Unit 19

ECONOMIC INEQUALITY
OUTLINE
A. Introduction
B. Trends in inequality
C. Types of inequality
D. Evaluating inequality
E. Explaining inequality
F. Addressing inequality
A. Introduction
 The Context for This Unit
Previously studied models of asymmetric economic
interactions e.g. bargaining, labour markets, credit markets.
(Units 5-9)
This asymmetry between parties involved can result in
unequal outcomes.
• Why do these asymmetries (inequalities) occur?
• How can we reduce inequality?
• How much equality should a society have?
 This Unit

• Trends in economic inequality within and between countries

• Types and sources of inequality

• When and how inequality should be addressed

B. Trends in inequality
 Income inequality within countries
Market income: Income from wages, businesses, and investments
Disposable income: Market income minus taxes and transfers
• Wealth is much more unequally
distributed than market income,
which is more unequally
distributed than disposable
income.
• More equality in disposable
income can be due to the tax and
transfer system.
 Trends in inequality across countries
• There are cross-country differences in the level of inequality,
but also common trends e.g. a fall in inequality over 1920-1980.
• Countries differed greatly in what happened after 1980 though.
 Global inequality
Blue line = Gini coefficient for the entire world.
Red line = if everyone in the country earns the average income.
• Since 1980, between-country
inequality fell rapidly, but
within-country inequality
increased.
• The net result is that global
inequality has started to
decline.
 Within-country inequality
Increasing inequality within most countries is associated with the
changing distribution of jobs.

‘Missing middle’ - Low-paying and high-paying jobs are increasing

in number while middle-income jobs are becoming scarcer.
C. Types of inequality
 Categorical inequality
Categorical inequality (group inequality): Economic differences
among people who are treated as different categories.
Usually based on ‘accidents of birth’:
• Country of citizenship - Passports
and borders limit access to
certain economic opportunities
• Gender or ethnic group
Example: income disparities between men and women with the
same level of education.
 Inherited inequality
Intergenerational inequality: The extent to which differences in
parental generations are passed on to the next generation.
Intergenerational transmission
process takes many forms:
• Inheriting parents’ wealth
• Inheriting parents’ genetic makeup
• Parental influence on growth
Intergenerational elasticity: the percentage difference in the second
generation's status associated with a 1% difference in the adult
generation's status. (High elasticity = low intergenerational mobility)
 Relation to cross-sectional inequality
Inequality in earnings tends to be positively correlated with
intergenerational inequality.
Possible reasons:
• Societies with strong culture of
fairness tend to have policies
that reduce cross-sectional
inequality and promote
intergenerational mobility.
• Effects of good/bad shocks (‘luck’) are passed on to the next
generation, contributing to cross-sectional inequality.
D. Evaluating inequality
 How much inequality is ‘too much’?
Inequality becomes a problem if there is ‘too much’ of it.
Example: In the US, actual wealth
inequality is much higher than
what people estimate it to be,
which is also higher than their
ideal wealth distribution.
People’s ideal wealth distribution
depends on income, but these
differences are small in
comparison.
 When is inequality unfair?
• Opinions about whether inequality
is ‘unfair’ depends largely on
individual beliefs about how
distributions came about (recall:
procedural justice Unit 5).
• Many people think categorical
inequality is ‘unfair’ and should be
addressed, but not inequality
based on hard work or taking risks.
 Modelling preferences over inequality
Feasible frontier – tradeoff between income for rich and poor (MRT).
Many possible allocations, depending
on criteria for distributing income:
• E = complete equality
• A = maximum average income
• R = Rawls’ ‘Veil of Ignorance’
(highest income for the poor)
• F = maximum income of the rich
• D = minimum income of the poor
 Choosing allocations
Points on DF and ER, and interior
points are Pareto inefficient.
Choice along line FR depends on
preferences (MRS):
• Optimal choice where MRS = MRT
• With inequality aversion (care
about own payoffs but dislike
inequality between groups), B
might be optimal.
E. Explaining inequality
 Economic inequality: Sources

