Welcome to Poverty and Inequality: Distribution of Income and Wealth
Hi there! This chapter moves away from how resources are produced and asks a crucial question:
"Who gets what?"
We will explore how income and wealth are shared (or not shared) within an economy. Understanding inequality is vital because extreme differences can lead to market failure, social instability, and hinder overall economic development. Don't worry if the concepts of Gini coefficients and Lorenz curves seem mathematical—we are focusing on interpreting them, not calculating them!
1. Defining Income and Wealth: The Key Distinction
1.1 Income vs. Wealth
Economists make a strict distinction between these two terms. It's often helpful to think of a bathtub analogy:
Income is a Flow (The Tap): This is money received over a period of time.
- Definition: A flow of earnings derived from owning assets or selling labour services.
- Examples: Wages, salaries, interest payments, rent from property, or dividends from shares.
Wealth is a Stock (The Bathtub): This is the total value of assets owned at a specific point in time.
- Definition: The accumulated stock of assets owned by individuals or households.
- Examples: Property (houses, land), savings in bank accounts, stocks and shares, and valuable possessions like art.
Key Takeaway: Relationship between Income and Wealth
Income can generate wealth (if you save your high salary, you build wealth). Wealth can generate income (if you own rental property, the rent is income). Generally, wealth is much more unequally distributed than income.
1.2 Equality vs. Equity (A Value Judgement)
This distinction is crucial for evaluating policies.
Equality: Everyone receives the exact same amount or share.
Example: Everyone earns $40,000 per year, regardless of job or effort.
Equity: The distribution is judged to be fair or just.
Example: A surgeon earns more than a cleaner, because they spent more time training and their job requires higher skills. This may be seen as equitable.
The syllabus notes that whether a given distribution is equitable involves a value judgement. This means it relies on personal, moral, and political beliefs, not just objective economic data.
2. Measuring Inequality: Lorenz Curve and Gini Coefficient
2.1 The Lorenz Curve
The Lorenz Curve is a graphical way to show the degree of inequality in the distribution of income or wealth within an economy.
How it works (Interpretation):
- The graph plots the cumulative percentage of the population (x-axis) against the cumulative percentage of income/wealth they receive (y-axis).
- The Line of Absolute Equality (45-degree line) shows the scenario where every person has the exact same income. (E.g., 20% of the population earns 20% of the income).
- The Lorenz Curve shows the actual distribution.
- The further the Lorenz Curve bows away from the Line of Absolute Equality, the greater the inequality in the economy.
Did you know? In a highly unequal country, the bottom 50% of the population might only earn 5% of the total income, causing the curve to be far from the 45-degree line.
2.2 The Gini Coefficient
The Gini Coefficient is a single number derived from the Lorenz Curve that measures the degree of inequality. (Remember: you are expected to interpret it, not calculate it.)
The Gini Coefficient (G) is calculated using the area between the Line of Absolute Equality and the actual Lorenz Curve (Area A) relative to the total area under the Line of Absolute Equality (Area A + Area B).
\(G = \frac{\text{Area A}}{\text{Area A} + \text{Area B}}\)
Interpretation:
- 0 (Zero): Represents perfect equality (the Lorenz curve is the 45-degree line).
- 1 (One): Represents maximum inequality (one person has all the income/wealth).
Memory Aid: Gini = Gap. Higher Gini means a bigger gap between the rich and the poor.
3. Understanding Poverty
3.1 Absolute vs. Relative Poverty
Absolute Poverty:
- Occurs when individuals lack the basic resources necessary for survival, such as adequate food, water, clothing, and shelter.
- This is often defined by a fixed international measure, like earning less than \$1.90 or \$2.15 a day (though definitions vary).
- If you are in absolute poverty, your life and health are at risk.
Relative Poverty:
- Occurs when individuals have incomes significantly lower than the average or median income in the rest of society.
- It means they cannot afford the standard of living considered typical for that society.
- Example: In the UK, being in relative poverty is often defined as having an income below 60% of the median household income.
3.2 Causes and Effects of Poverty and Inequality
Poverty is caused by many factors, including market forces.
Causes of Income/Wealth Inequality:
- Returns to Factors of Production: Those who own high-value capital or land receive high rental/interest income.
- Skills and Education: Higher-skilled workers (doctors, engineers) are scarcer and in higher demand, commanding higher wages.
