A world of differences

2 The meaning and evaluation of economic inequality

Inequality can arise along many dimensions. Economic inequality typically refers to inequality in the distribution of income and wealth across individuals, families, households, or groups in a society. Other forms of inequality include differences across people in status, rights, and opportunities. The right to vote in the US was originally restricted to white, male property owners in most states. This right was formally extended to African American men in 1870 and to women in 1920, but many barriers to voting were subsequently erected, including poll taxes, literacy tests, and felon disenfranchisement. Some of these remain in place to this day.

inequality of opportunity

Differences across people that arise because of barriers to access, such as school and neighbourhood quality, or discrimination based on race or gender.

inequality of outcomes

Differences across people in the material dimensions of wellbeing arising from any source, including family background and individual talent and effort.

As far as economic inequality is concerned, scholars distinguish between inequality of opportunity and inequality of outcomes. Inequality of opportunity refers to differences across people that arise because of barriers to access, such as school and neighbourhood quality, or discrimination based on race or gender. Such differences imply that some are less able to profit from their talents and efforts than others. Inequality in outcomes refers to differences across people in the material dimensions of well-being arising from any source, including family background and individual talent and effort. This view takes an outcome-oriented perspective, hence the name.

Some people think that society should primarily focus on equality of opportunity: inequality arising from individual differences in talent or effort is acceptable, but inequality arising from ‘accidents of birth’ such as gender, ethnicity, and family background is not acceptable. Others believe that extreme inequalities of outcome, and the material and social deprivation associated with them, ought to be reduced regardless of their source.

Exercise 1 Inequality of opportunity or inequality of outcomes

Jasmine grows up in an upper middle-class family. She enjoys science, works hard, and develops an interest in physics during high school. After attending an elite college, she gets accepted into a PhD program with a leading research lab. Later, she is hired at a tenure-track university position as a physicist in one of the top physics departments in the country.

Omar is not related to Jasmine. He also develops an interest in physics during high school. His interest and talents in the subject match those of Jasmine’s. Omar is unable to attend an elite college due to financial constraints and so he attends a lower-ranked university while working a part-time job. Omar does not benefit from the same level of education and associations that Jasmine has access to, and, therefore, is not accepted into a top PhD program. Even though he wanted to become a physicist, he becomes a wind turbine technician instead, making a lower income than Jasmine. If his family’s economic circumstances had been different, Omar could have ended up where Jasmine has.

Isaac is Omar’s brother. Isaac has had a similar upbringing to Omar, but his talents and interests are different. He does not go to college. Instead, he finds work as a cab driver making less than Omar.

1. Which of the differences between Jasmine, Omar, and Isaac reflect inequality of opportunity?
2. Which differences reflect inequality of outcomes?
3. Thinking about the country and society you live in, write two scenarios similar to those given in this exercise, with one scenario illustrating inequality of opportunity and the other scenario illustrating inequality of outcomes.

Certain inequalities that arise from accidents of birth seem arbitrary and unfair to most people, especially when such inequality is associated with mistreatment and discrimination targeted at specific groups, or lack of access to adequate nutrition, quality schooling, or a healthy environment. Yet certain accidents of birth—such as athletic, academic, or musical talent—when combined with discipline and effort, can give rise to income inequality that may be considered reasonable or fair when not too extreme.

Consider, for example, the question of whether all students in a class should receive the same grade. This would achieve equality of outcomes in a manner that some would consider unfair. It may also give rise to smaller investments of time and effort in learning. Similarly, consider the question of whether all workers in a firm should receive the same compensation, regardless of their productivity. This too would achieve equality of outcomes, possibly at the expense of overall productivity in the firm.

If some inequality is necessary and acceptable, then how much of it should there be? On what basis should we decide? Reasonable people can differ in what they believe are the right answers to such questions.

Evaluating inequality

Three hypothetical economies are listed below. Each consists of five quintiles, and the numbers represent the average income in each quintile (a quintile represents 20% of the population). For simplicity, suppose that all individuals within a quintile have the same income. Think of each number as corresponding to a hundred dollars of annual income, averaged over the course of one’s life, for each of five income quintiles.

• Economy A: 10, 18, 25, 34, 59
• Economy B: 6, 11, 17, 28, 89
• Economy C: 2, 6, 12, 23, 106

These economies correspond, roughly and respectively, to Bulgaria, Colombia, and South Africa as of 2005 (with income measured in hundreds of dollars).

For more details on how GDP per capita is calculated and used as a measure of income and living standards, see Section 1.2 of The Economy 1.0. You can find data on income distributions by country here.

Each of these economies has approximately the same GDP per capita. But life in these economies would be quite different. GDP per capita is a better representation of how people are doing in Economy A, which has relatively low levels of inequality, than in Economy C, which is much more unequal.

Which of the economies (A, B, or C) would you choose to live in if you knew you would be in the top quintile of earners? If you were entirely self-interested (that is, only concerned about maximizing your own income), then you would choose Economy C. But you may also be concerned about inequality, and prefer to live in one of the other economies, where your own income is smaller but total income is more equally distributed.

