8+9. Income Inequality within a country Flashcards
Why it is important to pay attention to the distribution of income?
One reason to pay attention to the distribution of income is its relationship to POVERTY. For any given average level of income, if income is distributed more unequally, more people will live in poverty. An example makes this point clear. In the year 2005, the average income per capita in India ($2,557) was 21% larger than average income per capita in Pakistan ($2,112). But the fraction of the population living on an income of less than $1.25 per day was 41.6% in India, compared with only 22.5% in Pakistan. The reason for the difference was the distribution of income. Pakistan has a more equal distribution of income than does India, although it has a lower total average income.
Beyond its link to poverty, the distribution of income is also intimately tied to the process of ECONOMIC GROWTH. We will see in this chapter that there are a NUMBER OF CHANNELS THROUGH WHICH INEQUALITY AFFECTS ECONOMIC GROWTH.
Although the empirical evidence is inconclusive, it is possible that a HIGH LEVEL OF INEQUALITY MAY BE GOOD FOR GROWTH AT SOME STAGES OF DEVELOPMENT AND BAD FOR GROWTH AT OTHERS.
Economic growth, in turn, feeds back to affect the degree of income inequality.
Also, REDUCING INEQUALITY IS ONE OF THE MOST IMPORTANT GOALS OF GOVERNMENT ECONOMIC POLICY.
Some POLICIES may achieve the twin goals of REDUCING INCOME INEQUALITY and RAISING ECONOMIC GROWTH. A good example of such a policy is the PUBLIC PROVISION OF EDUCATION.
In OTHER CASES, however, the goals of MAXIMIZING ECONOMIC GROWTH AND REDUCING INCOME INEQUALITY ARE IN CONFLICT.
In this chapter we discuss one such case in detail—the redistribution of income through taxation
To the EXTENT that people derive their HAPPINESSnot from the absolute level of their consumption but from how their RELATIVE CONSUMPTION compares with that of the people around them, income inequality within a country may be more important than differences in income among countries.
Measuring inequality: mean and median
In studying income inequality, we will focus on how the residents of a country differ from the country’s average, and thus also how they differ from each other.
Two useful statistics for summarizing a distribution are the mean (the simple average) and the median (the value that has exactly as many observations below it as above).
The mean income is usually higher than the median, because income distributions are skewed. The reason is that income distributions are always skewed—that is, they have a long right tail, rather than being symmetric around their means–> a few households with very high income raise the mean level of income.
At the same time, these households don’t have much effect on median income (because they are rather few).
Meassuring inequality: Gini Coefficient
The Gini coefficient is constructed by measuring the area between the
Lorenz curve and the line of perfect equality and dividing this area by the total area under the line of perfect equality.
The more bowed out is the Lorenz curve, the more unequally
income is distributed…
… the higher will be the value of the Gini coefficient : If a single household receives all household income in the country, it is 1.
If income is distributed perfectly equally, then the value of the Gini coefficient will be 0.
Meassuring inequality: Kuznets hypothesis and Kuznets curve
Economist Simon Kuznets hypothesized that AS A COUNTRY DEVELOPED, INEQUALITY WOULD FIRST RISE AND THEN LATER FALL.
Kuznets’s theory implies that if we graphed the LEVEL INEQUALITY (Y-AXES) (E.G. GINNI COEFFE) AS A FUNCTION OF THE LEVEL OF GROSS DOMESTIC PRODUCT (GDP/CAPITA X-AXES ) THE DATA WOULD TRACE AN INVERTED U-SHAPE CURVE–> KUZNETS CURVE
EVIDENCE OF A KUZNETS CURVE BASED ON THE RETURN TO EDUCATION:
HUMAN CAPITAL: Kuznets reasoned that ECONOMIC GROWTH —represented by the arrival of NEW TECHNOLOGIES AND CHANGES in the structure of the economy—would INITIALLY RAISE THE RATE OF RETURN TO SKILLS, SUCH AS EDUCATION AND ENTREPRENEURIAL BECAUSE SKILLED WORKERS ARE BETTER THAN UNSKILLED WORKERS AT ADAPTING TO NEW MODES OF PRODUCTION.
