Addressing Income and Wealth Inequality (AS Microeconomics Intervention)

Welcome to one of the most important and often debated topics in Economics: inequality! Why do some people earn fortunes while others struggle? And what can governments do about it?

In this chapter, part of your study on Government Microeconomic Intervention, you will explore the difference between income and wealth, learn how economists measure the gap between the rich and the poor, and critically evaluate the key policies governments use to try and make society fairer.

Don't worry if this feels complicated—we will break down the concepts, especially the difference between flow and stock, using simple examples.


1. Income vs. Wealth: Flow vs. Stock

Before we discuss inequality, we must understand the two fundamental concepts that are often confused: income and wealth.

Key Definitions: Flow and Stock

1. Income (Flow Concept)

  • Definition: Income is a flow of money earned over a period of time (e.g., per week, per month, per year).
  • Sources: It comes from the rewards to the Factors of Production (FOPs):
    • Wages (reward for labour)
    • Rent (reward for land)
    • Interest (reward for capital)
    • Profit (reward for enterprise)

2. Wealth (Stock Concept)

  • Definition: Wealth is the stock of assets accumulated at a specific point in time. It is what you own.
  • Examples of Assets: Housing, land, financial assets (stocks and shares), savings, and physical possessions.
Analogy: The Bathtub

Imagine a bathtub:
The water flowing *out of the tap* and into the tub is Income (a flow over time).
The water *already collected* in the tub is Wealth (a stock at a moment in time).

Did you know? You can have high income but low wealth if you spend everything you earn. Conversely, retired people might have low income (pension only) but very high wealth (owning a paid-off house and investments).

Quick Takeaway 1:

Inequality usually refers to income inequality (the gap in yearly earnings) and wealth inequality (the gap in accumulated assets). Wealth inequality is often much greater than income inequality.


2. Measuring Income and Wealth Inequality

How do economists quantify how unequal a society is? We use a powerful visual tool called the Lorenz Curve and a statistical measure derived from it called the Gini Coefficient.

The Lorenz Curve (Visualization)

The Lorenz Curve plots the cumulative percentage of income (or wealth) held against the cumulative percentage of the population.

  • Axis X: Cumulative percentage of households (e.g., the poorest 20%, 40%, etc.)
  • Axis Y: Cumulative percentage of total income/wealth they receive.

The Line of Perfect Equality: This is a diagonal straight line (45 degrees). If 20% of the population earns 20% of the income, 40% earns 40% of the income, and so on, society is perfectly equal.

The Lorenz Curve: This shows the actual distribution. In reality, the poorest 20% might only earn 5% of the income. The curve will bow away from the line of perfect equality.

The Gini Coefficient (Numerical Measure)

The Gini coefficient is a single number summarizing the inequality shown by the Lorenz Curve. It measures the area between the line of perfect equality and the Lorenz Curve, relative to the total area under the line of perfect equality.

  • Range: The Gini coefficient always falls between 0 and 1.
  • Gini = 0: Represents perfect equality (the Lorenz Curve lies exactly on the 45-degree line).
  • Gini = 1: Represents perfect inequality (one person has all the income/wealth).

(Syllabus Reminder: You need to understand what the Gini coefficient is and what its values mean, but you are not required to calculate it.)

Memory Aid for Gini:

Gini is the Gap. A smaller gap (closer to 0) means less inequality.

Quick Takeaway 2:

The Lorenz Curve visually shows the income gap, and the Gini Coefficient converts that gap into a simple number (0 = perfect equality, 1 = perfect inequality).


3. Economic Reasons for Inequality of Income and Wealth (Causes)

Market economies naturally generate inequality. This is not necessarily a failure of the market, but a consequence of how factors are rewarded based on productivity and scarcity.

