth or Income? Wealth is a stock of assets and income is a flow of earnings that result from a given stock of wealth. Wealth is more unequally distributed than income because wealth does not measure the quantity of human capital. Income reflects the quantity of human capital. Because the distribution of wealth excludes human capital, the distribution of income is a more accurate measure of economic inequality. 20

Economic Inequality in the United States Annual or Lifetime Income and Wealth? A household’s 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 income years and enjoys the highest level of wealth. A household headed by an older, retired person has lower income and is consuming, rather than accumulating, its wealth. 21

Economic Inequality in the United States Trends in Inequality To measure inequality as an index number, we use the Gini ratio, which equals the ratio of the blue area to the red area in the two figures below. 22

Economic Inequality in the United States With perfect equality, the Lorenz curve is the line of equality and the Gini ratio is zero. 23

Economic Inequality in the United States With the most extreme inequality—one person has all the income—the Lorenz curve runs along the axes and the Gini ratio is one. 24

Economic Inequality in the United States The closer the Gini ratio is to one, the more unequal is the distribution of income. In 2012, the U.S. Gini ratio was 0.47. 25

Economic Inequality in the United States Figure 19.5 shows the U.S. Gini ratio from 1972 to 2012. The Gini ratio shows that the distribution of income in the United States has become more unequal. Despite the changes in the definition, the trend is still visible. 26

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Economic Inequality in the United States 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. Poverty is a relative concept. In 2012, the poverty level calculated by the Social Security Administration for a four-person family was $23,492. About 46 million Americans live in households with incomes below this poverty level—15 percent of the total population in 2012. 28

Economic Inequality in the United States The distribution of poverty by race is unequal. In 2012, the poverty rate among White Americans was 13 percent (31 million). Hispanic-origin Americans was 26 percent (14 million). Black Americans was 27 percent (11 million). Poverty is also influenced by household status. More than 28 percent of households in which the householder is a female with no husband present had incomes below the poverty level. Poverty rates have increased during the past few years, but over the long term, poverty rates have been constant. Classroom activity Check out Economics in Action: The Rich Get Richer, but School Still Pays Check out Economics in Action: Is the American Dream Still Alive? 29

Inequality in the World Economy Which countries have the greatest economic inequality? Which countries have the least and the greatest equality? Where does the United States rank? How much inequality is there in the world economy as a whole? 30

Inequality in the World Economy Income Distributions in Selected Countries Figure 19.6 illustrates some extremes and the U.S. Lorenz curves. 31

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Inequality in the World Economy Global Inequality and Its Trends The global distribution of income is much more unequal than the distribution within any one country. Of the world population: 50 percent live on $2.50 a day or less; 30 percent live on between $2.50 and $10 a day. That is, 80 percent of the world population is very poor. The average American has $115 a day. 33

Inequality in the World Economy World Gini Ratio The global distribution of income is becoming less unequal. Despite individual countries becoming more unequal, incomes in poorer countries are rising faster than incomes in rich countries. 34

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The Sources of Economic Inequality Inequality arises from unequal labor market outcomes and from unequal ownership of capital. Three significant features of labor markets contribute to income differences among individuals: Human capital Discrimination Contests among superstars 36

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. Demand, Supply, and Wage Rates On the demand side of the labor market, high-skilled workers generate a larger value of marginal product than low-skilled workers. So firms are willing to pay a higher wage rate for high- skilled labor. 37

The Sources of Economic Inequality On the supply side of the labor market, high-skilled workers incur a cost of acquiring their skills—money 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. The supply of high-skilled workers is smaller than the supply of low-skilled workers. 38

The Sources of Economic Inequality Trends in Wage Inequality Technological change Computers and laser scanners are substitutes for low-skilled labor. The demand for low-skilled labor has decreased and the wage rate has fallen. 39

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The Sources of Economic Inequality New technologies and high-skilled labor are complements. The demand for high- skilled labor has increased and the wage rate has risen. The gap between the wage rates of high- and low- skilled labor has increased. 41

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The Sources of Economic Inequality Globalization The entry of China and other developing countries into the global economy has lowered the prices of manufactured goods and decreased the value of marginal product of labor. The demand for low-skilled labor has decreased and their wage rate has fallen. But a growing global economy has increased the demand for high-skilled workers and their wage rate has risen. 43

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 value of marginal product of one sex (or race) is perceived to be higher than that of another sex (or race), the equilibrium wage rates will vary across the gender (or racial) groups, despite holding human capital constant. 44