PHYSICAL CAPITAL: Similarly, NEW TECHNOLOGIES will raise the rate of return to physical capital because technologies are often embodied in new capital goods (new more efficient and productive machines).
WHY DOES INEQUALITY INCREASE AS BOTH HUMAN AND PHYSICAL CAPITAL INCREASE?
Because SKILLED AND CAPITAL ARE FOUND AT THE HIGH END OF THE INCOME DISTRIBUTION (i.e high-income share of the population), THIS INCREASE IN THE RATE OF RETURN TO HUMAN AND PHYSICAL CAPITAL WOULD RAISE INCOME INEQUALITY (i.e. the gap between low-income share of population and high-income share of population widens).
Over time, however, new forces would begin to operate. First, the DISTRIBUTION OF THE QUALITIES THAT DETERMINE INCOME DISTRIBUTION WOULD CHANGE IN A WAY THAT LOWERED INEQUALITY.
The HIGHER RETURN TO SKILLS WOULD INDUCE UNSKILLED WORKERS TO GET AN EDUCATION, and workers would migrate out of regions or sectors that were falling behind and into fast-growing areas.
Second, AS TECHNOLOGICAL PROGRESS and structural change SLOWED DOWN, THE RATES OF RETURN TO SKILLS WOULD DECLINE, WHICH TENDS TO REDUCE INCOME INEQUALITY.
I. Evidence on Kuznets Curve: examination of the level of inequality in a single country over time: industrialization in England and Wales, 1823-1915
One can look for evidence of a Kuznets curve either by examining the level of inequality in a single country over time or by looking at a single point in time in a cross-section of countries with different levels of income.
Figure 13.4 takes the first approach, showing the Gini coefficient in England and Wales from 1823 to 1915. This was a PERIOD OF RAPID INDUSRIALIZATION (TECHNOLOGICAL PROGRESS/ STRUCTURAL PROCESS/ ECONOMIC DEVELOPMENT PROCESS) during which income per capita increased by a factor of roughly three.
The data show a large rise in inequality during the first half of the period and an even larger decline in the second half, so that by 1915, income was distributed more equally than it had been in 1823. Thus, in these historical data, the Kuznets curve is clearly visible
II. Evidence of a Kuznets Curve: looking at a single point in time in a cross-section of countries with different levels of income.
Figure 13.5 (slide 17) takes the cross-sectional approach, graphing income per capita for the year 2009 on the horizontal axis and the Gini coefficient on the vertical axis.
The figure shows many interesting patterns. Many of the most unequal countries are in Latin America. The countries with the lowest levels of inequality are relatively rich countries with well-developed welfare states, such as Sweden and Norway, or else countries with a recent communist past, such as Hungary and Ukraine. The United States stands out as having an unusually high level of inequality for a rich country.
The data in Figure 13.5 do not provide strong evidence of the inverted-U-shaped relationship between development and income inequality that Kuznets hypothesized.
However, using more advanced statistical techniques, a number of researchers believe there is still good evidence for the Kuznets curve. The problem, they argue, is that many OTHER FACTORS, IN ADDITION TO THE LEVEL OF DEVELOPMENT, AFFECT A COUNTRY’S LEVEL OF INEQUALITY. Once the analysis accounts for these factors, the Kuznets curve “comes out of hiding.
According to a study by the economist Robert Barro, the peak of the Kuznets curve comes at a per-capita income level of $4,815 (in 2000 dollars), corresponding roughly to the income level of Romania in the figure. Barro’s estimates imply that a quadrupling of income per capita from the value that is at the peak of the Kuznets curve (as would happen if Romania grew to have the level of income per capita of the United Kingdom) would lead to a reduction of 0.05 in the Gini coefficient.
