4.2.2 Inequality – Edexcel Economics A Notes

Contents

Wealth versus income inequality

Wealth is a stock. It measures the value of assets that people own.

Income is a flow. It measures the amount of money someone earns in a time period.

Income inequality refers to how unequally income is distributed among the population. 

This is related but different to wealth inequality, which refers to how unequally wealth is distributed among the population.

How we measure income inequality

One way to measure income inequality is using the Lorenz curve diagram:

• The 45 degree red line shows perfect equality – everyone earns the same income. This means the lowest earning 20% of the population earn 20% of total income, while the lowest earning 80% of the population earn 80% of total income.
• The blue line represents the actual income distribution for a particular country. 
• This country faces some degree of income inequality.
• For example, it could be the case that the lowest earning 20% of the population earn only 5% of total income. 
• The lowest earning 80% of the population may earn only 40% of total income, and conversely the highest earning 20% of the population may capture the remaining 60% of the income.
• This puts the blue line below the perfect equality line.

From the Lorenz curve, you can calculate the Gini coefficient:

• The Gini coefficient is a measure of the degree of income inequality.
• A higher Gini score indicates more inequality, as the perfect equality line is further from the actual income line.
• Let A be the area between the perfect equality and actual income lines. 
• Let B be the area between the actual income lines and the axes.
• The Gini coefficient is calculated as:

For example in the UK, the Gini coefficient is 0.35 as of 2022. This has risen from 0.25 in the 1970s, indicating a rise in income inequality in the UK, particularly from the period from the 1970s to the 1990s.

What causes income and wealth inequality within countries?

Causes of income inequality within a country:

• Technological progress
  • The development and growing use of new technology, such as IT and artificial intelligence, can replace some jobs that can be done by a computer or robot. This could include certain manufacturing jobs.
  • However technology increases demand for workers with IT skills, increasing their wages.
  • Technology also reduces costs for businesses, increasing profits and making the CEO and shareholders better off.
    • However the economic growth generated by technology can increase tax revenues. These tax revenues can go towards supporting those who lose their jobs with welfare payments.
    • In addition, those who lose their jobs may decide to retrain to work in a sector where there is increasing labour demand. This retraining could also be supported by the government.
• Globalisation
  • Globalisation is when different economies become increasingly interconnected.
  • Globalisation may involve a reduction in trade barriers, allowing economies to specialise according to their comparative advantages.
  • So workers in sectors with a comparative advantage benefit from higher levels of production / exports and hence higher derived demand for labour. This includes financial services in the UK.
  • However workers who work in manufacturing in advanced economies may experience structural unemployment, as demand for manufactured goods falls due to greater international competition.
    • However, like with technology, welfare payments or retraining can mitigate the impact on inequality.
• Differences in education
  • Someone with more education or training in a skill may have greater human capital and become a more productive worker. 
  • This increased demand for this skilled worker, leading to higher wages.
  • This explains part of the reason why university graduates earn more than nongraduates on average.
    • However the wage gain from going to university has fallen in the UK for non-STEM subjects, due to an increase in the labour supply of university graduates.
• Discrimination
  • Discrimination could mean some managers wrongly perceive some groups of workers as being less productive compared to other groups of workers.
  • This reduces labour demand for the group facing discrimination, leading to lower wages.
    • However anti-discrimination legislation and pay gap transparency may reduce pay gaps due to discrimination to some degree.
• Removal of worker protections
  • Removing worker protections, such as making it harder for trade unions to strike, make it more difficult for workers to negotiate on wages, leading to lower wages.
  • This reduces the disruption arising from strikes for businesses, reducing costs and increasing profits. This may increase the incomes of CEOs and shareholders.
• Differences in fiscal policy e.g. government spending on infrastructure in different areas
  • If a government spends more on infrastructure in a particular area compared to another area, this increases demand for construction workers in the local area. This boosts wages relative to areas without infrastructure projects.
• Wealth inequality
  • Wealth generates income. A simple example is money in the bank earns interest. Another example is owning homes and renting them out to tenants generates income for landlords. 
  • Because there is wealth inequality, those with more assets can generate higher incomes from their assets, increasing income inequality.
    • However taxes on the returns on wealth, such as taxing bank interest, could reduce the extent to which wealth inequality leads to income inequality.
  • Note tax policies may also offer lower tax rates for income generated from wealth (e.g. interest, dividends, inheritance) compared to income from employment. This disproportionately benefits the wealthy as they can increase their wealth at a faster rate through capital gains, dividends and inheritance. However those with low wealth may only see large increases in wealth by saving income from employment or self-employment, which is more difficult when taxed at a higher rate.

