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Economic Inequality

Economic Inequality. 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

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Economic Inequality

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  1. Economic Inequality

  2. 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

  3. 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

  4. 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

  5. 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

  6. S (a) (b) L 2 S Hourly L Hourly 2 Wage Wage S L 1 S L A ¢ 1 B ¢ 26 $26 B $30 A D 20 L D L Number Number of Carpenters of Executive Assistants Disappearing Wage Differentials

  7. 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 long-run 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. The Market for Physicians

  21. 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 non-union wages

  22. (a) (b) S Wage Wage L 2 S L 1 A S ¢ L W 2 B W B ¢ 3 W W 1 1 A D L D L 250,000 350,000 225,000 200,000 300,000 Number Number of Long-Haul of Short-Haul Truckers Truckers Union Wage Differentials

  23. 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

  24. 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

  25. The Minimum Wage

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. Employer Discrimination and Wage Rates

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. Vicious Cycle of Discrimination

  38. 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

  39. 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

  40. 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

  41. The U.S. Lorenz Curve, 2001

  42. 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

  43. 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

  44. 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

  45. U.S. Lorenz Cures for Income and Wealth, 2001

  46. 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

  47. 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

  48. 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

  49. 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

  50. 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

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