Economics (9640) | An inequitable distribution of income and wealth

An Inequitable Distribution of Income and Wealth: Study Notes (3.1.5.6 & 3.3.5)

Welcome to this crucial chapter! This topic is where economics meets ethics, exploring whether the outcomes generated by free markets are fair. Understanding inequality is key because it’s a major source of Market Failure. If resources aren't distributed equitably, society suffers, and the economy operates inefficiently. Let's dive into what income and wealth are, how we measure them, and what governments can do about it.

1. Income vs. Wealth: Know the Difference!

Don't worry if these terms seem confusing—even experienced economists sometimes use them loosely. For your exams, you must keep them separate.

1.1 Defining Income

Income is a flow of money received over a period of time (e.g., per week, per month, or per year).

• Examples: Wages/salaries from a job, rent received from property ownership, dividends from shares, and state welfare benefits.
• Analogy: Think of income as the water flowing from a tap into a bathtub.

1.2 Defining Wealth

Wealth is a stock of assets owned at a specific point in time. It doesn't move or flow; it just sits there.

• Examples: Physical assets (houses, land, cars) and financial assets (savings accounts, bonds, stocks).
• Did you know? Wealth often generates income (e.g., owning a house is wealth; the rent you receive is income). This is why wealth inequality is often much greater than income inequality—wealth is passed down generations!
• Analogy: Wealth is the water already collected in the bathtub.

---

2. Equality vs. Equity: A Value Judgement

This is one of the most important conceptual distinctions in this chapter. Economists (and politicians!) often argue over whether inequality is acceptable.

2.1 Equality

Equality means everyone receives the exact same amount or outcome. It's a mathematical concept.

• Example: If a country’s national income is \$100 million and there are 10 million people, complete income equality means everyone gets exactly \$10 each.

2.2 Equity (Fairness)

Equity means fairness or social justice. It acknowledges that people have different needs, abilities, or put in different efforts, and therefore, a perfectly equal outcome might not be fair.

• Example: Is it equitable for a brain surgeon who trained for 15 years to earn the same wage as someone working part-time with no training? Many would argue no.

Key Syllabus Point: The degree of inequality can be measured objectively (using tools below), but whether a given distribution is equitable (fair and just) involves a value judgement. This means different people will have different, subjective opinions based on moral or political beliefs.

---

3. Inequality as Market Failure (3.1.5.6)

In the absence of government intervention, the market mechanism (supply and demand) is highly likely to result in a very unequal distribution of income and wealth.

3.1 The Misallocation of Resources

How does high inequality lead to market failure and a misallocation of resources?

1. Consumer Power is Skewed: In a market economy, your ability to consume goods and services depends heavily on your income and wealth. When inequality is high, resources are allocated not to satisfy the most pressing needs, but to satisfy the wants of the rich.
2. Example: Extremely wealthy individuals drive up the price of luxury real estate and yachts, while essential resources like affordable housing and clean water for the poor are neglected or underprovided. The market prioritizes luxury over necessity.
3. Human Capital Underinvestment: Poor individuals cannot afford the necessary education, training, or healthcare to become productive members of the workforce. This means society loses out on potential talent (a failure to use resources efficiently).
4. Lower Economic Welfare: Economic welfare is affected by how goods and services are *distributed*. If a large segment of the population is struggling or deprived, overall societal welfare is reduced, even if GDP is rising.

Key Takeaway: The market mechanism is excellent at allocation based on ability to pay, but this often leads to outcomes that society deems unfair (inequitable) and inefficient (misallocation).

---

4. Measuring Inequality: The Gini Coefficient and Lorenz Curve (3.3.5.1)

To discuss inequality, we need measurable, objective tools.

4.1 The Lorenz Curve

The Lorenz Curve is a graphical tool used to show the degree of income or wealth inequality in an economy.

• The Axis:
  • The horizontal axis (x-axis) measures the cumulative percentage of the population (from poorest to richest).
  • The vertical axis (y-axis) measures the cumulative percentage of total income/wealth held by that population.
• The Line of Perfect Equality: This is a 45-degree line running from 0 to 100. It represents a scenario where 20% of the population earns 20% of the income, 50% earns 50%, and so on.
• The Lorenz Curve Itself: This curve always lies beneath the line of perfect equality. The further the Lorenz Curve bows away from the 45-degree line, the greater the degree of inequality.

Don't worry if drawing this seems tricky at first; focus on understanding the concept: further away = more unequal!

4.2 The Gini Coefficient

The Gini Coefficient is a single number derived from the Lorenz Curve that measures the degree of inequality.

• The Gini Coefficient ranges from 0 to 1 (or 0% to 100%).
• 0 represents perfect equality (the Lorenz curve is the 45-degree line).
• 1 represents perfect inequality (one person has all the income/wealth).

The coefficient is the ratio of the area between the 45-degree line and the Lorenz curve (Area A) to the total area under the 45-degree line (Area A + Area B).

