MODERN LABOR ECONOMICS

THEORY AND PUBLIC POLICY 12TH EDITION

CHAPTER 15
Inequality in Earnings

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Chapter Outline
Measuring Inequality

Earnings Inequality Since 1980: Some Descriptive Data

• The Increased Returns to Higher Education
• Growth of Earnings Dispersion within Human-Capital Groups

The Underlying Causes of Growing Inequality

• Changes in Supply
• Changes in Demand: Technological Change
• Changes in Demand: Earnings Instability
• Changes in Institutional Forces

Appendix 8A Lorenz Curves and Gini Coefficients

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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 Workers as individuals, and society as a whole, are
concerned with both the level and the dispersion of income
in the economy.
• Concerns about the level of income stem from income being an important
determinant of the consumption of goods and services by individuals.
• Concerns about the distribution/dispersion of income stem from the
importance that we, as individuals, place on our relative standing in society
and the importance that our society places on equity.
 The distribution of family incomes (both earned and
unearned) or earnings is important in assessing the issues
of poverty and relative consumption opportunities.
• Earnings, as part of overall incomes, are a reflection of:
- marginal productivity,
- investment in (and returns to) education,
- training,
- migration activities, and
- access to opportunities.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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15.1 Measuring Inequality
 For example, if everyone had the same earnings, say
$20,000 per year, there would be no dispersion – see
Figure 15.1

 If there were disparities in the earnings people received,

these disparities could be relatively large or relatively small.

 If the average level of earnings were $20,000, and virtually

all people received earnings very close to the average, the
dispersion of earnings would be small. If the average were
$20,000 but some made much more and some much less,
the dispersion of earnings would be large.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 15.1 Earnings Distribution with Perfect Equality

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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Figure 15.2 Distributions of Earnings with Different Degrees of Dispersion

Distribution A
shows small
dispersion
around the
mean/average
income of
$20,000

Distribution B
shows large
dispersion
around the
mean/average
income of
$20,000

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
15.1 Measuring Inequality
 Distribution A exhibits smaller dispersion than Distribution B,
that is, earnings B exhibit a greater degree of inequality.
 Graphs (Figures 15.1 and 15.2) can help illustrate the concepts
of dispersion, but they are a clumsy tool for measuring
inequality.
 There are various quantitative indicators of earnings inequality,
and the most obvious measure of inequality is the variance of
the distribution. This is expressed as: 2
 (E  E)
i
Variance  i
(15.1)
n
where
Ei = the earnings of person i in the population
= the mean (average) level of earnings in the population
E = the summation sign indicating the sum over all persons in the population
n = the number of people in the population

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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 15.1 Measuring Inequality
 One problem with the use of variance is that it tends to rise as
earnings grow larger – thus variance is a better measure of
the absolute than of the relative dispersion of earnings.
 An alternative to the variance is the coefficient of variation
(CV): the square root of the variance (or the standard
deviation, σ) divided by the mean (μ):
 E 
2
i E
i
n Standard Deviation 
CV =  
 Mean 
• If all earnings were to double, the coefficient of variation, unlike the
variance, would remain unchanged.
 The most widely used measures of earnings inequality involve
ranking the population by earnings level and then classifying
them into percentiles to which a given level of earnings falls.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 15.1 Measuring Inequality
 Classification of earnings levels into percentile will enable us
to either compare the earnings levels associated with each
given percentile or compare the share of total earnings
received by each.
 Comparing shares of total income received by the top and
bottom fifth (or “quintiles”) of households in the population is a
widely used measure of income inequality.
• Another commonly used measure is comparing the ratio of earnings
at, say, the 80th (90th) percentile to earnings at the 20th (10th) percentile.
• For example, in 2011: earnings of men in the 20th percentile =
$21,361
earnings of men in the 80th percentile = $80,561
$80,561
 3.77
$21,361
Ratio of earnings =

• In 2010, households in the top fifth (quintile) of income distribution received

50.2% of all income, while those in the bottom fifth received 3.3%.
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15.1 Measuring Inequality
 Earning ratio (of 3.58 in 2008) of the 80th percentile to the
20th percentile is not very enlightening or useful unless it is
compared with something such as the ratios of prior years
to see if earnings distribution of men and women was
becoming stretched – earnings were becoming more
unequally distributed.

