Economic Inequality
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Economic Inequality
• We live in a country with extreme differences in
wealth and income
• One reason for this is a difference in wage rates
• Can explain much about wage differences, using
the tools you learned in a previous chapter
• To understand income inequality more broadly,
must extend our reach beyond labor market
– Look at earnings—or the lack of earnings—from all
sources
2
Why Do Wages Differ?
• At any time, some of the wage inequality we
observe is short-run inequality
• But long-run wage inequality exists as well
– Differences in wages that persist after all adjustments
have taken place
• Significant inequality exists in wage rates
– Among different occupations
– Among and within occupations in U.S. labor market
• Wage inequality is persistent
• Both highest and lowest paid occupations have
been so for decades
3
An Imaginary World
• To understand why wages differ in the real
world, let’s start by imagining an unreal
world
– Except for differences in wages, all jobs are
equally attractive to all workers
– All workers are equally able to do any job
– All labor markets are perfectly competitive
• In such a world, we would expect every
worker to earn an identical wage in long-run
4
An Imaginary World
• Figure 1 shows two different labor markets
that initially have different wage rates
– In our imaginary world, could this diagram
describe long-run equilibrium in these markets?
• No
• As these shifts occur, market wage rate of
elementary school teachers will rise and
that of systems analysts will fall
5
Figure 1: Disappearing Wage
Differentials
(a)
Hourly
Wage
(b)
Hourly
Wage
S
L2
S
L1
S
S
L2
L1
B
A
$30
26
$26
20
B
D
A
L
D
L
Number
of Executive Assistants
Number
of Carpenters
6
An Imaginary World
• When will the entry and exit stop?
– When there is no reason for an elementary school teacher to want
to be a systems analyst
• When both labor markets are paying same wage rate
• Long-run adjustments will occur even if no one actually
switches jobs
• Changes will continue until—at points A’ and B’—the longrun wage rate is equal in both markets
• Take any one of these assumptions away, and equal-wage
result disappears
– Tells us where to look for sources of wage inequality in real world
• A violation of one or more of our assumptions
7
Compensating Differentials
• In our imaginary world, all jobs were equally
attractive to all workers
• In real world, jobs differ in hundreds of ways that
matter to workers
• When one job is intrinsically more or less
attractive than another
– Can expect wages to differ by a compensating wage
differential
• Difference in wage rates that makes two jobs equally attractive
to workers
8
Nonmonetary Job Characteristics
• When evaluating a career, whether you are
aware of it or not, you are evaluating
hundreds of nonmonetary job
characteristics, including
– Risk of death or injury
– Cleanliness of work environment
– Prestige you can expect in your community
– Amount of physical exertion required
– Degree of intellectual stimulation
– Potential of advancement
9
Nonmonetary Job Characteristics
• You will also think about geographic location of job and
characteristics of the community in which you would live
and work
–
–
–
–
–
Weather
Crime rates
Pollution levels
Transportation system
Cultural amenities
• Nonmonetary characteristics of different jobs give rise to
compensating wage differentials
– Jobs considered intrinsically less attractive will tend to pay higher
wages, other things being equal
10
Nonmonetary Job Characteristics
• What about unusually attractive jobs?
