Why Income Inequality Matters

The Economist complements this week’s?print issue on rising income inequality with an online forum on the subject. Daron Acemoglu explains why we care about income inequality: “First, people’s well-being may directly depend on inequality, for example, because they view a highly unequal society as unfair or because the utility loss due to low status of the have-nots may be greater than the utility gain due to the higher status of the haves. Second and more importantly, equality of opportunity may be harder to achieve in an unequal society … Third and most importantly, inequality impacts politics. Economic power tends to beget political power even in democratic and pluralistic societies.” Meanwhile, Mark Thoma argues that inequality may soon restrict growth: “We may be near or even past the level of inequality where growth begins falling. The evidence on this is highly uncertain, so it’s difficult to say. But a few more decades like the last few could make the difference, so why take a chance?” [%comments]


Paul '52

Let's do American Inequality the Freakonomics way:
Imagine a room with 100 people in it. Total income in the room is $4,700,000.
Per Capita income in the room averages $47,000/year.

One guy gets $1,100,000 of this.
Per capita income for the other 99 AVERAGES $36,300/year.

That's America. We tell ouselves we're averaging $47,000, but for 99% of us (inclusive of most doctors, lawyers and executives) we really average $36,300. And that's why we're not as rich as we think we are.

Bruce W

@ Paul '52: While your math and logic are correct, all that it tells us is that most Americans don't understand the concept of "average". We're all as rich as we think we are, or perhaps more so, if we compare ourselves to the "average" which is falsely high. Maybe comparing oneself to the median would be more realistic, but most Americans can't comprehend that concept, a fact that is sadder than any income inequality.

Ivo Vegter

This strikes me as sophomoric musing, far removed from actual poverty. The second point is the only one with some merit (depending on how you define "opportunity"), though it does not follow that less inequality is the only, or best, solution. The real standard of living of the poor, and how it is changing, are the facts that truly matter. Because this has, by and large, been risking, worrywarts have fixed upon a more ominous-sounding statistic: the gini coefficient. I call this "ginidiocy". By diverting attention from real living standards with populist blame-the-rich or guilt-trip rhetoric, real gains go unremarked and unappreciated. This has strategic PR value, of course, by emphasising the urgency of doing something (anything! donate now!). However, such distraction from the real issue encourages supposed solutions to inequality (the logical extreme of which would be pure communism) that can only undo those unremarked gains in fighting poverty.

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Ivo Vegter

Sorry, rising, not risking.

pjt

Let's look at relative poverty. This means definitions like "households with an accumulated income less than 50% of the median income are living in poverty" (Wikipedia). An let's take a slightly Brazilian way to split the income among our group of 100: one gets $1,100,000, 9 get $220,000, and 90 get $18,000 each.

Median income is $18,000. No one gets less than 50 % of median. The problem of relative poverty is solved!

Actually, this is not far from the way things are done in a real (de facto) socialism (such as the system that existed in the Eastern Block until 1991 or so).

Gustav

I guess you should have become a doctor, lawyer, or executive then.

Gary K.

However; if the one that makes a million is the owner and starter of the company , the other 99 might have zero income without him.

Keith Johnson

MIDDLING FORTUNE AND GOOD MORALS

In his theory of 'Theory of Moral Sentiments', Adam Smith in effect postulates a 'nice adjustment' between social morality, individual opportunity and the curtailment of excess:

'In the middling and inferior stations of life, the road to virtue and that to fortune, to such fortune, at least, as men in such stations can reasonably expect to acquire, are, happily in most cases, very nearly the same. In all the middling and inferior professions, real and solid professional abilities, joined to prudent, just, firm, and temperate conduct, can very seldom fail of success. Abilities will even sometimes prevail where the conduct is by no means correct.

Either habitual imprudence, however, or injustice, or weakness, or profligacy, will always cloud, and sometimes depress altogether, the most splendid professional abilities ( my comment - politicians and Wall Street financiers take note!).

Men in the inferior and middling stations of life, besides, can never be great enough to be above the law, which must generally overawe them into some sort of respect for, at least, the more important rules of justice. The success of such people, too, almost always depends upon the favour and good opinion of their neighbours and equals; and without a tolerably regular conduct these can very seldom be obtained.

The good old proverb, therefore, that honesty is the best policy, holds, in such situations, almost always perfectly true. In such situations, therefore, we may generally expect a considerable degree of virtue; and, fortunately for the good morals of society, these are the situations of by far the greater part of mankind'.

'In the superior stations of life the case is unhappily not always the same. In the courts of princes, in the drawing-rooms of the great, where success and preferment depend, not upon the esteem of intelligent and well-informed equals, but upon the fanciful and foolish favour of ignorant, presumptuous, and proud superiors; flattery and falsehood too often prevail over merit and abilities. In such societies the abilities to please, are more regarded than the abilities to serve.
.........

To attain to this envied situation (success), the candidates for fortune too frequently abandon the paths of virtue; for unhappily, the road which leads to the one, and that which leads to the other, lie sometimes in very opposite directions.