The Sources of Economic Inequality Suppose that black females and white males have identical abilities as investment advisors. If everyone is free of race and sex prejudice, the market determines the same wage rate for both groups. But if customers are prejudiced against women and minorities, this prejudice is reflected in the wage rates— white men earn more than black women. 45

The Sources of Economic Inequality Counteracting Forces Economists disagree about the extent to which discrimination pervades the labor market. One line of reasoning states: Firms that discriminate would have higher production costs (pay higher wages for the same VMP) than those that do not. If this line of reasoning is correct, firms practicing discrimination will have 1. Smaller profit margins 2. Higher market prices 46

The Sources of Economic Inequality Either way, market pressures increase the opportunity cost to firms for practicing discrimination, eventually eliminating these practices. Differences in the Degree of Specialization Another line of reasoning is that sex discrimination can be explained by differences between the men and women regarding their willingness, on average, to specialize in earning a wage versus doing jobs in the home. 47

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 women’s wages will be lower, on average, than men’s wages. Accounting for this difference in labor specialization has been found to explain much of the wage differentials between men and women. 48

The Sources of Economic Inequality Contests Among Superstars Human capital differences can’t account for some of the really large income differences. The super rich—those in the top 1 percent of the income distribution—earn vastly more than can be explained by human capital differences. The contest and prize differences account for the large differences in earnings. Classroom activity Check out Economics in the News: Trends in Incomes of the Super Rich 49

The Sources of Economic Inequality Why Prizes for a Contest? The answer is that contests with prizes do a good job of allocating scarce resources efficiently when the efforts of the participants are hard to monitor and reward directly. There is only one winner, but many people work hard in an attempt to be that person. So a great deal of diligent effort is induced by a contest. 50

The Sources of Economic Inequality Why Are Prizes So Different? The answer is that prizes need to be substantially different to induce enough effort. With a small difference in the prizes of the winner and the runner-up, the gain from being the winner would be insufficient to encourage anyone to work hard enough. Big differences are necessary to induce a big enough effort to generate a quality performance. 51

The Sources of Economic Inequality Do Contests Among Superstars Explain the Trend? Contests among superstars can explain large differences in incomes. Globalization has increased the market reach of the winner in a winner-take-all contest and increased the spread between the winner and the runner up. 52

The Sources of Economic Inequality Unequal Wealth The inequality of wealth (excluding human capital) is much greater than the inequality of income. This greater wealth inequality arises from two sources: 1. Life-cycle saving patterns 2. Transfers of wealth between generations The significant aspect of intergenerational wealth transfers that increase economic inequality is that marriage concentrates wealth. 53

Income Redistribution The three main ways governments in the United States redistribute income are Income taxes Income maintenance programs Subsidized services Fight the caricature of capitalism as unfair/heartless Emphasize that there are no societies where income or wealth is equally distributed. There are two concerns: prosperity and equality. Private enterprise (capitalist) societies are, in general, more prosperous, and are in most cases (but not all) no less equal than socialist societies. Ask which is better for a family, to be the poorest in a rich but unequal society or equal with everyone else in a poor society. We vote for redistribution. Emphasize that we vote for policies that redistribute and we get the redistribution that the majority wants. To get more redistribution, we would need to change the rules about votes and give those who want more redistribution a bigger voice. That idea raises deep and serious questions. 54

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. 55

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. 56

Income Redistribution Income Maintenance Programs Three major types of programs provide direct payments to individuals: Social Security programs Unemployment compensation Welfare programs 57

Income Redistribution Subsidized Services A great deal of redistribution takes the form of subsidized services—services 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. 58

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: 1. Income redistribution uses up resources that could have otherwise been used for producing goods and services. 2. Redistribution of income requires taxes to be imposed and taxes generate a deadweight loss. The Big Tradeoff 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 used to implement the program rather than produce goods and services, • Redistribution requires taxations, 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. Classroom activity Check out Economics in Action: Income Redistribution: Only the Richest Pay 59

Income Redistribution 3. Income redistribution decreases the incentives for Taxpaying workers to provide labor when leisure is a normal good (by decreasing income from work) and Recipients of income assistance to provide labor and earn an income. A Major Welfare Challenge To find ways to assist the poorest identifiable group: Young minority women who have not completed high school, have dependent children, and live without a partner in the household. 60

Income Redistribution The long-term solution to their plight is education and job training—acquiring 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. 61

Income Redistribution The Personal Responsibility and Work Opportunities Reconciliation Act of 1996 increased the penalties for nonpayment of support. The Act also created the Temporary Assistance for Needy Families (TANF) program. 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. 62