– These jobs will generally pay negative compensating
differentials
• Different people have different tastes for working
and living conditions
• Cannot use our own preferences to declare a job
as less attractive or more attractive
– Or to decide which jobs should pay a positive or
negative compensating differential
• Rather, when labor markets are perfectly competitive
– Entry and exit of workers automatically determines compensating
wage differential in each labor market
11
Nonmonetary Job Characteristics
• Compensating wage differentials are one reason
most economists are skeptical about idea of
comparable worth
– Holds that a government agency should determine
skills required to perform different jobs and mandate
wage differences needed between them
• Economists generally prefer policies to increase
competition and eliminate discrimination
– So that the market itself can determine comparable
worth
12
Cost of Living Differences
• Differences in living costs can cause
compensating wage differentials
– Areas where living costs are higher than
average will tend to have higher than average
wages
• To compensate for the higher cost of living
13
Differences in Human Capital
Requirements
• All else equal, jobs that require more education and training will be
less attractive
– In order to attract workers, these jobs must offer higher pay than other
jobs that are similar in other ways, but require less training
• Differences in human capital requirements can give rise to
compensating wage differentials
– Jobs that require more costly training will tend to pay higher wages, other
things equal
• Compensating differentials explain much of the wage differential
between jobs requiring college degrees and requiring only a high
school diploma
• The idea of compensating wage differentials dates back to Adam
Smith
– First observed that unpleasant jobs seem to pay more than other jobs that
require similar skills and qualifications
14
Differences In Ability
• Not everyone has the intelligence needed to perform well
at any job
• Scientific discoveries and technological advances have
increased not only skill requirements of many jobs
– But also abilities needed to acquire those skills
• In general, those with greater ability to do a job well—
based on their talent, intelligence, motivation, or
perseverance—will be more valuable to firms
– Firms will be willing to pay them a higher wage rate
• Beyond any compensating differential for their human capital
investment
15
The Economics of Superstars
• Why was owner of Texas Rangers willing to pay $25 million per year to
have Alex Rodriguez play for his team?
– Immediate answer
• Because Rodriguez is so good
• When we try to explain extremely high wage rates of these superstars
based on their exceptional abilities alone, we confront a puzzle
• The very top writers, rock stars, comedians, talk-show hosts, and
movie directors all earn wage premiums that seem vastly out of
proportion to their additional abilities
– Why?
• Explanation in all these cases is based on ability
– And also by exaggerated rewards market bestows on those deemed the
best or one of the best in a field
16
The Economics of Superstars
• If most people rank recent mystery novels in the same order, then the
best will sell millions of copies, second best will sell hundreds of
thousands, and third best might sell only thousands
– Even though all three novels might be very close in quality
• A publisher will earn ten times more revenue selling the best novel
(compared to the second best), and ten times more revenue selling
the second best (compared to the third best), and so on
• Same thing happens in markets for athletes, rock concerts, action
movies, and news broadcasters
– But phenomenon is not limited to media markets or media stars
• Same logic can be applied in the business world
– Chief executive officers of the top corporations have earned huge—and
rapidly rising—salaries
17
Barriers to Entry
• In some labor markets, barriers keep out would-be
entrants
– Resulting in higher wages in those markets
• Since barriers to entry help maintain high wages
for those protected by the barriers—those who
already have jobs in the protected market
– Should not be surprised to find that in almost all cases,
it is those already employed who are responsible for
erecting barriers
18
Occupational Licensing
• In many labor markets, occupational licensing laws keep out potential
entrants
• American Medical Association (AMA) is perhaps the strongest
example of occupational licensing as a barrier to entry
– Professional organization to which almost half of American physicians
belong
– Much of AMA’s activity has been designed to decrease supply of doctors
– AMA has also increased demand for physicians’ services by preventing
nonphysicians from competing
– In late 1980’s, rising health care costs led to increased public scrutiny of
AMA, and its anticompetitive practices came under heavy attack
• Economists see AMA primarily as an instrument to maintain high
incomes for doctors
19
Figure 2: The Market for Physicians
20
Union Wage Setting
• A labor union represents collective interests of its
members
• Major objective of a union is to raise its members’
pay
– Higher union wage is contrary to interests of
employer—so why does employer agree?