How does growth affect the incomes of the poor?
(Hint: KUZNETS CURVE + Relationship between the average income per capita for bottom quintile (20% of the poorest population) and the average income per capita of a country)
The reason economists care about income inequality is that it is related to poverty.
If there is a KUZNETS CURVE, it is theoretically possible that economic growth can be bad for the poorest people in a country. Economic growth can be bad for the poorest people in a country. Specifically, GROWTH’S EFFECT OF RAISING THE AVERAGE LEVEL OF INCOME MAY BE COUNTERACTED BY WIDENING OF INEQUALITY AS THE POOREST PEOPLE FALL FARTHER BELOW THE AVERAGE.
Although the influence of inequality on the income of the poor is apparent in Figure 13.6 (comparison of the average income per capita (x-axis) and the average income per capita for the bottom quintile (y-axis)), the overall impression that the figure gives is that THE MOST IMPORTANT DETERMINANT OF THE INCOMES OF THE POOR IS A COUNTRY’S AVERAGE LEVEL OF GDP. –> POOR PEOPLE IN A RICH, UNEQUAL COUNTRY ARE FAR BETTER OFF THAN POOR PEOPLE IN A POOR EGALITARIANN COUNTRY.
How do growth-promoting policies affect income inequality?
Using these data, Dollar and Kraay examined WHETHER SPECIFIC POLICIES HAD DIFFERENT EFFECTS ON THE INCOME OF THE POOR VERSUS OVERALL INCOME.
Their key finding was that POLICIES THAT AFFECT GROWTH policies that affect growth for good or ill generally DON’T SIGNIFICANTLY AFFECT THE DISTRIBUTION OF INCOME.
For example, RULE OF LAW AND OPENNESS TO TRADE RAISE OVERALL INCOME IN A COUNTRY AND HAVE POSITIVE BUT MINOR EFFECTS ON THE SHARE OF INCOME GOINGTO THE LOWEST QUINTILE.
Similarly, a high rate of inflation and a high level of government consumption is bad for overall income and reduce (but only slightly) the share of income going to the poor.
Another approach to the question of HOW GROWTH AFFECTS THE INCOMES OF THE POOR is to look at INDIVIDUAL EPISODES OF ECONOMIC GROWTH.
A recent study examined 88 episodes in which the average level of income per capita in a country grew over a decade. In each case, the authors looked at data on the distribution of income at the beginning and ending points of the episode. They found that in 77 cases, the income of the poorest fifth of the population also grew. In all but one of the other cases, either growth of average income was very low, or the decline in the income of the poor was temporary and was reversed in subsequent decades. In only one case (Colombia between 1970 and 1980) was there rapid growth of average income.
Summarizing the results of these studies, GROWTH IS ALMOST GOOD FOR THE POOR, AND SO ARE THE POLICIES THAT LEAD TO GROWTH.
Nevertheless, THESE POLICIES DON’T SIGNIFICANTLY AFFECT THE DISTRIBUTION OF INCOME.
Source of income inequality:
Why is there income inequality at all? What are the three main sources of inequality?
The reason income inequality exists is that PEOPLE IN AN ECONOMY DIFFER FROM EACH OTHER IN MANY WAYS THAT ARE RELEVANT TO THERI INCOMES.
DIFFERENCES IN HUMAN CAPITAL OWNERSHIP OF PHYSICAL CAPITAL, GEOGRAPHY:
Differences occur in human capital (both education and health), in where people live (city versus countryside or different geographical regions of a country), in their ownership of physical capital, in the particular skills they have, and even in their luck. These differences are translated into differences in income by the economic environment.
So, 3 MAIN SOURCES OF INEQUALITY:
1) HUMAN CAPITAL: education and skills; health
2) GEOGRAPHY: urban or rural context
3) OWNERSHIP OF PHYSICAL CAPITAL
A man may be rich because he has a skill that is in high demand, because his parents gave him money when he was born, or because he just happened to be in the right place when a good job became available. He might be poor because he lives in a part of the country that is economically depressed because he suffers from a physical ailment that limits his earnings, or because he had no access to education.