The causes of wealth inequality within a country are:

• Income inequality
  • Causes of income inequality such as technology, globalisation and education can also influence wealth inequality.
  • Higher income inequality means those earning high incomes can save more, converting their income (flow) into wealth (stock) at a faster rate.
  • However as incomes get lower at the lower end of the income distribution, it will become more difficult to save money, as living costs approach or exceed income. Lower saving means those on low incomes cannot accumulate wealth.
    • However income tax systems, especially where progressive, reduce the disposable income of high earners. This makes it more difficult for high income earners to save their income to convert it into wealth.
• Inheritance
  • Wealth may be passed down through generations. This allows the children of wealthy parents to become wealthy and for families to grow their wealth over time. Meanwhile others may not have any wealth passed down from their family.
• Rising asset prices
  • Rising prices of assets such as housing and stocks increase the wealth of those who already have wealth. However those without wealth would not see an increase in their wealth values.
  • Rising asset prices could be driven by government policy. For instance, expansionary monetary policy such as quantitative easing may lower interest rates on safe assets such as government bonds, increasing demand for other assets such as housing and stocks.
    • However taxes on capital gains may reduce the extent to which rising asset prices automatically lead to higher wealth values. Note capital gains tax typically occurs when the assets are sold, and the increase in value of the asset is taxed.

What causes income and wealth inequality between countries?

Income inequality between countries is caused by:

• Differences in education or training
  • Some countries have higher levels of human capital than others. This means workers may have higher productivity in these countries, increasing demand for their labour and raising wages compared to countries with lower education or training levels.
• Differences in property rights or other “institutions”.
  • Institutions refer to the sets of rules or constraints governing the actions of individuals, firms and governments in a society.
  • An example of an institution is property rights. Property rights give the owner the right to decide what to do with their property. An absence of property rights leaves the property owner at risk of expropriation, where the government confiscates their property without good reason. This extra risk reduces incentives for firms to invest. This lowers investment, AD and reduces the rate of economic growth, meaning real incomes do not rise.
  • Other institutions include well developed financial markets or an independent judiciary.
  • Weak institutions may increase the likelihood of corruption. This is because there is less accountability for government officials. Corruption may lead to government officials or firm owners taking funds meant for investment or infrastructure projects, reducing the rate of economic growth in these countries. This means real incomes remain low compared to countries with strong institutions.
• Geographical factors
  • This could include the likelihood of natural disasters in a country, or whether a country is landlocked.
  • A country is landlocked if it does not border the sea. This makes it more costly to export goods and services, as firms cannot use shipping routes easily. This reduces AD and so economic growth is slower, so real incomes remain low.
• Globalisation
  • Globalisation often involves developed economies forming trade agreements among themselves and imposing trade restrictions, such as common external tariffs, mainly on developing economies. This makes it more difficult for developing countries to export their way to economic growth, keeping incomes low. However trading blocs allow rich countries to benefit from trade between member states, for instance by increasing export revenues. This would boost AD, economic growth and real incomes in developed economies.
  • However globalisation may contribute to a reduction in income inequality between countries. For example developing economies can benefit from copying technological innovations from abroad or from higher inward foreign investment, both of which would raise the economic growth rate and boost real incomes.
• Other factors could include infrastructure differences, differences in levels of government debt or differences in adopting technology.

