ECON Lecture 12.1: Inequality, Poverty, and Market Determinants of Income

Introduction to Inequality and Redistribution

• The study of inequality and redistribution is a central theme in economic theory, specifically focusing on the disparities in income and wealth among individuals.

• This lecture is the first of three sets of slides, specifically titled Lecture 12.1: Inequality and Poverty, corresponding to Chapter 12: Inequality and Redistribution.

• The primary objective of the chapter is to identify the sources of economic inequality, evaluate whether societal intervention is necessary, and explore potential policy responses.

Defining Income and Wealth

• Income:

  • Defined as a flow of money earned by an individual over a specific period (e.g., a week, a month, or a year).

  • Income is generated through the selling of factors of production in the market, specifically:

    • Labor: Selling one's work power.

    • Natural Resources: Selling or renting land and materials.

    • Capital: Investing in equipment or businesses to generate profit.

• Wealth:

  • Defined as a stock of money and other valuable assets at a particular point in time.

  • Calculated as the total value of assets net of debt accumulated by an individual.

  • Examples include savings accounts, checking accounts, and $401K$ balances.

• Consumption Ability: Both income and wealth are critical because they dictate a person's ability to consume goods and services, which is the functional definition of "having" in a market economy.

Personal Determinants of Productivity

Productivity is the primary driver of income in a market economy. It is influenced by several personal factors:

• Natural Talent and Ability:

  • Certain skills are inherent and difficult to replicate through training alone.

  • Examples provided include:

    • Sports: High-level athletes (e.g., NBA point guards, great quarterbacks, baseball sluggers) possess natural talents that coaching cannot fully replicate.

    • STEM Fields: Natural mathematical talent allows individuals to excel in Science, Technology, Engineering, and Math. Engineers typically command higher incomes due to the rarity of these skills.

    • Aesthetics: Interior decorators with a "stunning eye" for beauty can earn significant income.

    • Culinary Arts: Some individuals have a flair for inventing recipes (e.g., great chefs), whereas others merely follow instructions (e.g., "plodding along" by taking food out of cans or boxes).

• Acquired Skills (Human Capital):

  • Natural talent must be paired with acquired skills to maximize income. This is referred to as Human Capital.

  • Scenario: An individual with the mental capacity to be an engineer but who drinks on weekends instead of studying and fails to graduate will not earn a high income despite their innate talent.

• Effort and Diligence:

  • Talent without application leads to lower financial outcomes. Conversely, individuals who may not be "particularly talented" can succeed through hard work, showing up on time, and constant diligence.

• Location:

  • Location impacts the volume of opportunities available to utilize one's skills.

  • Comparison: An individual living in Atlanta likely has a higher long-term income potential than an identical individual in Valdosta due to market opportunities. Major hubs like San Francisco, Los Angeles, or New York offer even higher income ceilings.

• Inheritance:

  • Being born to wealthy parents can dramatically increase an individual's income and wealth through no agency of their own (defined as a matter of luck).

• Health:

  • Healthy individuals can work more years and apply more effort. Poor health interrupts work and reduces production capacity.

  • Health outcomes result from both genetics (what you are born with) and personal choices (e.g., overeating, over-drinking, smoking), which can manifest as serious issues by one's $50s$.

Market-Based Determinants of Productivity

These factors are often beyond an individual's direct control, determined by massive market forces:

• Market Supply and Demand:

  • Individual income is tied to the demand for the industry in which they work.

  • Example: Coal Mining: Despite having great natural ability, human capital, effort, and health, a coal miner's income will decline because environmental regulations and power company shifts are driving down the long-term demand for coal.

  • Contrast: A person with high skills should choose growing industries like Computers and IT over declining ones.

• Compensating Differentials:

  • These are extra payments used to compensate individuals for negative job characteristics.

  • Shift Differentials: A night shift nurse earns more than a day shift nurse with the same degree and skill because supply is lower for night work.

  • Distance/Lifestyle: Long-distance truck drivers earn more than local route drivers (who are home every day) despite using the same truck models.

  • Dangerous/Difficult Work: Cited in the TV show "Dirty Jobs" (announced by Mike Rowe), construction jobs often pay well relative to education levels because they are dangerous, dirty, and difficult.

• Technological Change:

  • Automation can hurt workers (e.g., a production line worker replaced by robotics) or help them (e.g., IT professionals whose skills become more valuable as technology evolves).

• Immigration:

  • Immigration affects the supply of labor. If immigrants are low-skilled, they increase the supply in low-skill markets, which puts downward pressure on wages. Restricted immigration would conversely cause wages to rise due to reduced competition.

