15
Income, Inequality,
and Poverty
US Distribution of Income
1940-2010 (in 2007$)
Comparison of US – World
Share of Top 1%
Basic Theory of Wages
• Demand for Labor is
– Derived from the demand for the final
good
• i.e, labor is one of several inputs into the
production process
– Labor’s value is determined by its
productivity
• i.e., how much does each additional unit of labor
increase output of the final good
Basic Theory of Wages
Basic Theory of Wages
• Labor’s wage is determined by:
– Increase in output, or “marginal
productivity” of labor (mpL ), and
– the market value of the final product
– Wage = poutput * mp
L
• Represents a “cap” or “ceiling on an
employee’s wage
Historical Relationship
Productivity and Wages
Non-Monetary Determinants
of Wages
Wage Differentials
• How do we explain variation in wages
between “similar” people?
– 1. Compensating Variation
• Wage differences resulting from non-monetary
characteristics of jobs
• E.g. risk, desirability of job
– 2. Location
– 3. Human capital
• Education, job-specific training, experience
• $15k-$20k annual salary difference – college grad
Wage Differentials
• How do we explain variation in wages
between “similar” people?
– 4. Unions
• 10-20% differential
• Decreased union membership
– Greater unionization in government jobs
– 5. Efficiency Wages
• Paying above equilibrium wage
• Decreases employee turnover, increases
productivity, attracts higher skilled employees
Wage Differentials
• How do we explain variation in wages
between “similar” people?
– Discrimination
• Median black male earns 21% less
• Median white female earns 24% less
• Educational differences
– Median white male 75% more likely to have college
– Among whites – men and women equally likely tohave 4year degree;
– but men 11% more likely to have graduate degrees
– > this has been changing since the last recession (2007)
Wage Differentials
• How much do these factors explain
the differences in wages between
“similar” people?
– Wage = a + b*mpl + c*location + …
– These factors “explain” (account for)
only about 50% of the observed
variation in wages
Factors accounting for
“above” equilibrium wages
• Unions
– Provide a single source of labor for the
firm
• Reaction to “monopsony” in some labor markets
(e.g., coal mines)
• Decrease unionization -> larger gaps in income
• Union “premium” declined from 20-30% to 8-15%
• Efficiency Wages
Efficiency Wages
• Efficiency Wages
– Wages higher than equilibrium
– Offered in hopes of increasing
worker productivity
– Reduce shirking, reduce turnover
– Hopefully efficiency gains are
greater than the increase in wage costs
• Historically
– 1914—Henry Ford: $5.00/day for assembly line workers
– Daily turnover decreased from 10% to 1%
– Increase in willing workers; Ford was able to pick out and
hire the most productive workers
Wage Discrimination
• Wage discrimination
– Occurs when workers of the same ability are not paid
the same as others because of their race, ethnicity,
sex, age, religion, or some other group characteristic
– Today, accounts for 3 to 5% of wage differences. Was
a much bigger problem 40 years ago.
• Legislation to prevent discrimination
– Equal Pay Act of 1963
– 2009 Fair Pay Act—gives employees more time to file
a complaint with the government
Gender Wage Gap
• Today
– Female workers earn 23% less than males
– Mostly due to compensating differentials rather than
discrimination
• Explanations
– Men more likely to work outdoors (road work,
construction) or in more dangerous conditions
– Women leave the labor force more (child or elder care)
• Trends
– Wage gap is shrinking
– Women have a 3-to-2 majority in college degrees
Other Wage Differential
Explanations
• Cultural differences
– Some cultures place more emphasis on education,
which leads to higher human capital, higher
productivity, and higher wages
• Location
– Higher costs of living in cities often translate into
higher wages
• Life cycle
– Wages rise, peak, and then fall as a worker ages
– Workers near retirement are less likely to learn new
techniques or keep up with technology
Median Annual Earnings
by Group
Occupational Crowding
• Imagine a community with only two types of jobs:
– A small number in engineering and a large number in
secretarial services.