Determination of income inequality: Education
Suppose that the only characteristic that determines income is the NUMBER OF YEARS OF EDUCATION.
To get from this distribution of education (fraction of the population in each of the possible educational categories) to a distribution of income, we need to know how education translates into income.
A useful concept, introduced in Chapter 6, is that of the RETURN TO EDUCATION: THE PERCENTAGE RISE IN EARNING THAT RESULTS FROM AN ADDITIONAL YEAR OF EDUCATION. It shows the RELATIONSHIP BETWEEN YEARS OF EDUCATION AND INCOME.
For the purposes of our example, we use a return to education of 10% per year. Thus, if a worker with no education earns an income of 100, a worker with one year of education will earn 110, a worker with two years of education will earn 121, and so on.
Putting together data on the distribution of education and the return to education, we can derive the distribution of income—that is, the fraction of the population that earns each level of income.
Using this analysis, we can examine what determines differences in the distribution of income among countries and what causes the distribution of income to change over time within a given country.
FROM THE POINT OF VIEW OF EDUCATION: DIFFERENCES AMONG COUNTRIES OR CHANGES OVER TIME MUST HAVE THEIR SOURCE IN EITHER THE RETURN TO EDUCATION OR IN EDUCATION DISTRIBUTION.
Let’s assume, there is a change in the return to education. We compare two countries with the identical distribution of education, but different returns to education: the first country has the return to education of 10%, whereas the other one - 5%. Changing the return to education from 10% to 5% lowers the Gini coefficient from 0.068 to 0.035.
We conduct a similar analysis of the effect of changing the distribution of education. In this case, the two countries have the same return to education, but differ in their distributions of education: first country has a narrower distribution of education—that is, more people in the middle educational groups and fewer people in the lowest and highest educational groups. this narrower distribution of education translates into a narrower distribution of income as well—its Gini coefficient of 0.049 is much smaller than that of the broader distribution of education and thus of income.
Nevertheless, we changed only one determinant of inequality at a time. More realistically, however, we would expect that BOTH MIGHT CHANGE SIMULTANEOUSLY, EITHER REINFORCING EACH OTHER OR WORKING IN OPPOSITE DIRECTIONS.
For example, in a given country, the distribution of education might become more equal while the return to education rises. In such a case, the total effect on inequality would depend on WHICH FORCE IS STRONGER.
Further, once we move beyond this simple model, we must remember that many characteristics affect income.
Reasons for the rise in income inequality?
1) TECHNOLOGICAL ADVANCES : skill-biased technological change:
Information technology COMPLEMENTED SKILLS OD EDUCATED WORKERS, INCREASINF THEIR PRODUCTIVITY AND RATE OF RETURN, WHILE DOING LESS TO RAISE THE PRODUCTIY OF LESS EDUCATED WORKERS.
The new technology also INCREASED RETURNS TO FLEXIBILITY (to work with a
new technology) or entrepreneurial spirit. If valid, EXPECRT that at some point the INEQUALITY-INDUCING EFFECTS OF THE CURRENT TECHNOLOGICAL REVOLUTION DISSIPATE.
2) INCREASES IN INTRNATIONAL TRASDE: STOLPER-SAMUELSON: the returns to the aundant factor of production will increase, while the returns to the scarce factor of production will decline. The effect of trade on inequality depens on HOW THE SKILLS, OF THOSE WHOSE RETURNS ARE AFFECTED ARE DISTRIBUTED IN THE POPULATION.
3) SUPERSTAR DYNAMICS: : represents a RISE IN THE RETURN TO CERTAIN QUALITIES and thus increases income inequality.