$Gini\ Coefficient = \frac{A}{A + B}$

Accessibility Note: You need to be able to interpret the Gini Coefficient (e.g., a Gini of 0.45 is more unequal than 0.30), but you are not expected to calculate it in the exam.

---

5. Poverty: Absolute and Relative (3.3.5.1)

Inequality is about the spread of income; poverty is about the level of income at the bottom end.

5.1 Absolute Poverty

Absolute Poverty occurs when people have insufficient income to afford the basic necessities of life, such as food, shelter, and clothing.

• This is often measured using a fixed international standard, like living on less than \$1.90 PPP (Purchasing Power Parity) a day.
• Effect: High risk of starvation, disease, and infant mortality.

5.2 Relative Poverty

Relative Poverty occurs when a person's income is substantially less than the average income in their country, meaning they cannot afford the standard of living considered normal by that society.

• In the UK or EU, this is often defined as having an income less than 60% of the median national income.
• Effect: Social exclusion, lack of opportunities (poor schooling), and inability to participate fully in society.

Causes and Effects of Poverty: Poverty is often self-perpetuating. Causes include unemployment, low skills, discrimination, disability, and market power leading to low wages. Effects include poor health, low productivity, and reduced economic growth potential.

---

6. Factors Affecting Distribution of Income and Wealth (3.3.5.1)

What determines who gets what in the economy?

6.1 Factors Affecting Income Distribution

• Wage Differentials: Differences in human capital (skills, education, training) lead to different wages (high demand for specialists).
• Ownership of Assets: People who own assets (wealth) receive income flows from them (rent, dividends), widening the income gap.
• State Benefits and Taxes: Government policies (taxation and welfare payments) can reduce market-generated inequality.
• Market Power: Monopoly power in certain sectors can lead to high executive salaries, while lack of worker power (e.g., weak unions) can depress wages.
• Discrimination: Bias based on gender, ethnicity, or age prevents some groups from accessing higher-paying jobs.

6.2 Factors Affecting Wealth Distribution

• Inheritance: The most significant factor. Wealth is often inherited, creating vast disparities across generations.
• Savings and Investment: Individuals who save early and invest successfully (often those already on higher incomes) accumulate greater wealth.
• House Prices and Asset Inflation: Rising property or stock values disproportionately benefit those who already own assets.

Connection: Income and wealth are linked. High income allows for greater saving and investment, which builds wealth. High wealth generates more income (rent, interest), reinforcing the cycle.

---

7. Government Policies to Address Inequality and Poverty (3.3.5.2 & 3.1.5.7)

Governments intervene to promote a more equitable distribution, often using taxes and public spending.

7.1 Policies to Influence Distribution and Alleviate Poverty

1. Progressive Taxation:
   • Mechanism: Tax rates rise as income rises (e.g., income tax). This directly reduces post-tax income inequality.
   • Tax Types: You must distinguish between Progressive (takes a higher percentage of income as income rises), Proportional (takes a constant percentage), and Regressive (takes a higher percentage of income from the poor, e.g., VAT/sales tax).
2. Welfare State / Transfer Payments:
   • Mechanism: Direct payments (e.g., unemployment benefits, pensions) and state provision of services (e.g., free healthcare and education). These target low-income groups, improving their economic welfare and ability to consume.
3. Minimum Wage Legislation (3.3.4.6):
   • Mechanism: Legal minimum hourly wage forces firms to pay more, directly raising the income of the lowest-paid workers.
4. Investment in Human Capital:
   • Mechanism: Government spending on education and training programs helps the poor gain skills, making them more productive and increasing their lifetime earning potential (supply-side improvement).
5. Inheritance and Wealth Taxes:
   • Mechanism: Taxes on accumulated wealth or assets passed upon death. This is specifically designed to tackle generational wealth inequality.

7.2 Consequences and Evaluation of Policies

When evaluating these policies, we must consider both the intended positive effects and the potential unintended consequences.

• Benefits of More Equal Distribution:
  • Increased Economic Welfare: Basic needs are met, leading to a healthier, more productive population.
  • Higher Aggregate Demand: Poor individuals have a higher marginal propensity to consume (MPC); redistributing income to them means a larger portion is spent, boosting AD.
  • Reduced Social Conflict: Less inequality may lead to a more stable society.
• Costs and Unintended Consequences of Redistribution:
  • Disincentives: Very high progressive income tax may reduce the incentive for highly skilled workers to work hard or take risks (the "effort disincentive").
  • Tax Avoidance/Evasion: High taxes may encourage tax flight (rich people moving abroad) or illegal evasion.
  • Inefficiency: Welfare benefits might create a "poverty trap," reducing the incentive for recipients to take up low-paid work if they lose their benefits.
  • Administrative Costs: Implementing complex tax and benefit systems is costly for the government (a source of potential Government Failure).

Key Takeaway: Policies to reduce inequality involve a trade-off. While they promote equity and social welfare, they may potentially conflict with objectives like economic efficiency or growth by dampening incentives.