• Because union has power to strike
• In a competitive labor market, a union—by raising
the wage firms must pay—decreases total
employment in the union sector
– This, in turn, causes wages in non-union sector to drop
– Result is a wage differential between union and nonunion wages
21
Figure 3: Union Wage Differentials
(a)
(b)
Wage
Wage
LS1
S
L
W2
S
L2
A
B
W1
W1
A
W3
B
D
L
250,000
350,000
300,000
Number
of Long-Haul
Truckers
D
L
200,000
225,000
Number
of Short-Haul
Truckers
22
Union Wage Setting
• Unions still maintain a significant, though declining,
presence in many industries
– Such as automobiles, steel, coal, construction, mining, and trucking
– Certainly responsible for at least some of the higher wages earned in
those industries
• Full effect of unions on labor markets is much more complex
• Many of the features of modern work that we take for
granted today originated in union struggles with
management
– Such as paid vacations and overtime pay
• Unions can raise workers morale and reduce labor turnover
– Through grievance procedures and other forms of communications
with management
23
The Minimum Wage
• Minimum wage law makes it illegal to hire a
worker for less than a specified wage
– In any labor market covered by the law
• Most people think about the minimum wage as a
means to increase living standards for the lowest
paid workers, and their analysis stops there
• But minimum wage creates a wage differential
among the least-skilled workers, depending on the
industry in which they work
– By raising wages rates in covered industries, and
lowering them in uncovered industries
24
Figure 4: The Minimum Wage
25
The Minimum Wage
• Only one group of workers in which everyone
benefits: skilled workers
– Should come as no surprise that for many decades the
most vocal advocates of raising the minimum wage
have been labor unions
• Membership is disproportionately made up of skilled workers
• What do economists think about the minimum
wage?
– Most regard it as an inefficient policy for helping poor
working families
26
The Minimum Wage
• You might think that economists would
overwhelmingly oppose any increase in minimum
wage
– But that is not the case
• Those who favored an increase in minimum wage tended to
believe the effect on unemployment was much smaller than
those who opposed an increase
• Others may believe that higher unemployment is more likely to
influence policy in a direction they favor
• The minimum wage, like most issues of public
policy, is not as simple as it appears
27
Discrimination and Wages
• Discrimination occurs when members of a group
of people have different opportunities because of
characteristics that have nothing to do with their
abilities
• First step in understanding economics of
discrimination is to distinguish two words that are
often confused
– Prejudice
• Emotional dislike for members of a certain group
– Discrimination
• Restricted opportunities offered to such a group
28
Employer Prejudice
• When you think of job discrimination, your first
image might be a manager who refuses to hire
members of some group because of pure prejudice
– Such as African-Americans or women
• May surprise you to learn that economists generally
consider employer prejudice one of the least
important sources of labor market discrimination
– When prejudice originates with employers, market forces
work to discourage discrimination and reduce or
eliminate any wage gap between favored and unfavored
group
29
Employee and Customer Prejudice
• What if workers—rather than employers—are prejudiced?
– In a competitive output market, non-discriminating firm will be
forced out of business
• Cannot count on the market to solve the problem
• Same argument applies if the prejudice originates with
firm’s customers
• When prejudice originates with firm’s employees or its
customers
– Market forces may encourage, rather than discourage,
discrimination
• Can lead to a permanent wage gap between favored and unfavored
groups
30
Figure 5: Employer Discrimination
and Wage Rates
31
Statistical Discrimination
• Suppose you are in charge of hiring 10 new employees at
your firm
– Young married women in your industry are twice as likely to quit
their jobs within two years than men and those that quit are very
costly to your firm
– 20 people apply for 10 positions—half men and half women
• Whom will you hire?