 Earning ratios 80:20 and/or 90:10 focus on two arbitrarily

chosen points in the distribution and ignores what happens
on either side of the chosen percentiles.
• If the earnings of 10th percentile decline and the earnings of the 20th
percentile rose with other earnings constant, the ratio would decline.
• If the earnings at the 20th and 80th percentiles were to remain the same,
but the earnings in between were to become similar, this step toward
greater overall equality would not be captured by the simple 80:20 ratio.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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15.2 Earnings Inequality Since 1980: Some
Descriptive Data
 Earnings distributions for both men and women, using the
80:20 ratio, showed that both earnings and the ratios for the
80th: 20th varied throughout the period – see Table 15.1

 Other ratios (apart from the 80:20) are: 80:50, 50:20, 90:10,
90:50, and 50:10

 It is important to know whether the changes in the upper

end of the earnings distribution and the lower end are
roughly the same:
• Are both halves of the earnings distribution becoming
more stretched?
• We might ask what was happening to earnings in each
tail of the earnings distribution over this period.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Table 15.1

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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Table 15.2

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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15.2 Earnings Inequality Since 1980: Some
Descriptive Data
 From 1980 to 1990, the 80:20; 80:50; 50:20; 90:10; 90:50;
and 50:10 ratios tell the same story for men and women –
earnings inequality clearly grew among men and women.

 Tables 15.1 and 15.2 suggest that:

a. Inequality unambiguously increased during the 1980s
b. Pronounced fall in relative earnings occur at the very
bottom of the distribution (lowest 10th percentile)
c. Earnings have become less dispersed in the lower half
of earnings distribution since 1990
d. Since 1990, earnings at the 90th percentile have pulled
farther away from the median (50th percentile) than have
earnings at the 80th percentile.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
15.2 Earnings Inequality Since 1980: Some
Descriptive Data

 Changes in the distribution of earnings since

1980 have occurred along two dimensions:
• Increased returns to investments in higher education,
which have raised the relative earnings of those at the
top of the distribution

• The growth in earnings disparities within human-capital

groups, which stretches out earnings at both the higher
and lower ends of the distribution

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
15.2 Earnings Inequality Since 1980: Some
Descriptive Data
The Increased Returns to Higher Education

The real earnings of men between age 35 and 44 with

college or graduate school education have risen since 1980
– particularly among those with graduate degrees – while
those with high school education or less have experienced
decreases in real earnings.

The rising returns to investing in bachelor’s degrees or a

graduate degree are also observed for women, although the
underlying changes within each level of education are
different.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Table 15.3

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 15.2 Earnings Inequality Since 1980: Some
Descriptive Data
Growth of Earnings Dispersion within Human-Capital Groups
Earnings within narrowly defined human-capital groups
became more diverse, if for example, those at the top of the
earnings distribution are older workers with college
educations (and are better-paid), while those at the bottom
are younger workers who dropped out of high school
(unskilled group with lower wages) – increase in the overall
80:20 or 90:10 ratio.
Division of men into different groups by age cohorts and
education (college and high school) revealed that earnings
disparities grew among each human-capital group since
the1980s – see Table 15.4.
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Table 15.4

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15.3 The Underlying Causes of Growing Inequality

The widening gap between the wages of highly

educated (skilled workers) and less-educated
workers (unskilled workers) suggests three possible
causes:
• The supply of less-educated workers might have risen
faster than the supply of college graduates.

• The demand for more-educated might have increased

relative to those for less-educated workers.