Now consider a different question: which of the economies do you consider to be the most just? To answer this question, you would probably want more information about whether basic human rights are protected, whether the government is representative or autocratic, whether people can exercise their religion freely, and so on. But even with all this information, people may disagree about what kind of society would be perfectly just.

The philosopher John Rawls argued that disagreement about what constitutes a just society arises because the positions we occupy affect our judgements and perspectives. He considered an interesting thought experiment: what if we had to decide on the kind of world we would want to live in if we did not know what our position in it would turn out to be?

From this “original position” he believed that we would agree on a set of principles that a just society would satisfy. First and foremost, each person would have an equal claim to certain basic liberties. Second, people would come to occupy positions in society based on fair equality of opportunity, and the resulting social and economic inequalities would be “to the greatest benefit of the least advantaged members of society.” This last criterion is known as the difference principle.

These principles allow for inequalities in income and wealth, provided that in “all parts of society there are… roughly the same prospects of culture and achievement for those similarly motivated and endowed.”

To illustrate, consider which of the following two income distributions would be chosen under Rawls’ principles of justice:

• Economy D: 6, 12, 21, 34, 112
• Economy E: 5, 11, 17, 29, 85

As before, think of each number as corresponding to a hundred dollars of annual income, averaged over the course of one’s life, for each of five income quintiles. These economies correspond roughly to Brazil and Ecuador, as of 2005.

Economy D has more inequality than Economy E, but the least advantaged person in D is better off materially than the least advantaged in E. In fact, income is higher in D at every quintile.

Does this mean that D is more just according to Rawls’ principles? Possibly, but not necessarily. If those in the most affluent quintile in Economy D were able to use their income to constrain the liberties of the remainder of the population, or to deny them fair equality of opportunity, the principles of justice may come to be violated over time. Only if basic liberties can be ensured and equality of opportunity sustained does the difference principle become decisive.

Exercise 2 Apply the principles of justice

Consider the following two societies, where the numbers represent mean income at each quintile:

• Economy F: 6, 10, 13, 17, 31
• Economy G: 5, 11, 16, 23, 47

Interpret each number as thousands of dollars of lifetime income, annualized. Given a choice between these two societies:

1. Which society do you think would be most consistent with Rawls’ principles of justice?
2. Suppose you were to choose between these societies without knowing which position you would come to occupy. Which one would you choose and why?
3. Now suppose that the income of the lowest quintile in Economy G were changed to some other number x, where 0 < x < 6. Is there any value of x such that you would make a different choice? Explain your answer.

Actual and perceived inequality

Research shows that most people do not have an accurate understanding of the disparities within their own country and across the world, nor do they have a good sense of their position in life relative to others. This could bias their attitudes and beliefs about what is fair and reasonable and about what policies they want to support.

You can read more about Perceived, Ideal, and Actual Inequality in Section 19.3 of CORE’s The Economy 1.0.

Michael Norton, a professor of business administration, and Dan Ariely, a psychologist and behavioural economist, asked a large sample of Americans how they thought the wealth of the US should be distributed: what fraction of it, for example, should go to the wealthiest 20%? They also asked them to estimate what they thought the distribution of wealth actually was.

Let’s try a version of that here, but with income rather than wealth.

Exercise 3 Perceptions of inequality

1. In the country you live in, what share (%) of total income do you think goes to the richest quintile of the population?
2. In your opinion, what share (%) of total income in your country should go to the richest quintile? Explain the reasoning behind your answer.
3. Go to Our World in Data’s webpage for income inequality. Find the answer to Question 1 in the ‘Income shares’ chart, for the latest year available (use the ‘Change country’ option to display data for the country you live in). Discuss any differences between your answers to Questions 1 (perceived income share), 2 (ideal income share), and 3 (actual income share).

Instrumental factors

A final reason to care about inequality is because high levels of income or wealth inequality can make it harder to achieve other desired objectives. By the same token, attempts at redistribution can interfere with other goals. Here are some examples:

• Economic inequality contributes to political inequality, which can, in turn, exacerbate economic inequality. For instance, high income individuals can contribute to political campaigns, and be rewarded for this by tax cuts that leave them even better off.
• Very high levels of redistribution could lower the returns for effort and innovation, or the returns for investment in the development of skills, and could lower total output (we considered this earlier with the example of a class where all students receive the same grade regardless of effort and performance). On the other hand, high levels of inequality could stand in the way of economic growth by keeping people from economic opportunities and success. For an example of this, see CORE’s Economist in Action video ‘What promotes or kills innovation?’ featuring University of Michigan economist, Lisa Cook. Extreme inequality can further result in the misallocation of investment, where people can’t get financing for promising projects, and it can also lower macroeconomic aggregate demand, making business cycles worse.

Section 19.5 of The Economy 1.0 explains how differences in endowments, together with institutions and policies, transmit economic inequality from one generation to the next.

• Levels of inequality can be amplified from one generation to the next, as accidents of birth accumulate and are transmitted within families and neighbourhoods. Even complete equality of opportunity in one generation must give way to unequal opportunity in the next, as those with greater talent or effort in the first provide advantages to their children in the next.