– Everyone is equally proficient at both occupations and
everyone in the community is indifferent to working
either job.
• Under these assumptions
– We would expect the wages for engineers and
secretaries to be the same
Occupational Crowding
• Occupational crowding
– The crowding of a group of workers into a small
number of jobs
– May occur because certain groups may have limited
skills or opportunities to enter a larger variety of jobs
• Results?
– Supply of labor increases in crowded jobs, decreasing
wages for those jobs
– Supply of labor may decrease in other jobs, increasing
wages for those jobs
Occupational Crowding
• Now imagine that not everyone in the community
has the same set of opportunities.
– Suppose women were not allowed to be engineers.
– Women who wanted to work could only find
employment as secretaries.
– Also, suppose the number of jobs as engineers was
relatively small compared to the number of jobs as
secretaries.
• Labor market results
– Large supply of secretary labor, low wages
– Small supply of engineer workers, high wages
Occupational Crowding
• Occupational crowding is often referred to within
the context of wages for men and women
– Women may be crowded into jobs
– The higher supply of labor lowers wages
• With today’s increased opportunities, why don’t
more women leave the lower-paying jobs and
become engineers?
– Rigidity in changing careers
– Social customs
– Personal preferences
Where the Men Aren’t
Economics in Anchorman:
The Legend of Ron Burgundy
• Occupational crowding
• Ron Burgundy loses his job . . . to a
woman!
Winner Take All
• Winner take all
– Exists when relatively small
differences in ability lead to
large differences in compensation
• Examples
– Professional athletes
• Major leaguers earn much more than minor leaguers, even
though playing abilities are often not that much different
– CEOs
• Some CEO salaries today are more than 500 times greater
than the average worker for the firm
Inequality of Income
• Income inequality exists when some workers
earn more than others.
• Caused by
–
–
–
–
Compensating differentials
Discrimination
Corruption
Differences in marginal product of labor
Factors That Lead
to Income Inequality
• What would it take to equalize wages?
– All workers would have to have same skills, ability,
productivity
– All jobs must be equally attractive
– All workers must be perfectly mobile
• Would that be good or bad?
– If society’s income structure is too equal, the incentive
to work is diminished
– Free riding would occur
Role of Corruption
• Corruption
– More widespread in less developed countries
– Bribes may be more valued than innovation and work
– Assets may not be safe from criminals or government
seizure
• Implications?
– Investors less likely to develop a business
– Short run gains may be achieved at the expense of
long run costs
– People may fight back if the corruption becomes too
severe
Measuring Inequality
Measuring Inequality
Understanding Observed
Inequality
• Why does the United States have a higher
inequality ratio than Germany or Canada?
– Similar poverty rate (26.3%) to other developed
countries
– However, the top earners in the United States earn
much more compared to other countries
Understanding Observed
Inequality
• High-income inequality also occurs in countries
that are very poor and less developed
– This is due to the lowest income people having much
less income (compared to low-income individuals in
developed countries)
Difficulties in Measuring
Inequality
• Income inequality numbers can be unreliable and
misinterpreted
– Data reflects pretax income, rather than disposable
income
– Does not account for in-kind transfers, (goods and
services given to poor rather than cash)
– Does not account for unreported or illegal income.
Black markets may play a larger role in less developed
countries, further skewing this.
– No (monetary) value is placed on goods or services
produced at home—child-rearing or growing
vegetables
Difficulties in Measuring
Inequality
• Are the shortcomings a serious measurement
issue?
– Each individual year, probably not
– Across generations, maybe so
• Comparing inequality today to 50 years agp would probably
violate many ceteris paribus assumptions. Birth rates, tax
rates, population age, and technology all change.
• Need to figure out exactly what causes changes in income
inequality; tough to do if many things change
• Further problems?
