ECONOMIC

INEQUALITY 6
CHAPTER

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 Objectives

After studying this chapter, you will able to:

 Describe the inequality in income and wealth 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.
 Measuring economic inequality.
 The sources of economic inequality.

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why anyone should worry
about inequality
• To understand what life is like in a country, it is not enough to know its per
capita income or the percentage of poor people. High inequality can also
foster social conflict and macroeconomic instability and impede efficiency-
promoting reforms.

• Recent studies show that persistent income disparities among individuals

are associated with poverty and deprivation, mental illness, social unrest,
and crime, as well as lower levels of education, employment, and life
expectancy.

• Mostly because high levels of inequality can impede future growth and
hence poverty reduction.

• Free market is likely to lead to situation where income and wealth are not
distributed fairly amongst the population. So this inequitable distribution of
income and wealth can be described as market failure.
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Measuring Economic Inequality

When looking at disparities in income among individuals, it

is necessary to distinguish between income, wealth, and
pay inequality.
Market income equals wages, interest, rent, and profit
earned by the household in factor markets, before paying
income taxes.
Money income, which equals market income plus cash
payments to households by the government.
“Pay inequality” refers to differences in wages paid to
different people.

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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.
Why is wealth much more unequally distributed than
income?
-differences in income
-savings behavior
-rates of return
-and others…
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Measuring Economic Inequality

Income inequality is the extent to which income is distributed unevenly across

people or across households. Income encompasses:

labor earnings (such as wages, salaries, and bonuses)

capital income derived from dividends, interest on savings accounts, rent
from real estate, as well as welfare benefits, state pensions, and other
government transfers.

The other dimension of economic inequality is differences in “wealth”

distribution. While income refers to the flow of money over a given period (say,
a year or a month), an individual's wealth represents the stock of all assets that
a person holds. These include financial assets, such as bonds and stocks,
property, and savings.

Income and wealth are not perfectly correlated.

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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.
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10
Social Classes according to the Average Annual Household
Expenditure for several Governorates in 2008
Measuring Economic Inequality

The Income Lorenz Curve

Lorenz curve graphs the
cumulative percentage of
income earned against the
cumulative percentage of
households.
The vertical axis of a Lorenz
curve is the cumulative
percentage of total income.
The horizontal axis is the
cumulative percentage of
households.

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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.

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Measuring Economic Inequality

The closer the Lorenz

curve is from the line of
equality, the more equal is
the distribution of income.

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Measuring Economic Inequality

The Distribution of
Wealth
Wealth is the value of all
the things that are
owned by a household
at a given point in time.
The distribution of
wealth is another way of
examining the degree of
economic inequality.

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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.

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Measuring Economic Inequality

The Gini Ratio

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. Gini ratio
takes values between 0 (which refers to “perfect equality”) and the maximum
value of 1 (when one person earns all the income).

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Measuring Economic Inequality

The Gini Ratio

With perfect equality, the Lorenz curve is the line of equality and the
Gini ratio is zero. The lower the Gini value, the more equal a society
is.

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Measuring Economic Inequality

The Gini Ratio

With the most extreme inequality—one person has all the income—
the Lorenz curve runs along the axes and the Gini ratio is one.

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Measuring Economic Inequality

The Gini Ratio

The closer the Gini ratio is to one, the more unequal is the
distribution of income. In 2010, the JOR Gini ratio was
0.33

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Measuring Economic Inequality

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Measuring Economic Inequality

Trends in Inequality
The figure shows trends in the JOR. Gini ratio trends 1986-
2010. The trend is toward lower inequality.

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The Sources of Economic Inequality

Who Are the Rich and the Poor?

The figure on the next slide identifies the five
characteristics that appear to influence the amount of
income earned by a household (USA).
These characteristics are: (JORD)
 Education
 Gender and marital status
 Economic activity and age
 Household composition


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The Sources of Economic Inequality

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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.

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The Sources of Economic Inequality

Human Capital
The more human capital a person, 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(MRP)
than low-skilled workers.
So firms are willing to pay a higher wage rate for high-
skilled labor.

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The Sources of Economic Inequality

The Figure shows the

difference in demand
curves for high-skilled
versus low-skilled labor.

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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.

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The Sources of Economic Inequality

Figure shows the

difference in supply curves
for high-skilled versus low-
skilled labor.

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The Sources of Economic Inequality

Discrimination
While the level of human capital attained varies across
households, discrimination alone does not explain all the
observed inequality in income.
If the levels of marginal revenue product of men are
perceived to be higher than that of women, the equilibrium
wages will vary across each gender group of households,
despite holding the level of human capital constant.

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The Sources of Economic Inequality

Economists disagree to the extent that discrimination

pervades the labor market.
One line of reasoning states that those firms that practice
sex discrimination in the labor market would face higher
production costs (pay higher wages for the same marginal
revenue product) than those firms that do not.
If this line of reasoning is correct, the profit margins for the
firms practicing discrimination will be lower and that the
market price of their goods and services would be higher
than non-discriminating firms.

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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 sex 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
average, to specialize in providing income generating
labor versus providing non-income generating labor in the
home.

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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.

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The Sources of Economic Inequality

Unequal Ownership of Capital

Income inequality is increased by the unequal distribution
of wealth.
Unequal wealth results from savings and wealth transfers
between generations.

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Income Redistribution

• There is nothing in positive economics that tells us that

one distribution of income is better than another.
Nevertheless, three economic arguments for public
policy action to redistribute income are often heard:

• First, some economists have suggested that the rich

man's loss of satisfaction from a redistribution of income
to the poor would be less than the poor man's gain.
Thus, public sector redistribution from the rich to the
poor could expand the general welfare.

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Income Redistribution

• Second, government may redistribute income because

of concern for low income citizens. Alleviation of poverty
may help not only the poor, but also those who are well
off. Middle- and upper-income recipients, for example,
may benefit if the less fortunate members of the
community enjoy better food, clothing, housing, and
health care.

• Third, a redistribution policy may be based on the

community's desire for equality of opportunity regardless
of one's social status.

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Income Redistribution

The governments use three main ways to redistribute

income to alleviate some degree of economic inequality:
 Income taxes
 Income maintenance programs
 Subsidized services.

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Income Redistribution

Income Taxes
By taxing incomes of different levels at different tax rates,
economic inequality can be decreased.
A progressive income tax taxes household incomes at
an average rate that rises with income.
A regressive income tax taxes income at average rates
that fall with income, thereby redistributing income away
from poorer taxpayers.
A proportional income tax (also called a flat-rate income
tax) taxes income at a constant average rate for all income
levels.
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Income Redistribution

Income Maintenance Programs

Three major types of programs provide direct payments to
individuals:
 Social Security Programs
 Unemployment Compensation
 Welfare Programs

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Income Redistribution

Subsidized Services
A great deal of income redistribution takes the form of
subsidized services, where people other than those who pay
for it consume the services provided.
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 expenses for
educating a college student.
The families of these students enjoy a sizeable subsidy for
acquiring human capital.
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Income Redistribution

The Figure shows the

influence of government
income redistribution
efforts.
The distribution after taxes
and benefits is …
…more equal than the
distribution of market
income.

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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 could generate a deadweight loss in
the markets that are taxed (See Ch.3, p 36).

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Income Redistribution

• Income redistribution decreases the incentives for

taxpaying workers to provide (by decreasing income
from work) and decreases the incentives for income
assistance recipient’s to provide labor and earn income.

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