• If your sole goal is to maximize the firm’s profit
– You will hire men
• Even if there isn’t a trace of prejudice in you, in the firm’s
employees, or in its customers, profit maximization may
still dictate hiring the men
32
Statistical Discrimination
• When individuals are excluded from an activity
based on the statistical probability of behavior in
their group
– Rather than their personal characteristics
• Some observers have suggested that statistical
discrimination is often a cover for prejudice
• According to critics of the statistical discrimination
theory, the negative behavior of a favored group is
rarely considered by employers
33
Dealing With Discrimination
• Discrimination due to pure employer prejudice is unlikely
to have much of an impact on labor markets
• For other types of discrimination market incentives work in
the opposite way, leading to a permanent and stubborn
problem
– Such as statistical discrimination or discrimination due to worker or
consumer prejudice
• In these cases, many economists and other policy makers believe that
government action is needed
– Some favor affirmative action programs
– Others favor stricter enforcement of existing antidiscrimination laws and
stiffer penalties when discriminatory hiring occurs
» Both approaches to policy force all firms to bear costs of
nondiscriminatory hiring
34
Discrimination and Wage
Differentials
• Consider the black-white differential for men
• Several studies suggest that if we limit comparisons to whites and
blacks with same educational background, geographic location, and, in
some cases, same ability (measured by a variety of different tests),
50% or more of the earnings difference disappears
• In addition to job-market discrimination, there is pre-market
discrimination
– Occurs before an individual enters labor market
• Such as unequal treatment in education and housing
• For women, as well as blacks and other minorities, differences in skills
and experience can be the result of lower wages
– Since women know they will earn less than men and will have more
trouble advancing on the job
• They have less incentive to invest in human capital and to stay in labor force
35
Discrimination and Wage
Differentials
• In the end, we do not know nearly as much about the
impact of discrimination on wages as we would like to
know
– But research is proceeding at a rapid pace
• As we’ve seen, data must always be interpreted with care
– In measuring impact of job market discrimination on earnings
• Wage gap between two groups gives an overestimate
– Since it fails to account for differences in skills and experience
– However, comparing only workers with similar skills and
experience leads to an underestimate
• Since some of the differences are themselves caused by
discrimination—both in the job market and outside of it
36
Figure 6: Vicious Cycle of
Discrimination
37
Income Inequality
• Wage differentials among households are an important
cause of income inequality, but not the only cause
– Two people with identical hourly wage rates may have vastly
different wage or salary incomes
• Because one is unemployed more often than the other or
• Because one works more hours each week than the other
• Wages and salaries are not the only source of income
– Property income
• Income derived from supplying capital, land, or natural resources
– Transfer payment
• Any payment that is not compensation for supplying goods, services,
or resources
• Although there are many measures of income inequality,
they all leave much to be desired
38
The Poverty Rate
• Percentage of families whose incomes fall below
a certain minimum, called the poverty line
• Important because they keep policy makers and
public aware of conditions at the bottom of
economic ladder
• Gives us important information about the poorest
families and how poverty is distributed among
different groups within society
39
The Lorenz Curve
• Line showing cumulative percent of income received by
each cumulative percent of households
– When households are arrayed according to their incomes
• One of the most popular numerical measures of income
inequality—the Gini coefficient—is obtained from the
Lorenz curve in a very simple way
– Ratio of area above a Lorenz curve and under the complete
equality line to the area under the diagonal
• The larger the Gini coefficient—up to a maximum of 1.0—
the greater the degree of income inequality
40
Figure 7: The U.S. Lorenz Curve,
2001
41
Growing Income Inequality
• There is a clear trend upward in the Lorenz curve
– Suggesting that Lorenz curve has become more
“bowed out”, and inequality is increasing
• Some of what you’ve learned in this and the
previous chapters can help explain this rise in
income inequality that has accelerated after 1990
– Most of technological changes of past decade have
been
• Complementary with highly-skilled (and high-wage) labor and
• Substitutable for less-skilled (low-wage) labor
42
Growing Income Inequality
• Increased international trade with low-wage countries may
have slowed income growth for least skilled workers in
U.S.
– While it has benefited the nation as a whole
– At the other end, very rapid income growth of thousands of
superstars has played a role
• But what about those at the very, very top?