– Assuming income distribution is a reflection of welfare;
we may also value leisure, safety, community, etc.
Income Mobility
• Income mobility
– The ability to move up and down the economic ladder
over time
• Higher levels of income mobility?
– Give workers an incentive to improve human capital
and work harder
– Workers have increased change of rewards
– Poverty may be only temporary
Income Mobility in United States
Income Mobility
• Marginal poor
– Poor at a point in time, but have skills to move up the
ladder
– Low earnings are the exception
– Willing to borrow to make a big purchase
– Fit well into life-cycle theory model
– Student straight out of college
• Long-term poor
– People who lack the skills to advance to higher
income levels
Poverty
• Poverty rate
– Percent of population whose income is below the
poverty threshold
• Poverty threshold
– The income level below which a person (or family) is
considered impoverished
– Adjusted each year for inflation
– Does not include in-kind transfers
– Does not include geographic cost-of-living differences
Poverty, Historically
• Equal Opportunity Act, 1964
• However, poverty rate has remained stagnant for
about 40 years. Why?
– Gains from growth have accrued to the middle and
upper class rather than the poor
– Many low-income workers continue to lack skills to
earn higher wages
• Solution?
– Not easy—perhaps long run investment in education
and skills aimed at poor
– Job retraining for structurally unemployed
Poverty Rate for Households
Poverty Rate for
Various Groups
Poverty Policy
• Many policies (each with their costs and benefits)
have been designed to address poverty
• Two conflicting motivations
– We want to give generously
– We want the poor to become self-sufficient
• Policies
– Welfare
– In-kind transfers
– Earned income
tax credit (EITC)
– Minimum wage
Welfare
• Not a government program but a series of
initiatives
–
–
–
–
Monetary payments
Subsidies and vouchers
Health services, housing
Examples: TANF, SSI, SNAP
• Who receives this?
– Unemployed, disabled, veterans, dependent children
– Eligibility is often limited by time and only if income is
below a cutoff amount
In-Kind Transfers
• Direct assistance in the form of goods
and services
– Food banks, housing shelters, private
charities, health care through Medicaid
• Why give goods and services rather than
cash?
– Mainly to prevent the misuse of funds
– Possibility of cash transfers going to alcohol,
gambling addictions, or expensive clothes
– In-kind transfers can be targeted at essential
services
Earned Income Tax Credit
• The EITC is a refundable tax credit designed to
encourage low-income people to work more
– Can lower taxes as much as $6,000 per year
– Helps over 20 million families, making it the largest
poverty-fighting policy
– Benefits are phased out over higher incomes, so there
is no sizeable work disincentive at a specific cutoff
• The EITC is a form of a negative income tax
– This is a tax credit that is paid to poor households out
of taxes collected from middle- and upper-income
taxpayers
A Negative Income Tax
Minimum Wage
• Discussed previously—a price floor on wages in
labor markets
• However, the same problems can be discussed
– Low-skill people may be less productive
– Firms may hire less low-skill workers
– Minimum wage doesn’t guarantee employment
Problems with Traditional Aid
• There is one glaring problem with assistance for
low-income individuals. Many welfare programs
create work disincentives!
– Often when income is increased, many benefits are
severely reduced or eliminated
– People may consciously work less to keep their benefit
eligibility
– The EITC does the best at addressing the work
incentive problem by having phased-out assistance
Problems with Traditional Aid:
A Mathematical Example
• Family of five earns $20,000 a year, and qualifies
for $10,000 in annual welfare benefits
– Total income for the year is $30,000
• What happens if earned income rises to $30,000
per year?
– $30,000 earned income disqualifies the family from
receiving much of the assistance it previously
received. Benefits fall from $10,000 to $2,000
– Family earned $10,000, but lost $8,000 in welfare
benefits. That’s similar to an 80% marginal tax rate!
– That is a strong disincentive to work!