People with the highest levels of some qualities earn much more than people with only slightly lower qualifications (e.g. sports)
I. Effect of income inequality on economic growth: Examination of channels through which inequality affect economic growth: Accumulation of physical capital
1) EFFCT OF THE ACCUMULATION OF PHYSICAL CAPITALl:
One channel through which income inequality can have a beneficial effect on economic growth is SAVING RATES. A country with a HIGHER SAVING RATE will have a HIGHER STEADY-STATE LEVEL OF INCOME/CAPITA, and a country that raises its saving rate will experience a period of TRANSITIONAL GROWTH AS IT MOVES TOWARD A NEW STEADY STATE.
–>INEQUALITY AND SAVING RATE:
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Inequality is related to the saving rate for the simple reason that SAVING RATES TEND TO RISE WITH INCOME. That is, the HIGHER a person’s INCOME is, the HIGHER his or her SAVING RATE is likely to be. The total amount of saving in a country is the sum of saving by people in all different income groups. The MORE INEQUAL IS INCOME—that is, the HIGHER THE FRACTION OF TOTAL INCOME EARNED BY RICH PEOPLE - HIGHER WILL BE TOTAL SAVING.
The saving rate for the highest quintile is almost three times the saving rate for the lowest quintile.
For example, suppose that we took one dollar of income away from a household in the richest quintile and gave it to a household in the poorest quintile. Such a redistribution of income would reduce the degree of inequality in the country. But because the average saving of the poor out of their income (9.0 cents per dollar) is smaller than the average saving of the rich out of their income (24.4 cents per dollar), the effect of redistributing income would be to reduce total savings by 15.4 cents (that is, 24.4–9.0) for every dollar transferred.
INCOME INEQUALITY AS AN ESSENTIAL PREREQUISITE FOR ECONOMIC GROWTH (KEYNES):
John Maynard Keynes, writing of the late 19th and early 20th centuries, argued that income inequality, which put money in the hands of those LEASR LIKELY TO SPEND IT ON CONSUMPTION, was an essential, though distasteful, prerequisite for economic growth: It was precisely the INEQULITY OF THE DISTRIBUTON OF WEALTH WHICH MADE POSSIBLE THOSE VAST ACCUMULATIONS OF FIXED WEALTH AND OF CAPITAL improvements which distinguished that age from all others. The IMMENSE ACCUMULATIONS OF FIXED CAPITAL which, to the great benefit of mankind, were built up during the half-century before the war, COULD NEVER HAVE COME ABOUT IN A SOCIETY WHERE WEALTH WAS DIVIDED EQUITABLY.
II. Effect of inequality on economic growth through the accumulation of human capital
Although a MORE UNEQUAL DISTRIBUTION OF INCOME IS BENEFICAL FOR ACCUMULATING PHYSICAL CAPITAL AND THUS FOR ECONOMIC GROWTH–>
OPPOSITE SITUATION IN THE CASE OF HUMAN CAPITAL:
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A MORE UNEQUAL DISTIRBUTION OF INCOME LEADS TO LOWER HUMAN CAPITAL ACCUMULATION. The source of the difference between these two cases goes back to one of the fundamental differences in the two factors of production. HUMAN CAPITAL IS “INSTALLED” IN A SPECIFIC PERSON, IT WORKS ONLY WHEN ITS OWNER WORKS, AND IT CANNOT BE TRASNDERRED FROM ONE PERSON TO ANOTHER
By contrast, a piece of physical capital can be used by different people at different times and can easily be sold by one person to another. As a result, it is fairly easy for one person to own physical capital that is used in production by a different person. For example, a rich woman may own a factory that uses the labor of hundreds of other people. But it is almost impossible for a person to own the human capital that is installed in someone else.
Thus, unlike the case for physical capital, the opportunities that any one person has to invest in human capital are limited to the human capital that he can install in himself.