Here are the key economic causes:

A. Differences in Labour Income (Wages)
  • Skills and Education: Highly skilled workers (e.g., surgeons, specialized engineers) command higher wages because their labour is scarce and highly productive. They have invested heavily in human capital (education and training).
  • Demand and Supply: Occupations with high demand and low supply (like expert software developers) will earn much more than occupations with high supply and low skill requirements.
  • Risk and Effort: Jobs that are dangerous, unpleasant, or require long hours may attract a higher wage (a compensating differential).
B. Differences in Asset Ownership (Wealth)
  • Inheritance: This is a massive factor. Wealth is often passed down generations, creating a huge head start for some.
  • Savings and Investment: People who save and invest their money (in property, stocks, bonds) will see their wealth grow over time through compound returns, while those who cannot save fall further behind.
  • Rewards for Capital and Land: Those who own large amounts of capital or land receive high returns (interest, rent, profit), further increasing their wealth and income flow.
C. Other Factors
  • Luck and Opportunity: Being in the right place at the right time (e.g., buying property in a booming area early on).
  • Market Power: Individuals running monopolies or firms with significant market power can generate huge profits (enterprise rewards), leading to very high personal incomes.

4. Policies to Redistribute Income and Wealth

If a government decides that the market outcome is too unequal (inequitable), it uses policies aimed at bridging the gap. These policies fall under the microeconomic category of government intervention.

Policy 1: Minimum Wage

A minimum wage is a legal minimum price floor set on the hourly wage rate that firms must pay their workers.

  • Mechanism: It directly raises the income of the lowest-paid workers, moving their earnings closer to a living standard.
  • Impact on Inequality: Reduces income inequality for those who remain employed.
  • Evaluation/Drawback: Setting the wage too high above the market equilibrium might lead firms to hire fewer low-skilled workers, potentially increasing unemployment (an unintended consequence).
Policy 2: Transfer Payments

Transfer payments are benefits or money transfers made by the government to individuals without any corresponding output or service being provided in return.

  • Mechanism: They provide a basic income safety net for those who cannot work (due to age, illness, or unemployment).
  • Examples: Unemployment benefits, state pensions, disability allowance, and child benefits.
  • Impact on Inequality: Significantly reduces income inequality and helps alleviate absolute poverty (lack of basic necessities).
Policy 3: Taxation Policies

Governments use taxation structure to redistribute income from the rich to the poor.

A. Progressive Income Taxes

  • Definition: A tax where the percentage of income paid in tax increases as income rises.
  • Example: If you earn $10k, you pay 10%; if you earn $100k, you pay 30%.
  • Impact on Inequality: High earners contribute a larger proportion of their income, funding transfer payments and services that benefit the poor. This is the primary tool for income redistribution.

B. Inheritance and Capital Taxes

  • Inheritance Taxes: Taxes on the assets one receives upon the death of another.
  • Capital Taxes: Taxes on assets like property or investments (e.g., capital gains tax).
  • Impact on Inequality: These policies directly target wealth, not just flow income, helping to break up the generational accumulation of assets and reduce wealth inequality.
Policy 4: State Provision of Essential Goods and Services

This involves the government directly supplying goods and services deemed necessary for a basic standard of living, often free at the point of use.

  • Mechanism: By providing services like healthcare, education, and subsidized housing, the government increases the real income and welfare of the poor without giving them cash.
  • Impact on Inequality: Reduces relative poverty and improves equality of opportunity. A poor family and a rich family both receive the same standard of free primary education, narrowing the gap in access to essential services.

Quick Review: Redistribution Policies
  • Minimum Wage: Raises lowest incomes, but risks unemployment.
  • Transfer Payments: Direct cash to boost low incomes (e.g., pensions).
  • Progressive Taxes: Takes proportionally more from high incomes.
  • Capital/Inheritance Taxes: Targets inherited wealth.
  • State Provision: Provides essential non-cash welfare (e.g., free education).

Conclusion and Key Concepts

Addressing income and wealth inequality is a core function of modern governments in mixed economies. It involves a fundamental trade-off:

Equity vs. Efficiency:

Many redistribution policies (like high progressive taxes or transfer payments) increase equity (fairness) by reducing the gap. However, they can potentially reduce efficiency, as high taxes may discourage work, saving, and investment, leading to a smaller overall economic pie to distribute.

The goal for policymakers is to find the balance: maximizing economic growth and efficiency while maintaining a socially acceptable level of equity.