CHAPTER 1

Economic Inequality
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
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?
Measuring Economic Inequality

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.
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.
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.
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.
Measuring Economic Inequality

Figure 18.2 shows

the distribution of
income shares for
the United States in
2005.
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.
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.
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.
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.
Measuring Economic Inequality

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.
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.
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 capital—only 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.
Measuring Economic Inequality

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 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.
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.
Measuring Economic Inequality

With perfect equality, the Lorenz curve is the line of

equality and the Gini ratio is zero.
Measuring Economic Inequality

With the most extreme inequality—one person has all the

income—the Lorenz curve runs along the axes and the
Gini ratio is one.
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.
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.
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
Measuring Economic Inequality
Measuring Economic Inequality

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 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 level—12.6 percent of the total
population in 2005.
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.
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
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.
The Sources of Economic Inequality

Figure 18.7(a) shows the

difference in demand
curves for high-skilled
versus low-skilled labor.
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, which
exceed the wage rates at which low-skilled workers are
willing to supply labor.
The Sources of Economic Inequality

Figure 18.7(b) shows the

difference in supply curves
for high-skilled versus
low-skilled labor.
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.
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.
The Sources of Economic Inequality

The demand for high-

skilled labor has increased
and the wage rate has
risen.
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.
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.
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.
The Sources of Economic Inequality

If white men are

discriminated for, the
perceived MRP is higher
and their wage rate and
employment level
increase.
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.
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.
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 the 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.
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
Income Redistribution

The three main ways governments in the United States

redistribute income are
 Income taxes
 Income maintenance programs
 Subsidized services
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.
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.
Income Redistribution

Income Maintenance Programs

Three major types of programs provide direct payments to
individuals:
 Social security programs
 Unemployment compensation
 Welfare programs
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.
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.
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.
Income Redistribution

The three lower income

groups gain …
…and the highest
income group loses.
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.
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 recipient’s 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.
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.
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.
THE END