• Changes in institutional forces such as minimum

wage or the decline in unions.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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15.3 The Underlying Causes of Growing Inequality
Changes in Supply
The changes in supply (increase and/or decrease) can be
the dominant force/cause of the wage changes or the
increasing gap and thus the growth of wage inequality in
recent years – see Figure 15.3.
If supply shifts are primarily responsible for the increasing
gap between the wages of highly educated (skilled) and less-
educated workers, we should observe that the employment of
less-educated workers increased relative to the employment
of the college-educated workforce.
Table 15.4 contains data indicating that supply shifts could
not have been the primary cause – shows earnings and
employment were positively correlated.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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Figure 15.3 Changes in Supply as the Dominant Cause of Wage Changes

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Table 15.5

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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15.3 The Underlying Causes of Growing Inequality
Changes in Demand: Technological Change
Shifts in labor demand curves were a prominent factor
raising inequality since 1980.
•Rightward shifts in labor demand curve will ↑W and ↑E for university
educated workers.
•Leftward shifts in labor demand curve will ↓W and ↓E for high school
education or less.

“Skill-based technological change” and/or “high-tech”

investment that increased productivity of highly skilled workers
and reduced the need for low-skilled workers cause these
shifts in demand curves.
– Recall that capital and skilled labor tend to be gross complements,

while capital and unskilled labor are more likely to be gross

substitutes.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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15.3 The Underlying Causes of Growing Inequality
The rapidity and scope of workplace technological change
associated with the introduction of computerized processes
required workers to acquire new skills.
Economic theory suggests that those with lower learning
costs are likely to invest more in education, so it should be no
surprise to find that workers with more schooling were the
ones who adapted more quickly to the new, high-tech
environment.
Within human-capital groups, the psychic costs of learning
cause some workers to be more resistant to change than
others, and as some adapt more quickly and completely than
others, it is quite likely that earnings disparities within human-
capital groups will grow.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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Table 15.6

 Share of workers who are managers or professionals or service

increased while the share of workers in office and administrative support
job declined.
 These findings lend some credence to the hypothesis that technological
change has had a polarizing effect on employment.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
15.3 The Underlying Causes of Growing Inequality
Changes in Demand: Earnings Instability
Given technological change and coupled with growing
competition within the product markets through deregulation
and the globalization of production, also may have led to a
growth in the instability of earnings for individual workers –
thus growth in earnings inequality.
Product-market changes that contribute to employment or
unemployment of those workers in the lowest quintile would
cause their earnings to fluctuate if:
• Some workers in this group may be unlucky to experience
unemployment that reduces their earnings.
• Other workers in this group may be lucky enough to experience
temporary earnings increases through overtime work or profit-
sharing bonuses.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
15.3 The Underlying Causes of Growing Inequality
Changes in Institutional Forces
Two other causes of growing earnings inequality come from:
• The decline in unions, and this could have caused the increase in the
80:50 or 90:50 ratios.
• Minimum wage remained constant over much of the period since
1980, while wages in general rose, thus the falling real minimum
wage could have reduced wages at the very bottom of the earning
distribution.

Note that the declining share of unionized workers in the United

States started in the 1950s and has continued unabated throughout
each decade.
Recall that women are less highly unionized than men, therefore,
the fall in their rates of unionization has been considerably smaller,
yet increases in the returns to education were as large among
women as among men, or larger, after 1980.
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15.3 The Underlying Causes of Growing Inequality

Studies that estimated the effects of the declining unionization on

wage inequality concluded that it explains perhaps 20 percent of the
growth in inequality for men (but not women) in the 1980s but played
no important role after 1990.
• Findings corroborate the summary observations that the sizeable
growth in the 80:50 ratio in the 1980s, but stopped after 1990.
• That the increases in the 90:50 ratio after 1990 were thus a function
only of rising relative earnings at the very top of the distribution
(which unionization does not affect).