– In 2000, for example, cutoff point for the IRS’s top-400 list was a
reported income (including capital gains) of $87 million
– But issue raised by numbers like this is an entirely different
dimension of economic inequality than we’ve discussed so far, one
having to do with wealth
43
Wealth Inequality
• A household’s wealth or net worth
– Total value of all the assets it owns—including real estate, stocks, bonds,
and bank accounts—minus value of its debts
– A household that owns (owes) more than it owes (owns) has positive
(negative) wealth
• Wealth inequality is related to income inequality
– Greater wealth leads to greater income
• Those with lowest incomes are least able to save, which is how most
families build up their wealth
– Thus, income inequality contributes to wealth inequality
• Concentration of wealth at the top, and tiny share held by the bottom
half of the population, raises issues that go far beyond income
inequality
44
Figure 8: U.S. Lorenz Cures for
Income and Wealth, 2001
45
Earned Income Versus Available
Income
• Our inequality measures are based on income earned by different
groups, not income available for spending
– For a variety of reasons, these can be very different
• United States has a progressive income tax
– Higher-income households pay a greater percentage of their income in
taxes
• However, since our inequality measures are based on income before tax, they
tend to overstate inequality in available income
• Ignoring transfers, like ignoring taxes, leads to an overstatement of
inequality
• If we included fringes and capital gains in our measures, they would
show a greater proportion of total income going to the middle and the
top
– For these reasons, our measures may understate income inequality
46
Income Mobility
• It is one thing to say that the bottom 20% of
households earn only 3.5% of the income
– Quite another to say that, year after year, the same
households remain at the bottom
• If many of those at the bottom or top are there
only temporarily
– Then over a longer time horizon, there is less inequality
than our measures suggest
• Most workers start out earning low incomes,
which then rise as they acquire more skills and
experience, and, finally, fall sharply in retirement
47
Income Mobility
• Problem is that Lorenz curves, Gini coefficients, poverty
rates, and most other measures of inequality give us a
snapshot picture of the distribution of income
– What we would ideally like is a moving picture
• U.S. income distribution exhibits significant mobility
between extremes and middle
– Lorenz curves, poverty rates, Gini ratios, and other measures of
income inequality may exaggerate long-run income inequality
• Because they provide only a snapshot of the income distribution at a
moment in time
• Decrease in mobility—coupled with rising inequality—has
caused considerable concern
48
Careless Interpretations
• Another problem with measures of income
distribution is a criticism not of the measures
themselves, but of how they are interpreted
• As you have been reading this chapter, have you
made the implicit assumption that more inequality
is bad and more equality good?
• Even if we had perfect measure of income
inequality
– Caution would be needed in drawing conclusions about
equity or fairness
49
Economic Inequality and Fairness
• Fairness is difficult to define, in large part because
we all have such different ideas about what it is
• Economics often steers clear of the fairness
controversy
– Most economic research emphasizes positive (descriptive
and predictive) issues, rather than normative (prescriptive)
ones
• Despite the controversy, there are some issues of
fairness on which almost everyone agrees
– Almost everyone would agree that income inequality due
solely to compensating wage differentials is entirely fair
– Same holds for some of the inequality in property income
50
Economic Inequality and Fairness
• Inequality that results from equal opportunity—but different
choices—is generally regarded as fair
• Much of the income inequality—especially at the
extremes—seems to originate in different opportunities
• There is even more disagreement about inherited wealth
• One famous effort to form a consensus about fairness was
made by philosopher John Rawls, a Harvard philosopher,
in A Theory of Justice
– Inequality would be justified only if it helped raise the position of
the person at the bottom
– His ideas were highly controversial
51
Using the Theory—CEOs in the 1990s and
early 2000s: Ability…or Something Else?
• During 1990s and early 2000s, payments to CEOs of
major U.S. corporations rose dramatically
• Stock options give person who holds them automatic right
to buy shares in the company at a predetermined price
– Usually, the market price of shares on the day options are awarded
• Restricted stock grants are actual gifts of shares of stock
– Restriction is that shares cannot be immediately sold
• Why is CEO compensation—especially in these additional
stock-based forms—so high?