- Immobility of Factors: Labourers unable to move geographically or occupationally to where jobs are needed.
- Inheritance: Wealth can be passed down through generations.
- Monopoly Power: Firms with market power can earn high profits, distributing large dividends to owners/shareholders.
- Market Failure: In the absence of intervention, the market mechanism naturally leads to unequal distribution as it rewards scarcity.
Effects of Excessive Inequality:
- Social Costs: Increased crime, health inequalities, social division.
- Economic Stagnation: The poor have a lower marginal propensity to save (MPS), meaning inequality can lead to lower overall savings and investment.
- Market Failure: Inequality is considered a cause and consequence of market failure, leading to a misallocation of resources (e.g., resources flow to luxury goods demanded by the rich, rather than essential merit goods needed by the poor).
Quick Review: A market economy, left alone, rewards success and ownership, which naturally results in a very unequal distribution of income and wealth.
4. The Debate: Benefits and Costs of Distribution
4.1 Case for More Inequality (Costs of Equality)
Some economists argue that a degree of inequality is necessary for economic dynamism:
- Incentive to Work: High rewards (profits, high salaries) act as an incentive for individuals to work harder, innovate, take risks (enterprise), and gain skills.
- Saving and Investment: Wealthier people typically save a higher proportion of their income. These savings can be channelled into investment, fueling economic growth.
4.2 Case for More Equality (Costs of Inequality)
A more equal distribution can lead to significant economic benefits:
- Increased Consumption: Poorer individuals have a higher Marginal Propensity to Consume (MPC). Redistributing money towards them can boost overall Aggregate Demand (AD).
- Better Human Capital: Equality allows more people to access education and healthcare, improving the quality and productivity of the workforce (long-run supply-side benefit).
- Reduced Market Failure: Inequality reduces economic welfare and efficiency by creating poverty traps and misallocating resources away from essential needs.
5. Government Policies to Influence Distribution and Alleviate Poverty (3.3.5.2)
Governments use various methods—taxation, expenditure, and regulation—to correct the unequal distribution caused by the market mechanism.
5.1 Policies for Redistribution and Alleviation
The goal of these policies is typically to move toward a more equitable distribution of income and wealth.
1. Progressive Taxation:
- This involves taxing higher incomes at a higher percentage rate (e.g., income tax).
- Effect: Directly reduces post-tax income inequality.
2. Transfer Payments/Welfare Benefits:
- Cash payments (like unemployment benefits, child benefits, or state pensions) given to those on low or no income.
- Effect: Acts as an income floor, directly targeting absolute and relative poverty.
3. Provision of Merit Goods:
- Government spending on essential services like free education and healthcare.
- Effect: Improves equality of opportunity (equity) and breaks the cycle of poverty by boosting human capital.
4. Minimum Wage Laws:
- A legally mandated minimum hourly wage for workers.
- Effect: Directly increases the earnings of the lowest-paid workers, helping to tackle relative poverty.
5. Wealth/Inheritance Taxes:
- Taxes on assets (like property) or on wealth passed down when someone dies.
- Effect: Targets the distribution of wealth, which is often far more unequal than income.
5.2 Consequences and Evaluation of Redistributive Policies
While these policies aim for a fairer society, they come with trade-offs. You must be able to evaluate both the moral/political and economic consequences.
Potential Costs and Unintended Consequences:
- Disincentive Effects (The Trade-off): High progressive taxes or generous benefits might reduce the incentive to work, save, or invest, potentially slowing economic growth. This is the classic trade-off between equity and efficiency.
- Poverty Trap: If an individual's benefits are withdrawn sharply as they start earning more, they may be deterred from finding work, as the net gain from employment is minimal.
- Administrative Costs: Implementing complex tax and welfare systems can be expensive for the government.
- Tax Evasion/Avoidance: Highly progressive tax regimes can encourage the wealthy to legally avoid or illegally evade taxes.
Evaluation Tip: Moral and Political Perspectives
When discussing income distribution policies, remember that the "best" policy is subjective.
- Some argue that wealth redistribution is a moral imperative, based on the belief that everyone deserves a minimum standard of living (utilitarian view).
- Others argue that high taxation violates property rights and is politically undesirable, as it punishes hard work (libertarian view).