An individual’s income depends on:

1) His/her endowments - facts about an individual that may affect his
or her income (e.g. wealth, physical assets, human capital)
2) The value of each item in his/her endowment.
Technology and institutions affect the value of particular endowments.
 Economic inequality: Sources

Economic inequality is due to changes in institutions, technology,

and differences in endowments.
Economic inequality can also influence institutions and policies in
future periods e.g. political advantages for the rich, as well as
technology e.g. automation due to minimum wage introduction.
 Economic inequality: Sources
Differences in endowments affect the balance of power in
interactions: In principal-agent relationships, the principal can
exercise power over agents, but not vice versa.

Differences in endowments also determine the ability to become

the principal or the agent e.g. ability to borrow/lend.
 Example #1: Worker productivity rises
Productivity can rise if the entire workforce is better educated
e.g. an increase in the compulsory schooling age.
At the initial wage, firms make
higher profits -> Firms enter,
reducing unemployment.

-> Workers have better

reservation option so can
have higher wages
-> Inequality falls.
 Example #2: Labour market segmentation
• Primary labour market: ‘Good’
jobs, with high wages, job
security, and trade unions
• Secondary labour market: short-
term contracts, limited wages
and job security.
• Eliminating segmentation raises
average wages, reducing
inequality.
 Example #3: Automation
Automation: Technologies that allow machines to do the work
that people used to do.
New technology increases demand for some
skills and reduces demand for others.
In the short run:
• Machines replace routine labour,
increasing unemployment.
• Workers whose skills are complementary
earn higher wages, increasing inequality.
 Example #3: Automation
In the long run, there are two opposing effects on wages and
employment:
1. Higher unemployment reduces workers’ reservation option,
lowering the wage that firms have to set.
2. But an increase in productivity increases profits, which
motivates and finances capital expansion, which in turn creates
new jobs and reduces unemployment, increasing the wage.
Policies can help the transition process:
• Opportunities for displaced workers to upgrade their skills
• Job opportunities and higher wages in non-routine sectors
F. Addressing inequality
 Addressing unfair inequality
Government policies can influence economic inequality by:
• Redistribution – Taxes and transfers to reduce differences in
disposable income, and expenditure on public services.
• Predistribution - Greater equality of endowments e.g.
property redistribution, or raising the value of endowments of
the poor via legislation
e.g. statutory minimum wage for specific types of workers
Predistribution policies: Examples
 Redistribution policies
Welfare state: policies that turn market income into final income.
• Policies are usually a combination of 1) taxation and 2)
expenditure i.e. In-kind transfers (free/subsidised services) or
social insurance (targeted at specific groups).

Progressive policies directly reduce

inequality; regressive policies
directly increase inequality.
Example: In Mexico, expenditures
are more progressive than taxes.
Explaining trends in income inequality
 Inequality and Economic Growth
Rich countries Catch-up countries

Most countries grow at similar rates and there is no correlation with

the level of inequality. High taxes and transfers do not necessarily
reduce incentives to work hard or innovate.
 Inequality and Economic Growth
Economic benefits of lower
inequality:
• Cooperation and trust necessary
for production of knowledge and
caring services is harder to sustain
with high inequality.
• Policies that enhance endowments
of the poor improve productivity.
• Less guard labour needed (which diverts resources from
production)
 Summary
1. Technology and institutions influence inequality directly and
indirectly (via differences in endowments).
2. Various types of inequality: between countries, group
inequality, inherited inequality.
3. Policy can reduce inequalities by affecting technology,
institutions and the distribution of endowments.
4. How equal should society be? Depends on beliefs about
inequality and preferences for fairness.
 In the next unit
• The effects of technological progress on the environment

• Environmental policies and their limitations

• How to quantify the value of the environment