Chapter 16 Challenge To Market Effectiveness 6: Inequality McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Chapter 16

Challenge To Market Effectiveness 6:

Inequality

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Learning Objectives

• Why do we face income inequality?• How does inequality affect a nation?• What are the problems of reducing inequality?• Should the government reduce inequality?• How can one make very high income?• Why is there income inequality between men and

women?• Why does household inequality increase with assortative

mating?• How does racial discrimination affect income inequality?• How does education affect inequality?

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Inequality • People are not equal before markets.• Income inequality may be due to differences in

choice of careers, education, skills and abilities, amount of hard work or opportunities.

• One reason why people object to income inequality is fairness.

• Whether fairness is important is a moral issue lying outside the boundaries of economics.

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U.S. Income InequalityPopulation Group

Average Family Income in 2001

Poorest Fifth $10,136

Second Fifth $25,468

Middle Fifth $42,629

Fourth Fifth $66,839

Richest Fifth $145,970

Top 5% $260,464

Middlefifth

Fourthfifth

Second fifth

Poorest fifth

Richest fifth

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Inequality

• Inequality is a different type of market challenge. It does not lower a nation’s wealth.

• Government's efforts at reducing inequality often lower a nation’s wealth.

• When the government transfers wealth to the poor it actually encourages more people to become poor.

• When the government gives money to the poor, it reduces poor peoples’ incentives to work.

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Choice and Inequality

• A key lesson of economics is that tradeoffs are everywhere.

• One tradeoff is choosing between free time and income.

• Some professionals must put in long work hours. Other jobs pay less but also require less time.

• However, not everyone has comparable choices.

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Problems of Reducing Inequality

• Reducing income inequality could be unfair because some people with relatively low incomes might, overall, be no less happy than those with high incomes.

• Reducing income inequality creates incentives for people to stop working and become poor so they can receive welfare from the government.

• Reducing income inequality punishes the rich, reducing incentives for people to work hard to become rich.

• Reducing income inequality empowers politicians and so increases the amount of resources citizens spend lobbying politicians.

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Should the Government Reduce Inequality?

• Government's efforts at reducing inequality often lower a nation’s wealth.

• If one is morally committed to notions of fairness and equality you could rationally decide that even though significantly reducing income inequality causes some problems, the government should still do it.

• Many people believe that excessive wealth acquisition is socially destructive. For them, the case for wealth redistribution is very strong.

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Paths to Great Wealth

To make an extremely high income while working for other people, you first need to be one of the best in your field as well as:

• Get very wealthy people to value your work highly.

• Excel at running a large organization.

• Get millions of people to value your work.

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Sex and Income Inequality

• In the U.S. full-time working women make about 76% as much, on average, as full-time working men.

• There is discrimination against women.• Child-rearing decisions made by women significantly

contribute to male/female disparity.• Women are far more likely than men to stop working for

a few years to raise children.• Women often prefer lower paying professions than men. • Even though parents don’t get paid for taking care of

their children, economists consider parenting a wealth-creating activity.

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Assortative Mating

• Assortative mating means that men and women marry people like themselves.

• With women making up a significant part of all high-paying professions, now it’s common for high-income men to marry high-income women whom they meet in the workplace.

• By teaming up high-income individuals, assortative mating has increased household income inequality.

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Racial Discrimination

• If a restaurant, law firm or athletic team refuses to hire people from a given racial group then that firm’s quality will suffer.

• Therefore, if customers care only about quality, then profit-maximizing firms won’t discriminate.

• But if customers care about both quality and the racial makeup of employees, then racial discrimination may be profit maximizing, e.g. South African miners, Baseball Leagues in 1940s.

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Jim Crow Laws in American History• Jim Crow Laws are racially segregated seating

on public transportation in the American South.• Private owners of streetcar, bus, and railroad

companies in the South lobbied against the Jim Crow laws.

• This resistance was not based on a desire for civil rights, but on a fear of losing money if racial segregation caused black customers to use public transportation less often.

• The incentives of the economic system and the incentives of the political system were not only different, they clashed.

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Educational Premiums• Colleges probably teach people useful information, so

that will likely make them more productive workers. • Many highly intelligent people go to college and so

naturally earn more when they graduate than other workers do.

Education Level Average Income In 2005

Advanced Degree $74,602

Bachelor’s Degree $51,206

High School Diploma Only $27,915

No High School Diploma $18,734

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Generational Mobility

• Being born to a poor parent is a significant but surmountable obstacle to earning a high income as an adult.

• 20% of kids who grew up in households that were among the 20% poorest of the U.S. population ended up in the richest 40% of the U.S. population.

• There is generational mobility in the U.S.

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High Fixed Costs Goods and Inequality

• The world’s rich and middle class generally buy the exact same high fixed costs/low marginal costs goods.

• The cost structure of many goods has created a significant level of consumption equality between the rich and middle class.

• But the prevalence of high fixed costs goods has still not given us total consumption equality.

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Inequality

• There are many inequalities in life besides inequality of income, e.g. inequality of good looks.

• Inequality creates envy and a negative “mental” externality for the have-nots.

• Radically eliminating inequality can be very brutal.

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Do You Know?

• Many people have a choice of how much to work. How does this affect the fairness of income inequality?

Many people have choice between free time and income. We can’t necessarily claim that it is unfair that some people earn more than others. People who choose low-paying jobs might receive compensating benefits such as having large amount of free time and less job stress.

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Do You Know?

• What problem can occur when the government takes money from the rich?When the government takes wealth from the rich it reduces peoples’ willingness to work hard to become rich.

When do markets punish racists who refuse to hire members of some racial groups?When a firm refuses to hire people from a given racial group, then that firm’s quality will suffer. If customers care only about quality, markets will punish the racists firm by loosing customers and profits.

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Summary

• People are not equal before markets.• Income inequality may be due to differences in choice of

careers, education, skills and abilities, amount of hard work or opportunities.

• Inequality does not lower a nation’s wealth.• Government's efforts at reducing inequality often lower a

nation’s wealth.• When the government gives money to the poor, it

reduces poor peoples’ incentives to work. • When the government takes wealth from the rich it

reduces peoples’ willingness to work hard to become rich.

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Summary

• Child-rearing decisions made by women significantly contribute to male/female income inequality.

• By teaming up high-income individuals, assortative mating has increased household income inequality.

• Markets punish racial discrimination only when customers care only about quality.

• The cost structure of many goods has created a significant level of consumption equality between the rich and middle class.

• There are many inequalities in life besides inequality of income.

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Coming Up

How can we apply economics everywhere?

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