Income, Inequality, and Poverty15

Previously…

• The demand for each factor of production is a derived demand that stems from a firm’s desire to supply a good in another market.

• Labor markets reconcile the forces of demand and supply into a wage signal that conveys information to both sides of the market.

• A monopsonist in the labor market is able to leverage market power by paying workers less.

• In the long run, outsourcing moves jobs to workers who are more productiv, and thus increases the overall productivity of workers everywhere.

Big Questions

1. What are the determinants of wages?

2. What causes income inequality?

3. How do economists analyze poverty?

The Non-Monetary Determinants of Wages• Compensating Differentials

– Extra income that must be paid to perform a job– People who do dangerous, stressful, risky, or

unpleasant jobs get paid more, ceteris paribus– “Fun” jobs may get paid less

The Non-Monetary Determinants of Wages

• Education and human capital– Human capital are the

skills acquired through education and training

– Generally, more education and human capital lead to higher wages

– Highly educated or skilled individuals may be more difficult to replace and can command a higher wage

Education and Pay

The Non-Monetary Determinants of Wages• Location

– People may be willing to accept lower wages to work in areas that are more desirable to live in

– Areas with a high cost of living will pay higher wages as a compensating differential

• Lifestyle– Wage is not top priority

for some individuals– Workers of nonprofits,

religious organizations,caretakers, musicians,artists, etc.

The Non-Monetary Determinants of Wages

• Union– A group of workers that

bargains collectively forbetter wages and benefits

– Able to increase wages bythreat of a strike, or workstoppage

• Binding arbitration– An impartial third party makes decision in wage and

benefit negotiation if workers and employers cannot reach agreement

Union History

• 1950s– One in three jobs was unionized– Union wage premiums as high as 30%

• Today– One in eight jobs unionized– Wage premiums between 6 and 15%

• Why the change?– Competition from the private sector– High labor costs cause firms to use more capital or relocate to

nonunion labor areas– Unions still common among public sector where cost containment

isn’t as much of an issue and competition is absent– Public school teachers, police, fire, and sanitation workers

Are Unions Still Necessary?• Early unions

– Protected workers from monopsony employers– Classic example: company town, coal mining– Established worker protection laws for dangerous jobs

• Today– With increased safety, increased labor mobility, and

increased private competition, are unions needed?– Some fear that unions have outlived their purpose and

remain an inefficient and costly relic of the past– Mandatory breaks, worker slowdowns, etc.

Teachers’ Unions

• Normative question: what should teacher’s unions do?– Ensure decent wages and working conditions for

people doing an important job– Prevent unfair firings

• Unintended consequence– Some believe the unions have become TOO powerful– Has become nearly impossible to fire bad teachers– Teachers paid to NOT teach because it’s cheaper than

trying to take on the union and fire them

Teachers’ Unions

• Whether you agree or disagree with the concept of teachers’ unions, they are not going away anytime soon.

• Are there solutions to the unintended consequences of the unions?– Require new teachers to “earn” tenure through

apprenticeship, rather than giving it immediately– Stop defending objectively bad teachers– Allow the best teachers to be paid more (merit pay)

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

Non-Monetary Determinants of Wages

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

• Finish the phrase: for every dollar a man earns, a woman earns . . .– 75 cents

• Think about this phrase– Is this true?– Did it used to be true but now isn’t?– Is this huge difference caused

entirely by discrimination?– Can economics explain the

difference?

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 tolarge 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 sh

e’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 incomeC. Workers in dangerous jobs will tend to

receive higher payD. 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 illegalC. Workers no longer feel the need to join a

union since most jobs are saferD. 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 workersC. Most people would work harder since their

wealth may get redistributedD. 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