Wealth inequality between countries is caused by:

• Differences in incomes between countries
  • As above, there can be differences in incomes due to globalisation or education differences.
  • Such differences in income mean households in high income economies have more income left over after spending on goods and services.
  • This enables households in higher income countries to save more money in total, even if saving rates are the same across countries.
  • This increases the savings of higher income economies relative to lower income economies, so households in higher income countries are more likely to have greater wealth.
• Differences in the levels of natural resources
  • Some countries may have more natural resources such as oil reserves or forests.
  • More natural resources in a country means that country has more assets, increasing its wealth. That country can also use the revenues from selling such assets to invest and build sovereign wealth funds – an example of this is Norway.
    • However natural resources can prove to be a “curse”. A resource curse, for instance could be that selling natural resources leads to higher demand for the domestic currency to buy the natural resource. This leads to currency appreciation, making exports dearer and reducing demand for other exports.
    • Natural resources may be extracted by multinational companies or by colonialist powers. This exploitation means some countries do not have ownership of their natural resources, nor o they receive the revenues from selling their natural resources.
• Conflict and natural disasters
  • Natural disasters and conflict may lead to the destruction of capital. This reduces the wealth of the nation affected.
  • In comparison, countries that face fewer natural disasters and no conflict do not experience significant destruction of their capital.
• Property rights and other “institutions”
  • Property rights give the owner the right to decide what to do with their property.
  • Weak property rights mean there is a higher risk of governments seizing property such as factories.
  • This reduces firms’ incentives to invest and accumulate capital.
  • This leads to lower asset values in countries with weak property rights, compared to countries with well enforced property rights.
• Access to developed financial markets
  • Developed financial markets allows households and firms to have access to banking services.
  • This enables households to save or invest to earn interest, increasing saving rates. So households can increase the value of their wealth.
  • Similarly firms receive greater investment, boosting their level of capital and increasing total wealth in a country.
    • However having developed financial markets does not guarantee a higher savings rate for a country.
    • Some developed economies have lower saving rates and tend towards “consumerism”.

How does economic change and development impact inequality?

The changing structure of the economy, due to technology and globalisation, benefits some workers while others lose out.

For instance, technological progress may increase demand for workers with technology related skills such as computer scientists, raising their wages. Meanwhile technology may replace other jobs such as assembly line work in manufacturing.

This means economic growth can increase inequality.

However economic growth can also decrease inequality. This can occur because economic growth is associated with higher real incomes and higher firm profits. This increases government tax revenue which can be spent on welfare spending and retraining for those earning low incomes, raising their incomes.

The Kuznets curve is one theory about the relationship between development and inequality. The Kuznets curve (see below) has two sections

• As a country sees its income per capita increase from a low base, income inequality at first increases. When a country industrialises, economic growth benefits those in urban areas and not those in rural areas.
• However as income per capita keeps increasing, eventually income inequality will begin to fall. This is when there is greater government spending on education and more redistribution of wealth and income through progressive taxation and welfare systems. 
• In practice, the evidence on the relationship between economic growth and income inequality suggests that this relationship is not as simple as the Kuznets curve.
• For example, Thomas Piketty has shown income inequality has increased since the 1970s in developed economies. He argues that the post-World War II fall in income inequality in advanced economies were broadly an exception to a general trend of rising income inequality.

What is the significance of capitalism for inequality?

Capitalism is an economic system in which:

• The “means of production” including businesses, factories, capital and natural resources are privately owned and used to make profit.
• Market forces determine the allocation of goods and services without government intervention.

Capitalism creates inequality. In capitalism, workers’ wages are determined by labour supply and labour demand in each occupation. Differences in labour demand or labour supply lead to differences in wages between workers.

Marxist theories of economics would claim workers’ wages do not solely move in line with labour demand or labour productivity. Instead under capitalism, there are power dynamics with private ownership of capital, factories and natural resources for firms while workers must sell their labour to earn a living. According to Marxist theories, these power dynamics may allow firm managers to keep worker wages low in order to maximise profits. This is another explanation for why capitalism may lead to inequality.

Inequality also sustains capitalism. Capitalism requires incentives to work and for innovation. To create incentives to work, differences between income may be required. Thus inequality may be an inherent part of capitalism.

However too much inequality can make it difficult for capitalism to function. High inequality can lead to social unrest. An example of this is the French Revolution in the late 18th century, where anger about wealth inequality contributed to protests.

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