– And why has it risen so rapidly over the past decade?
52
Using the Theory: The Ability
Explanation
• Part of the explanation can be found in the normal
workings of the market for CEOs
– Steering a major U.S. corporation is a difficult job
• Very few people have the ability to do this job
– Fewer still have proven ability by having successfully
managed a large corporation in the past
• A major corporation that wants to hire a top CEO
will find itself bidding with hundreds of other
corporations for this scarce pool of labor
• Market for CEOs shares some of the features of
the superstar labor markets discussed earlier
53
Using the Theory: The Ability
Explanation
• Hiring the slightly better CEO, who is able to make slightly
better decisions, could make a huge difference in total profits
– It could even make the difference between survival and bankruptcy
• Result is a bidding war in which the slightly more able
candidate earns an astronomical compensation package
– Many times greater than the pay of a candidate who is almost as good
• If the scenario based on ability entirely explained high and
rising CEO pay, there would be no reason for shareholders to
be upset
• But shareholders and government have been upset about
skyrocketing CEO pay—because there is more to the story
54
Using the Theory: The Market
Failure Explanation
• Market for CEOs seems to suffer from some
serious market failures
– A market fails when its normal equilibrium does not
allocate resources in the best interests of society
• How does labor market for CEOs fail?
– Principal-agent problem arises when an agent is able to
maximize his own well-being instead of the well-being
of the principal who hired him
• CEO-shareholder relationship is a case in point
– Shareholders are the principals
• They have neither expertise nor information needed to monitor
management performance
55
Using the Theory: The Market
Failure Explanation
• Shareholders vote into office a board of directors
to monitor the firm for them
– Board members—who are paid for their work—are
supposed to have the expertise, motivation, and power
to ensure performance on behalf of stockholders
• Corporations also create incentives to align
interests of managers with those of shareholders
• That’s all well in theory
– But in the view of many economists, these very
methods designed to solve the principal-agent problem
have become part of the problem itself
56
Using the Theory: The Market
Failure Explanation
• CEOs control flow of information to the board
– So they can present a biased view of their decisions and outcomes
• One that hides actions that are harming shareholders
• Let’s again consider stock options and grants
– Who could complain about granting options that only have value if CEO
succeeds?
– But critics have pointed out numerous practices that seem to contradict
options as a reward for good performance
– Though a change in stock prices does not prove a good or bad
performance
• Numerous examples of generous options being awarded to CEOs whose stock
performed poorly relative to other firms in same industry
– Another contradiction of options and stock grants as a performanceincentive is that they reward CEOs for any rise in the stock’s price
• Even one caused by a general boom in stock market to which CEO contributed
nothing
57
Using the Theory: The Market
Failure Explanation
• There have been hefty raises, “good performance”
bounces, and lavish fringe benefits awarded to
CEOs who have been outperformed by the market
in general, and even most competitors in their
industry
– And boards of directors have agreed to contracts
guaranteeing CEOs millions of dollars in severance pay
• Even if CEOs are fired for poor performance
• Treatment suggests that CEOs are being
rewarded for reasons other than creation of
shareholder wealth
58
Using the Theory: The Market
Failure Explanation
• In first half of 2003, groups of shareholders filed more than 800
resolutions to limit their boards’ flexibility in designing and awarding
stock options, stock grants, bonuses, salaries, severance pay, and more
• Change may not be as dramatic as toughest critics might hope
– Scarcity of qualified CEOs, and exaggerated rewards to shareholders from
hiring a CEO with a slight edge in ability suggest that CEOs of large
corporations will continue to earn many times wage rate of average worker
• Even in a well-functioning market
• We’ll also continue to see high CEO pay at poorly performing
corporations
– When a company is in trouble, it most needs the services of a highlyqualified chief executive
59