Problems with Traditional Aid
• Samaritan’s dilemma
– Occurs when an act of charity causes the recipient not
to work hard on their own to escape poverty
– Another example of an unintended consequence
• Addressed by Bill Clinton in 1996 as part of
welfare reform
– As part of TANF, he encouraged states to require
employment searches as a condition for benefits
– Also put a five-year maximum on benefits
– Changed from entitlement to temporary safety net,
reducing the samaritan’s dilemma
Economics in
Million Dollar Baby
• Welfare and the samaritan’s dilemma
• Can people become dependent on
welfare?
100% Inheritance Tax
• Would a 100% inheritance tax decrease wealth
inequality in our country? What if we combined it
with a redistribution policy?
• Some normative statements
– “It’s not fair. She was born with a silver spoon and
she’ll inherits millions while I have to work all day”
– “He earned his money. He should be able to give it to
his kids if he wants.”
– “Why should the government (or anyone else) get to
take what I earn? Double taxation!”
– “We should all start out on the same footing.”
100% Inheritance Tax
• Incentives created from a 100% inheritance tax:
– People may start frivolously spending. If I can’t keep
wealth in my family after I die, may as well blow it now.
– People will “launder” money to their children. Cash
and other gifts will be given to avoid the tax. People
will have the incentive to do financial planning earlier
in their life before its too late.
• Currently
– You can give anyone $13,000 per year as an untaxed
“gift.”
Economics in Milton Friedman—
Redistribution of Wealth
• Watch this Q & A session about wealth
distribution and the 100% inheritance tax
Conclusion
• Income inequality in itself is neither good nor bad
– Too equal incomes = work disincentive
– Too unequal incomes = political unrest
• Welfare policies can help decrease the problem
of income inequality
– However, they must be designed correctly as not to
create work disincentives
Summary
• Non-monetary determinants of earnings include
compensating differentials, human capital,
location, lifestyle, unions, and efficiency wages.
• Economic studies of wage discrimination have
found that the amount of discrimination is
relatively small—accounting for 3 to 5 % of wage
differences.
• Despite recent gains, women still earn
significantly less than men. The wage gap can be
partially explained by occupational crowding.
Summary
• Some amount of income inequality is to be
expected in a market economy.
• Economic mobility reduces inequality over long
periods of time.
• The poverty rate in the United States has been
stagnant for the last 40 years, despite many
efforts (welfare, in-kind transfers, and the EITC)
designed to reduce it.
Practice What You Know
Which of the following statements is related to
compensating wage differentials?
A. Long-term labor contracts may be undesirable
for firms
B. Education is directly correlated with income
C. Workers in dangerous jobs will tend to receive
higher pay
D. Middle-aged workers tend to earn higher
incomes than new college graduates
Practice What You Know
Why has union prevalence decreased over the
last 50 years?
A. Firms are using more capital and relocating to
avoid high union labor costs
B. States have made unions illegal
C. Workers no longer feel the need to join a union
since most jobs are safer
D. The demand for goods produced by union labor
has decreased
Practice What You Know
What is true about the gender wage gap?
A. The most likely explanation for the gender
wage gap is discrimination against females.
B. Economics shows that most of the gender
wage gap is caused by nondiscrimination
factors
C. Women earn less because they tend to choose
more dangerous jobs than men
D. Men earn more because they tend to choose
jobs with more flexible work hours than women
Practice What You Know
Suppose the United States took the extreme
step to enact wealth redistribution programs
until income was equal for all people. What is
the most likely result?
A. High-earners would be supportive of this policy
B. Firms would hire more workers
C. Most people would work harder since their
wealth may get redistributed
D. Free riding would occur
Practice What You Know
Name the key “conflict” with welfare programs.
A. We want the rich to pay more taxes but not too
much more
B. We want to help workers without hurting firms
looking for people to hire
C. We want to help people in their time of need
but don’t want to create work disincentives
D. We want to decrease inequality but not
decrease it too much