1. © 2013 Pearson

2. Who are the rich and the poor?

3. © 2013 Pearson 20 When you have completed your study of this chapter, you will be able to 1 Describe the economic inequality in the United States. 2Explain how economic inequality arise. 3Explain how governments redistribute income and describe the effects of redistribution on economic inequality. CHAPTER CHECKLIST Economic Inequality

4. © 2013 Pearson We measure economic inequality by looking at the distributions of income and wealth. Market income is a household’s wages, interest, rent, and profit earned from the markets for factors of production before paying income taxes. Money income is market income plus cash benefits paid by the government. A household’s wealth is the value of the things that it owns at a point in time. Table 20.1 shows these distributions in the United States. 20.1 MEASURING ECONOMIC INEQUALITY

5. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY

6. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY

7. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY  Lorenz Curves A Lorenz curve is a curve that graphs the cumulative percentage of income (or wealth) against the cumulative percentage of households. Figure 20.1 on the next slide shows the Lorenz curves for the U.S. income in 2010 and U.S. wealth in 2004. These Lorenz curves are based on Table 20.1

8. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY The cumulative percentages of income and wealth are graphed against the cumulative percentage of households. 1. If each 20 percent of households received 20 percent of total income, there would be no rich and poor— there would be equality as shown by the Line of equality.

9. © 2013 Pearson

10. 20.1 ECONOMIC INEQUALITY 2. The distribution shows that the 20 percent of households with the lowest income received 3.3 percent of total income, and the highest paid 20 percent received 49.8 percent. 3. The distribution of wealth shows that the poorest 40 percent of house- holds owned 0.2 percent of total wealth, and the richest 1 percent owned 34.4 percent.

11. © 2013 Pearson 20.1 ECONOMIC INEQUALITY The farther the Lorenz curve is from the line of equality, the greater is the inequality. The distribution of wealth is much more unequal than the distribution of income.

12. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY  Inequality over Time U.S. income inequality has increased the past few decades. The highest incomes have increased much faster than the lower incomes. The gap between rich and poor has widened. Figure 20.2 (a) on the next slide shows how the distribution of income changed from 1970 to 2010.

13. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY The lowest income quintile share fell from 4 percent to 3 percent of total income. The next lowest quintile fell from 11 percent to 9 percent. The highest income quintile share rose from 43 percent to 50 percent. The middle quintile fell from 17 percent to 15 percent.

14. © 2013 Pearson

15. 20.1 MEASURING ECONOMIC INEQUALITY  Economic Mobility Economic mobility is the movement of a family up or down the income ladder and through the income quintiles. If there were no economic mobility, a family would be stuck at a given point in the income distribution— persistently rich to persistently poor. How much economic mobility has there been? Figure 20.2(b) shows the percentage of families that moved by one quintile or more over a ten-year period.

16. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY The figure shows quite a lot of economic mobility. About 30 percent of families move up a quintile or more in a decade. Between 35 and 40 percent remain in the same quintile. About 30 percent move down by a quintile or more. Mobility decreased over the 1980s and 1990s.

17. © 2013 Pearson

18. 20.1 MEASURING ECONOMIC INEQUALITY  Poverty Poverty is a state in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. In 2010, the poverty level for a household with 2 adults and 2 children was an income of $22,113. In 2010, 46 million Americans lived below the poverty level. Figure 20.3 on the next slide shows the distribution of poverty by race in 2010.

19. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY Part (a) shows the distribution of poverty in 2010: 44 percent of white families 29 percent of Hispanic families 23 percent of black families 4 percent of Asian families

20. © 2013 Pearson

21. 20.1 MEASURING ECONOMIC INEQUALITY Poverty Incidence and Trends To measure the incidence of poverty, we look at the poverty rate. The poverty rate is the percentage of families living in poverty. In 2010, the poverty rate was 15.1 percent. Figure 20.3(b) on the next slide shows the poverty rates and their trends for whites, blacks, and Hispanic families from 1970 to 2010.

22. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY The white poverty rate has been steady. The black poverty rate fell during the 1960s and the 1990s. Poverty rates for blacks and Hispanics are double that for whites. The Hispanic poverty rate fell in the 1990s.

23. © 2013 Pearson

24. 20.1 MEASURING ECONOMIC INEQUALITY Poverty Duration Another measure of poverty is duration. Duration of poverty is an important indicator of the hardship poverty brings. Figure 20.4 on the next slide shows the duration of poverty spells in the United States from 2001 to 2003.