But the ambitious man flatters himself that, in the splendid situation to which he advances, he will have so many means of commanding the respect and admiration of mankind, and will be enabled to act with such superior propriety and grace, that the lustre of his future conduct will entirely cover, or efface, the foulness of the steps by which he arrived at that elevation.

But, though they should be so lucky as to attain that wished-for greatness, they are always most miserably disappointed in the happiness which they expect to enjoy in it'.

Picking up on Smith's text, it appears that he puts forward three propositions:

1. The interplay of effort, modest income and modest wealth among ordinary citizens promotes personal good behaviour and social justice, in line with a desire to conform

2. Excess beyond the margins of the ordinary (and its attendant rewards and risks) likely leads to personal financial and psychological overstretch, anti-social behaviour and the erosion of social injustice if it is sustained

3. Shifts in society in the relative balance of income and wealth away from those who are 'ordinary' towards those who are 'excessive', will tend to reduce overall levels of sociability and social justice - and will erode the happiness and productive effectiveness of society as a whole.

For further comment see: http://kjohnsonnz.blogspot.com/2010/12/adam-smith-and-inequity-of-nations.html

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Doc

That's why we use median incomes, not averages. The actual income distribution is fat-tailed but the bulk of the curve lokks basically normal.

tim

income inequality has a clear economic consequence.

Just consider the utility of a rich aristocrat 150 years ago. His utility is high, based on his consumption and he doesn't feel a need to resort to stealing, crime, nor does he feel that he doesn't have opportunities.

Now imagine how much of his consumption he'd trade away for a machine that would replace his horse drawn carriage and run on fuel which he can acquire at a low cost. It requires less maintenance, goes faster, and is more efficient. Yes, I'm talking about a car. This guy would be much much more well off with a car, let alone a TV or access to the internet.

Now let's come back to modern day. A relatively poor person in America can generally still own or lease a car, have a TV and access to the internet (at least at the library). This person is wealthier today, than the aristocrat 150 years ago, yet I wouldn't expect his consumption to yield him higher utility.

The piece that's missing is that everything is relative and we compare our own wealth to others in our society. That's just how we're wired and I think going forward this is going to play a big role in economics and we'll give less weight to GDP and start giving more weight to new metrics that come from behavioral econ.

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James

It seems the concept and definition of utility is redefined in order to allow those with more to continue to make incremental increases in utility at the expense of others utility. This is not capitalism, and the "banksters" know it. If you don't think Capitalism is zero sum, you are not taking into account enough variables or you are deluding yourself into believing all variables are knowable.

James

Re #1: "One guy gets $1,100,000 of this.
Per capita income for the other 99 AVERAGES $36,300/year."

Maybe we ought to ask why the guy with $1.1 million is getting that money. Did he steal it, or did he invent something popular, like Google, Facebook, or Twitter? In the latter case, what's the problem with his inequality?

And if you look at e.g. the Forbes list of richest Americans, you find that the majority of them got their wealth by doing just that: inventing something that people wanted to buy. There aren't many apart from the Waltons who are even first-generation inheritors of wealth, and virtually none in the second generation.

Seems like the same applies to many of us with lesser, but still above average, incomes. We get the money because we provide services that people are willing to pay for.

pablo

The guy getting 1.1 million is probably raking it in from an estate he inherited. It's not just income inequality that matters, it's wealth inequality. For all the same reasons, but with more permanent effects.

aubrey

"First, people's well-being may directly depend on inequality, for example, because they view a highly unequal society as unfair"

I think income equality matters, and I still don't care about these people. This is your FIRST group of people that is impacted?

Eric M. Jones

2% of the population has 50% of the wealth. 50% of the population has 2% of the wealth. This is remarkable, terrible, unsustainable, and might cause a revolution.

LG

I pretty much never hear anybody talking about average income. It's always medium, specifically because it resists big changes by a few outliers.

RNB

The reason that inequality matters is because resources are limited. Not everyone, but most people, would like a decent sized house that is detached from neighbouring houses with a bit of garden space, very close to amenities yet not under pylons or traffic paths. However if you have that space then other people cannot. No increase in gadgets or appliances or average GDP is going to change that. It could be argued that the desire to have some control of others, to get personal service of some kind, is fundamental to human nature. Again if some have this then by definition others do not.

PSC

Carroll Quigley discusses income inequality in his book, The Evolution of Civilizations. He argues that for a civilization to grow, income inequality is mandatory. If incomes were identical, there would not be sufficient capital available to be invested by the rich which provides jobs and therefore growth.

Mr. Bad Example

So if I made $1 more than I should have, who did I take it from? The poor guy or the rich guy?

Nikki

Income inequality creates temptations (not owning an island and a private plane is not an issue if you don't know that owning those is an option) and provides an unfavorable frame of reference (which is not exclusive to finance at all: the average face and body looks way more attractive when Adriana Lima is not looking at you from magazine covers, just like the average income feels much more comfortable if you don't know that Donald Trump gets paid for speaking for an hour what you get paid for working for a quarter of a century).