The effect of inequality in the presence of this limitation on human capital investment can be easily seen in a simple example. Consider two people, one rich and one poor. Each person has two types of investment that can be made: in human capital or in physical capital. We assume that at low levels of investment, the MARGINAL PRODUCT OF HUMAN CAPITAL IS VERY HIGH. But as the quantity of human capital that is invested in any one person increases, its marginal product goes down (since there is a limitation–> so to say Sättigungspunkt).
By contrast, the MARGINAL PRODUCT OF PHYSICAL CAPITAL that any one investor faces does not depend on the amount that person invests in physical capital because any single person’s investment is minuscule in relation to the national level of capital.
The relationship between the quantities that an individual invests in human and physical capital and the marginal products earned by these investments is shown in Figure 13.1 (slide 33). As Figure 13.11 makes clear, if a person has only a little money, he or she will invest in human capital rather than in physical capital because it is always better to invest in the form of capital with the highest marginal product.
But people with a lot of money to invest will invest their marginal dollars in physical capital. More specifically, if a person has less than I* available to invest, he or she will invest it all in human capital (higher marginal product for this level of I). If he or she has more than I to invest, then he or she will invest I* in human capital and the rest of his or her money in physical capital.
One of the implications of this story is that human capital will be distributed much more equally (max. investments in human capital up to the level of I, no investments in physical capital at all, since income of poor people is limited to the level I (assumption)) than physical capital (investments are made for an infinite large level income).
The reason is that many poorer people will do all of their investment in the form of human capital and therefore will own no physical capital, whereas many wealthy people will hold almost all of their wealth in the form of physical capital. Recall the definition of Gini-coefficient (1- complete inequality; 0-perfect equality). Gini coefficients can also be used to measure the degree of inequality in the ownership of specific assets such as physical capital and human capital. In the United States, the Gini coefficient is 0.78 for physical capital and 0.14 for years of education (considered as a human capital). Thus, ownership of physical capital is indeed more unequal than that of human capital.
Once again, why is human capital more equally distributed than physical capital:
Both people with income up to I* and people with the income I< will invest in human capital up to I, since the marginal product of investment into human capital up to this level is higher than that of physical capital. On the other hand, investment in the physical capital will only be done by people whose income lies above the level I*. Only a few rich people possess incomes of this magnitude and thus the ownership of physical capital will be accumulated by a smaller share of population as compared to human capital accumulation.
II. Effect of inequality on economic growth through accumulation of human capital: How does inequality affect the accumulation of human capital?
Let’s consider two people, one with more than I* available to invest, and the other with less than I. The person with less than I will invest all of the wealth in human capital; the person with more than I* will invest I* in human capital and the rest of the wealth in physical capital. Notice that the marginal product of the last dollar invested by the poor person is higher than the marginal product of the last dollar invested by the rich person.
If INCOME REDISTRIBUTED FROM RICH TO THE POOR PERSON, two things will happen.
1) HUMAN CAPITAL ACCUMULATION WILL RISE because the poor person will invest extra money in human capital, whereas the rich person will reduce investment in physical capital.
2) TOTAL OUTPUT WILL GO UP because the MARGINAL PRODUCT OF HUMAN CAPITAL BEING INVESTED IN BY THE POOR PERSON IS HIGHERr than the marginal product of physical capital that the rich person invests in.
What kind of effects does inequality have on the pace of economic growth at different stages of growth?
The different effects of inequality on physical and human capital accumulation - beneficial in the case of physical capital and harmful in the case of human capital—suggest that inequality may have different effects on the pace of economic growth at different stages of growth.
As Keynes’s quotation suggests, the driving force of 19th-century economic growth was the accumulation of physical capital.
For example, many of the new technologies of this period were oriented toward the more effective use of physical capital—that is, building better machines. Thus, in this period, inequality may have contributed to economic growth.
However, as discussed in Chapter 6, economic growth in the last several decades, at least among the most developed countries, has been driven by the accumulation of human capital rather than physical capital. In this circumstance, inequality is detrimental to growth.