• Luck:

  • Includes factors like birth, inheritance, innate health, and the sector of the economy one happens to be in when government policy changes (e.g., the government pushing to cut back on coal for environmental reasons).

Measuring Inequality: The Lorenz Curve

• The Lorenz Curve (named after Professor Lorenz) is a graphical representation of income inequality.

• Axes:

  • Vertical Axis: Fraction of total income earned (e.g., $0.115$, $0.319$, $0.541$, and $1.0$).

  • Horizontal Axis: Fraction of the population.

• The 45-Degree Line:

  • This represents perfect income equality, where every percentage of the population earns the exact same percentage of income (e.g., $50\%$ of people earn $50\%$ of income).

• Observations from the Curve:

  • In the provided example, the bottom 50% of the population earns only $11.5\%$ of total income.

  • The bottom 75% of the population earns $31.9\%$ of total income.

  • The bottom 90% of the population earns $54.1\%$ of total income.

• Degree of Inequality: The more the Lorenz Curve is "bowed out" from the 45-degree line, the greater the inequality in that country.

The Gini Coefficient and U.S. Trends

• Definition: The Gini Coefficient is a numerical value between $0$ and $1$ used to measure inequality.

  • $0$: Perfect income equality (no area between the curve and the 45-degree line).

  • $1$: Perfect income inequality.

  • Calculation: It is the ratio of the yellow highlighted area (the space between the 45-degree line and the Lorenz Curve) to the entire triangle area.

• Historical Gini Coefficients in the U.S.:

  • 1974: $0.395$ (or $39.5\%$

  • 1984: $0.41$

  • 1994: $0.456$

  • 2004: $0.66$

  • 2014: $0.48$

• Income Growth Trends (1974-2014):

  • While inequality increased, the society also became wealthier.

  • Median Household Income (Adjusted for inflation; half make more, half make less):

    • 1974: $\$48,497$

    • 2014: $\$53,000$

  • Mean Household Income (The average income calculated by summing all items and dividing by the count):

    • 1974: $\$56,713$

    • 2014: $\$75,000$

  • Conclusion: Incomes for those at the top rose much more rapidly than those at the bottom, leading to higher Gini values even as absolute income rose for many.

Defining and Measuring Poverty

• Economics Definition of Poverty: A condition of very limited access to goods and services, where a household lacks enough income for necessities (food, clothing, shelter, medical care, transportation, and recreation).

• Poverty Threshold: The minimum income level necessary to escape poverty.

  • In 2015, the U.S. threshold for a family of four was $\$24,036$.

  • Note: This amount would be considered middle class or wealthy by world standards, but it is the poverty level based on U.S. standards of living.

• Poverty Rate: The percentage of the total population falling below the threshold.

• Historical Trends in the Poverty Rate:

  • 1950s-1960s: Significant decline as the economy expanded.

  • Early 1980s: Sharp increase due to a major recession ($1981$-$1983$).

  • 1991: Bounced up due to another recession.

  • Late 1990s-Early 2000s: General decline.

  • 2007-2009: Sharp increase due to the Great Recession.

  • Long-term trend: Over the last $40$ to $50$ years, the rate has held mostly steady with no significant downward trend since the late $1960s$.

Material Living Standards and Amenities (1950 vs. 1997)

Despite a steady poverty rate, the material quality of life for those below the poverty line has shifted. Economists compare the average household in $1950$ to low-income households in $1997$:

• Electricity: $94\%$ of the general population had it in $1950$; universal today.

• Flush Toilets: Only $76\%$ of the total U.S. population had indoor plumbing in $1950$. Universal today among those in poverty.

• Refrigerators: $20\%$ of the entire population lacked one in $1950$.

• Televisions: In $1950$, only $10\%$ of the population (the wealthy) had TVs.

• Telephones: In $1960$, only $80\%$ of the general population had phones.

• Automobiles: Under $60\%$ of the population had one in $1960$. By $1997$, people below the poverty line had a higher rate of car ownership than the average person in $1950$.

• Air Conditioning:

  • In $1960$, only $12\%$ of the total population had it; it was a "tremendous luxury."

  • By $1997$, $70\%$ of households below the poverty line had air conditioning.

• Other Amenities (1997 Poor Ownership Rates):

  • Washing Machines: Common among the poor.

  • Clothes Dryers: $2\%$ of the total population in $1950$ vs. $48\%$ of those in poverty in $1997$.

  • Dishwashers: Unheard of for most in the instructor's youth; $28\%$ of those below the poverty line had one by $1997$.

• Conclusion: While the dollar threshold defines poverty, the consumption ability of those technically "in poverty" today often exceeds the material standard of the average American $50$ to $60$ years ago.