25. © 2013 Pearson 20.1 MEASURING ECONOMIC INEQUALITY Almost 50 percent of poverty lasts for between 2 and 4 months. More than 20 percent of poverty lasts for more than 1 year. These families experience chronic poverty.

26. © 2013 Pearson

27. 20.2 HOW ECONOMIC INEQUALITY ARISES Economic inequality and poverty arise from five key factors Human capital Discrimination Financial and physical capital Entrepreneurial ability Personal and family characteristics We look at each in turn.

28. © 2013 Pearson 20.2 HOW ECONOMIC INEQUALITY ARISES  Human Capital High-skilled workers have a higher value of marginal product than low-skilled workers. Figure 20.5(a) on the next slide illustrates the demand for high-skilled and low-skilled labor.

29. © 2013 Pearson 20.2 HOW ECONOMIC INEQUALITY ARISES High-skilled labor has a higher VMP than low-skilled labor and a greater demand. The demand curve for high- skilled labor, D H, lies above the demand curve for low- skilled labor, D L, by the VMP of skill. The Demand for High-Skilled and Low-Skilled Labor

30. © 2013 Pearson

31. 20.2 HOW ECONOMIC INEQUALITY ARISES The Supply of High-Skilled and Low-Skilled Labor Skills are costly to acquire, and a worker pays the cost of acquiring a skill before benefiting from a higher wage. Figure 20.5(b) on the next slide illustrates the supply of high-skilled and low-skilled labor

32. © 2013 Pearson 20.2 HOW ECONOMIC INEQUALITY ARISES High-skilled labor bears the cost of acquiring skill. The supply curve of high- skilled labor, S H, lies above the supply curve of low-skilled labor, S L, by the compensation for the cost of acquiring skill.

33. © 2013 Pearson

34. 20.2 HOW ECONOMIC INEQUALITY ARISES Wage Rates of High-Skilled and Low-Skilled Labor The combined effects of skill on the demand for and supply of labor generate a higher wage for high-skilled labor than for low-skilled labor. Figure 20.5(c) on the next slide illustrates the skilled wage differential.

35. © 2013 Pearson 20.2 HOW ECONOMIC INEQUALITY ARISES The demand for low-skilled labor, D L, and the supply of low- skilled labor, S L, determine the wage rate of low-skilled labor— in this example at $10 an hour. The demand for high-skilled labor, D H, and the supply of high- skilled labor, S H, determine the wage rate of high-skilled labor— in this example at $20 an hour.

36. © 2013 Pearson

37. 20.2 HOW ECONOMIC INEQUALITY ARISES  Discrimination Human capital differences explain much of the income inequality that exists. Economists are not sure whether and by how much discrimination adds to income inequality. One line of argument is that competition prevents discrimination. But race and sex income differences do persist.

38. © 2013 Pearson 20.2 HOW ECONOMIC INEQUALITY ARISES  Financial and Physical Capital People with high incomes are usually those who own large amounts of financial capital and physical capital. They receive income in form of interest, dividends, and capital gains. Families with a lot of capital tend to become even more wealthy because They bequeath wealth to their children. Rich people marry rich people (on average).

39. © 2013 Pearson 20.2 HOW ECONOMIC INEQUALITY ARISES Saving and wealth accumulation is not inevitably a source of inequality. When a family saves to redistribute an uneven income over the life cycle, it enjoys more equal consumption. If a lucky generation that has a high income saves and makes a bequest to an unlucky generation, this saving decreases economic inequality.

40. © 2013 Pearson 20.2 HOW ECONOMIC INEQUALITY ARISES  Entrepreneurial Ability Some people become extremely rich through a combination of hard work, good luck, and outstanding entrepreneurial ability. But others who borrow to create a business, work hard, and have bad luck become extremely poor.  Personal and Family Characteristics Personal and family characteristics play a crucial role, for good or evil, in influencing economic well-being.

41. © 2013 Pearson 20.3 INCOME REDISTRIBUTION  How Governments Redistribute Income Three main ways in which governments in the United States redistribute income are Income taxes Income maintenance programs Subsidized services

42. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Income Taxes Income taxes may be progressive, regressive, or proportional. A progressive tax One that taxes income at an average rate that increases with the level of income. A regressive tax One that taxes income at an average rate that decreases with the level of income. A proportional tax One that taxes income at a constant rate, regardless of income.

43. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Income Maintenance Programs Three main types of programs are Social Security programs Unemployment compensation Welfare programs

44. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Social Security Programs Social Security is a public insurance system paid for by compulsory payroll taxes on employers and employees. OASDHI or Old Age, Survivors, Disability, and Health Insurance provide cash payments to retired or disabled workers and their families. Medicare, which provides hospital and health insurance for the elderly and disabled.

45. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Unemployment Compensation States provide an income to unemployed workers. A tax is paid based on the income of each covered worker. Each worker receives a benefit when he or she becomes unemployed.

46. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Welfare Programs 1. Supplementary Security Income (SSI), designed to help the neediest elderly, disabled, and blind people. 2. Temporary Assistance for Needy Families (TANF) program, designed to help households that have inadequate income. 3. Food Stamp program, designed to help the poorest households obtain a basic diet. 4. Medicaid, designed to cover the costs of medical care for households receiving help under the SSI and TANF programs.

47. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Subsidized Services Services provided by the government at prices far below the cost of production. Those who consume these services get a transfer from those who don’t. The most important of these are Education Health care

48. © 2013 Pearson 20.3 INCOME REDISTRIBUTION  The Scale of Income Redistribution Market income is the income that a household earns in factor markets with no redistribution. Money income is the market income plus cash benefits paid by the government. Disposable income is market income plus cash benefits paid by the government minus taxes.

49. © 2013 Pearson 20.3 INCOME REDISTRIBUTION We can measure the scale of income redistribution by calculating the percentage of market income paid in taxes minus the percentage received in benefits at each income level.

50. © 2013 Pearson Figure 20.6 shows market income redistribution in 2007. In part (a), the Lorenz curve for the market distribution of income. Part (b) shows the taxes and benefit which redistribute income. The distribution of disposable income (income after taxes and benefits) is even closer to the line of equality. 20.3 INCOME REDISTRIBUTION

51. © 2013 Pearson

52. In 2007, The quintile with the lowest incomes received net benefits that increased its share of total income by 3.5 percentage points. The quintile with the highest incomes paid taxes that decreased its share of total income by 7.5 percentage points. 20.3 INCOME REDISTRIBUTION

53. © 2013 Pearson 20.3 INCOME REDISTRIBUTION  Why We Redistribute Income Two approaches: Normative approach Discusses why we should compel everyone to help the poor and looks for principles to guide in the appropriate scale of redistribution. Positive approach Seeks reasons why we do compel everyone to help the poor and tries to explain the actual scale of redistribution.

54. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Normative Theories of Income Redistribution Utilitarianism points to the ideal distribution being one of equality. But efficiency is also desirable. Greater equality can be achieved only at the cost of inefficiency—the big tradeoff. John Rawls proposed the principle that income should be redistributed to the point at which the poorest person’s share is maximized.

55. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Libertarian philosophers, such as Robert Nozick, say that any redistribution is wrong because it violates the sanctity of private property and voluntary exchange. Modern political parties stand in the center of these extremes—some favor a bit more redistribution than others, but the major parties are basically happy with the current scale of redistribution.

56. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Positive Theories of Income Redistribution There is no good positive theory, but economists have a promising idea called the median voter theory. Median voter theory is a theory that government pursues policies that make the median voter as well off as possible. In the majority voting system, the voter whose views carry most weight is the one in the middle—the median voter. Political parties will deliver the scale of redistribution that the median voter prefers.

57. © 2013 Pearson 20.3 INCOME REDISTRIBUTION  The Major Welfare Challenge The poorest people in the United States are young women who have not completed high school, have a child (or children), live without a partner, and are more likely to be black or Hispanic than white. These young women and their children present the major welfare challenge: The long-term solution involves education and job training. The short-term solution is welfare.

58. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Welfare must be designed to strengthen the incentive to pursue the long-term solution while giving support in the short term. The Current Approach: TANF TANF is a block grant paid to the states to administer payments to individuals. An adult member of a household receiving assistance must work or perform community service. Assistance is limited to 5 years. Some economists suggest a negative income tax.

59. © 2013 Pearson 20.3 INCOME REDISTRIBUTION Negative Income Tax A negative income tax is a tax and redistribution scheme that provides every household with a guaranteed minimum annual income and taxes all earned income at a fixed rate. A negative income tax does not remove the burden of the tax but it does improve the incentives to work and save at all levels of income.

60. © 2013 Pearson In the United States today (excluding the ultra rich), the families with the highest incomes are likely to be college- educated Asian married couples between 45 and 54 years of age living together with two children in the West. At the other extreme, the person with the lowest income is likely to be a black woman over 65 years of age who lives alone in the South and has fewer than nine years of elementary school education. Another low-income group are young women of a single female household who have not completed high school, have a child (or children), and who live without a partner.. Who Are the Rich and the Poor?

61. © 2013 Pearson The figure shows the influences on income. Who Are the Rich and the Poor?