The nominal minimum wage was constant throughout the 1980s

and with increases in general wages, the legal minimum had fallen to
about one-third of the average wage by the time it was again
increased in the early 1990s.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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MODERN LABOR ECONOMICS
THEORY AND PUBLIC POLICY 12TH EDITION

CHAPTER 15A
Lorenz Curves and
Gini Coefficients

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The most commonly used measures of distributional inequality
involve grouping the distribution into deciles or quintiles and
comparing the earnings (or income) received by each.
It is assumed that:
• Each household in the population has the same income
• Each fifth of the population receives a fifth of the total income

Equal Share of Cumulative Share Cumulative Share

Quintiles Income of Households of Income
First Fifth 20 % 20 % or 0.2 20 % or 0.2
Second Fifth 20 % 40 % or 0.4 40 % or 0.4
Third Fifth 20 % 60 % or 0.6 60 % or 0.6
Fourth Fifth 20 % 80 % or 0.8 80 % or 0.8
Highest Fifth 20 % 100 % or 1.0 100 % or 1.0

 The equality shown in the table above will yield the straight line
AB in Figure 15A.1, its slope is 1, and the area of the ∆ is 0.5
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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As indicated in the table below, the distribution of income is not
perfectly equal.
Actual Share Cumulative Share Cumulative Share
Quintiles of Income of Households of Income
First Fifth 3.5 % 20 % or 0.2 3.5 % or 0.035
Second Fifth 8.8 % 40 % or 0.4 12.3 % or 0.123
Third Fifth 14.8 % 60 % or 0.6 27.1 % or 0.271
Fourth Fifth 23.3 % 80 % or 0.8 50.4 % or 0.504
Highest Fifth 49.6 % 100 % or 1.0 100 % or 1.0

Plotting the cumulative income yields Lorenz curve ACDEFB for

2002 in Figure 15A.1, which shows unequal distribution of
household income in the United States in 2002.
With two Lorenz curves as shown in Figure 15A.1, we can
conclude that one that lies closer to line AB – perfect equality –
shows better distribution than the one farther from line AB.
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Figure 15A.1 Lorenz Curves for 1980 and 2002 Distributions of Income in the United States

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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Figure 15A.2 Lorenz Curves That Cross
If two Lorenz curves
cross, it is not
possible to conclude
which one represents
a greater/better
equality.

Lorenz curve A
shows a lower
proportion of total
income received by
the poorest quintile
than does the
distribution shown by
Lorenz curve B. For
B, the other
remaining quintiles
are lower in
comparison to those
of A.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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A popularly known measure of inequality is the Gini coefficient,
which is a measure of the ratio of the area between the Lorenz curve
and line AB – line of perfect equality.
An easy way to calculate the Gini coefficient is to split the area
under the Lorenz curve into a series of triangles and rectangles and
compute as below:
Triangles Rectangles
0.5 x 0.2 x 0.035 = 0.0035
0.5 x 0.2 x 0.088 = 0.0088 0.2 x 0.035 = 0.0070
0.5 x 0.2 x 0.148 = 0.0148 0.2 x 0.123 = 0.0246
0.5 x 0.2 x 0.233 = 0.0233 0.2 x 0.271 = 0.0542
0.5 x 0.2 x 0.496 = 0.0496 0.2 x 0.504 = 0.1008
Total 0.1 0.1866

The sum of the areas of the five triangles and four rectangles yield
0.2866 (note that the sum of the triangles will also be 0.1, so the
focus should be on finding the areas of the four rectangles).
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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Figure 15A.3 Calculating the Gini Coefficient for the 2002 Distribution of Household Income

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
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 0.5  0.2866
Gini Coefficient   0.4268 (15A.1)
0.5
Gini coefficient (GC) is generally between 0 and 1
•GC = 0 → perfect equality
•GC = 1 → perfect inequality

Gini Coefficient will become smaller when the rich give up

some of their income to the middle class as well as when
they give up income in favor of the poor.

When two Lorenz curves cross as in Figure 15A.2, judging

or comparing the relative equality of two distributions is not
always susceptible of an unambiguous answer.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.