A person’s earnings depend on the supply and

demand for that person’s labor, which in turn

depend on natural ability, human capital,
compensating differentials, discrimination, and
so on.
 How much inequality is there in our society?
 How many people live in poverty?
 What problems arise in measuring the

amount of inequality?
 How often do people move among income

classes?
 Reasons for Recent Increase in Income
Inequality
◦ The following have tended to reduce the demand for
unskilled labor and raise the demand for skilled
labor:
 Increases in international trade with low-wage
countries
 Changes in technology
◦ Therefore, the wages of unskilled workers have
fallen relative to the wages of skilled workers.
◦ This has resulted in increased inequality in family
incomes.
 The percentage of women who hold jobs has
risen from about 32 percent in the 1950s to
about 54 percent in the 1990s.
 The poverty rate is the percentage of the
population whose family income falls below
an absolute level called the poverty line.
 The Poverty Line
◦ The poverty line is an absolute level of income set
by the federal government for each family size
below which a family is deemed to be in poverty.
Percent of the
Population
below Poverty
Line
25

20

Poverty rate
15

10

1960 1965 1970 1975 1980 1985 1990 1995 2000

Copyright©2003 Southwestern/Thomson Learning

 The Poverty Line and Income Inequality
◦ As economic growth pushes the entire income
distribution upward, more families are pushed
above the poverty line because the poverty line is
an absolute rather than a relative standard.
◦ Despite continued economic growth in average
income, the poverty rate has not declined.
◦ Although economic growth has raised the income
of the typical family, the increase in inequality has
prevented the poorest families from sharing in this
greater economic prosperity.
Copyright©2004 South-Western
 Three Facts About Poverty
◦ Poverty is correlated with ethnicity.
◦ Poverty is correlated with age.
◦ Poverty is correlated with family composition.
 Data on income distribution and the poverty
rate give an incomplete picture of inequality
in living standards because of the following:
◦ In-kind transfers
◦ Life cycle
◦ Transitory versus permanent income
 In-Kind Transfers
◦ Transfers to the poor given in the form of goods
and services rather than cash are called in-kind
transfers.
◦ Measurements of the distribution of income and the
poverty rate are based on families’ money income.
◦ The failure to include in-kind transfers as part of
income greatly affects the measured poverty rate.
 The Economic Life Cycle
◦ The regular pattern of income variation over a
person’s life is called the life cycle.
 A young worker has a low income at the beginning of
his or her career.
 Income rises as the worker gains maturity and
experience.
 Income peaks at about age 50.
 Income falls sharply at retirement, around age 65.
 Transitory versus Permanent Income
◦ Incomes vary because of random and transitory
forces.
 Acts of nature
 Temporary layoffs due to illness or economic
conditions, etc.
 A family’s ability to buy goods and services depends
largely on its permanent income, which is its normal,
or average, income.
 Permanent income excludes transitory changes in
income.
 The movement of people among income
classes is called economic mobility.
 Economic mobility is substantial in the

economy.
 Movements up and down the income ladder
can be due to:
◦ Good or bad luck.
◦ Hard work or laziness.
◦ Persistence of economic success from generation to
generation.
 What should the government do about
economic inequality?
◦ Economic analysis alone cannot give us the answer.
◦ The question is a normative one facing
policymakers.
 Three Political Philosophies
◦ Utilitarianism
◦ Liberalism
◦ Libertarianism
 Utilitarianism is the political philosophy
according to which the government should
choose policies to maximize the total utility
of everyone in society.
 The founders of utilitarianism are the English

philosophers Jeremy Bentham and John Stuart

Mill.
 The utilitarian case for redistributing income
is based on the assumption of diminishing
marginal utility.
◦ An extra dollar of income to a poor person
provides that person with more utility, or well-
being, than does an extra dollar to a rich person.
 Liberalism is the political philosophy
according to which the government should
choose policies deemed to be just, as
evaluated by an impartial observer behind a
“veil of ignorance.”
 This view was originally developed by the

philosopher John Rawls.

 Public policy should be based on the maximin
criterion, which seeks to maximize the utility
or well-being of the worst-off person in
society.
 That is, rather than maximizing the sum of

everyone’s utility, one should maximize the

minimum utility.
 This idea would allow for the consideration of

the redistribution of income as a form of

social insurance.
 Libertarianism is the political philosophy
according to which the government should
punish crimes and enforce voluntary
agreements, but should not redistribute
income.
 Libertarians argue that equality of

opportunity is more important than equality

of income.
 Minimum-wage laws
 Welfare
 Negative income tax
 In-kind transfers
 Advocates view the minimum wage as a way
of helping the working poor.
 Critics view the minimum wage as hurting

those it is intended to help.

 The magnitude of the effects of the minimum
wage depends on the elasticity of the demand
for labor.
 Advocates argue that the demand for
unskilled labor is relatively inelastic, so that a
high minimum wage depresses employment
only slightly.
 Critics argue that labor demand is more

elastic, especially in the long run when firms

can adjust employment more fully.
 The government attempts to raise the living
standards of the poor through the welfare
system.
 Welfare is a broad term that encompasses

various government programs that

supplement the incomes of the needy.
◦ Temporary Assistance for Needy Families (TANF)
◦ Supplemental Security Income (SSI)
◦ 4Ps
◦ Etc.
 A negative income tax collects tax revenue
from high-income households and gives
transfers to low-income households.
 High-income families would pay a tax based
on their incomes.
 Low-income families would receive a subsidy

—a “negative tax.”
 Poor families would receive financial

assistance without having to demonstrate

need.
 In-kind transfers are transfers to the poor
given in the form of goods and services
rather than cash.
 Food stamps and Medicaid are examples.
 Advocates of in-kind transfers argue that
such transfers ensure that the poor get what
they most need.
 Advocates of cash payments argue that in-

kind transfers are inefficient and

disrespectful.
 Many policies aimed at helping the poor can
have the unintended effect of discouraging
the poor from escaping poverty on their own.
 An antipoverty program can affect work
incentives:
◦ A family needs Php15,000 to maintain a reasonable
standard of living.
◦ The government promises to guarantee every
family a Php15,000 income.
◦ Any person making under Php15,000 has no
incentive to work due to the effective marginal tax
rate of 100 percent.
 Workfare refers to a system that would
require any person collecting benefits to
accept a government-provided job.
 A 1996 welfare reform bill advocated
providing benefits for only a limited period of
time.
 Data on the distribution of income show wide
disparity in our society.
 The richest fifth of the families earns about

ten times as much as the poorest fifth.

 It is difficult to gauge the degree of inequality

using data on the distribution of income in a

single year.
 Political philosophers differ in their views
about the role government should play in
redistributing income.
 Utilitarians would choose the distribution of

income to maximize the sum of the utility of

everyone in society.
 Liberals would determine the distribution of
income as if we were behind a “veil of
ignorance” that prevented us from knowing
our own stations in life.
 Libertarians would have the government

enforce individual rights but not be

concerned about inequality in the resulting
distribution of income.
 Various policies aimed to help the poor
include: minimum-wage laws, welfare,
negative income taxes, and in-kind transfers.
 Although each of these policies helps some

families escape poverty, they also have

unintended side effects.