SM14ce_Micro_Chap016B.doc

Chapter16B - Income Inequality, Poverty, and Discrimination Chapter16B - Income Inequality, Poverty, and Discrimination McConnell Brue Flynn Barbiero 14ce DISCUSSION QUESTIONS 1. Use quintiles to briefly summarize the degree of income inequality in Canada. What criticisms have been made of standard data on income inequality? How and to what extent does government contribute to income equality? LO 16B.1 Answer: The income share received by the highest 20 percent was 44.2 percent in 2011, which is almost ten times the 4.8 percent received by the lowest 20 percent. The middle three quintiles receive under 50 percent of the total before-tax income. The top two quintiles receive twice as much as the bottom three quintiles combined. 2. Assume Al, Beth, Carol, David, and Ed receive incomes of $500, $250, $125, $75, and $50 respectively. Construct and interpret a Lorenz curve for this fiveperson economy. What percentage of total income is received by the richest and by the poorest quintiles? LO 16B.1 Answer: See the figure below. In this simple economy each person represents a complete income quintile—20 percent of the total population. The richest quintile (Al) receives 50 percent of total income; the poorest quintile (Ed) receives 5 percent. This follows from the calculations below. Total Income equals $1000 (= $500 + $250 + $125 + $75 + $50). The lowest quintile (Ed) is 5% of total income (=$50/$1000) The second quintile (David) is7.5% of total income (=$75/$1000) The third quintile (Carol) is 12.5% of total income (=$125/$1000) The fourth quintile (Beth) is 25% of total income (=$250/$1000) The upper quintile (Al) is 50% of total income (=$500/$1000) 3. How does the Gini ratio relate to the Lorenz curve? Why can’t the Gini ratio exceed 1? What is implied about the direction of income inequality if the Gini ratio declines from 0.42 to 0.35? How would one show that change of inequality in the Lorenz diagram? LO16B.1 Answer: The Gini ratio is the numerical measurement of the inequality depicted by the Lorenz curve. It is calculated by dividing the area between the curve and the diagonal by the total area below the diagonal. The Gini ratio can’t exceed 1 because if the Lorenz curve is as far as possible from the diagonal (line of equality), the area between the curve and the diagonal will equal the total area below the diagonal. The equality will result in a Gini ratio of 1. A decline in the Gini ratio implies less income inequality; and it would be graphically depicted by moving the Lorenz curve closer to the diagonal. 4. Why is the lifetime distribution of income more equal than the distribution in any given year? LO16B.1 Answer: The disparity of incomes in a single year reflects the income distribution at a point in time. Of course, the very young and very old will receive lower incomes, and the middle-aged tend to receive higher incomes, giving a picture of great inequality. However, if we view these same groups over time, there is considerable mobility both up and down the income scale, suggesting that income is more equally distributed over a five-, ten-, or twenty-year period for these same households. 5. Briefly discuss the major causes of income inequality. With respect to income inequality, is there any difference between inheriting property and inheriting a high IQ? Explain. LO16B.2 Answer: The reasons for income inequality are: differences in abilities and talents among individuals, differences in the amount of education and training an individual obtains, labour market discrimination, differences in tastes and preferences toward work and job attributes, inequality in the distribution of wealth, the ability to use market power to transfer income to oneself, luck, connections, and misfortune. A high IQ normally does not lead to high income unless it is combined with personal initiative and favourable social circumstances. Inherited property—as long as it is competently managed—provides income irrespective of one’s character and personal attributes. Both factors are largely a matter of luck to the recipient. 6. Should a nation’s income be distributed to its members according to their contributions to the production of that total income or to members’ needs? Should society attempt to equalize income or economic opportunities? Are the issues of “equity” and “equality” in the distribution of income synonymous? To what degree, if any, is income inequality equitable? LO16B.3 Answer: The answer to this question is inextricably tied to value judgments, but most of us probably favour a combination of the two types of income distribution. A purely capitalist system, in which incomes are determined exclusively by the market mechanism, would mean that those who, for whatever reason, are unable to contribute to production would have to depend exclusively on private charity for their livelihood. A (hypothetical) communist state also leads to a seemingly intractable problem: If income is to be distributed purely on the basis of need, why would anyone engage in production? Most modern societies represent attempts to seek a compromise of one sort or another between these two extremes. The compromise that is actually found often differs markedly from what prevailing political rhetoric in that society might suggest. Socialist economies historically exhibited large differences in income, and wideranging government transfer programs are a seemingly permanent fixture in most capitalist economies. Conservatives contend that because of the trade-off between equality and efficiency, society should content itself with attempting to ensure equality of opportunity. Liberals argue that income redistribution is essential since equality of economic opportunity is impossible in an economy with wide differences in income, especially when these differences are related to the inheritance of property. Income equity refers to how fairly income is distributed. One can argue that some inequality of income is not only necessary for reasons of efficiency but is fairer than an equal distribution of income, since those who produce more deserve to be rewarded for their efforts. But unequal incomes are not necessarily related to differences in individual ability or effort. It is difficult to defend the inequalities that result from market power and discrimination as being equitable. The justness of inherited wealth is also questionable. Liberals argue that because it creates inequality of opportunity, property inheritance is inherently unjust. Conservatives contend that allowing individuals to pass on wealth to whom they wish is much fairer than having wealth appropriated by the government. 7. Do you agree or disagree with the following statement? Explain your reasoning. “There need be no trade-off between equality and efficiency. An ‘efficient’ economy which yields an income distribution which many regard as unfair may cause those with meagre income rewards to become discouraged and stop trying. Hence, efficiency is undermined. A fairer distribution of rewards may generate a higher average productive effort on the part of the population, thereby enhancing efficiency. If people think they are playing a fair economic game and this belief causes them to try harder, an economy with an equitable income distribution may be efficient as well.” LO16B.3 Answer: It is hard to imagine that the disincentive effects on both high and lowincome earners of income redistribution will be swamped by an increased interest on the part of some of the poor in “playing the economic game.” Without the prospect of higher incomes, few individuals in an economy—including the poor—would choose to increase their productivity. What would increase individual effort and hence aggregate efficiency is the perception that opportunities for all are equal in every respect. In other words, it is not so much an unequal distribution of income that causes some members of society to become discouraged and stop participating in the market, but rather the wideranging perception that the deck is stacked against them. Many feel they can never earn incomes commensurate with their abilities and efforts because of a lack of financial resources, restricted access to education, or barriers in the workplace. 8. Comment on or explain: LO16B.4 a. “To endow everyone with equal income will make for very unequal enjoyment and satisfaction.” b. “Equality is a ‘superior good’; the richer we become, the more of it we can afford.” c. “The mob goes in search of bread, and the means it employs is generally to wreck the bakeries.” d. “Some freedoms may be more important in the long run than freedom from want on the part of every individual.” e. “Capitalism and democracy are really a most improbable mixture. Maybe that is why they need each other—to put some rationality into equality and some humanity into efficiency.” f. “The incentives created by the attempt to bring about a more equal distribution of income are in conflict with the incentives needed to generate increased income.” Answer: (a) No distribution of income can ensure equal enjoyment. It can be argued that by equating incomes in a society we maximize the probability of maximizing total utility for all individuals. (b) The lessening of poverty provides a host of indirect benefits to affluent members of society—social peace, physical security, and perhaps the intangible satisfaction of living in a more equitable society. The better off the affluent become, the more they are willing to spend in order to purchase these benefits. (c) Mobs commonly exhibit a marked preference for present over future consumption. Many conservatives contend that the income redistribution schemes resulting from democratic decision-making suffer from a similar failing in that they decrease the incentive to accumulate capital in order to provide present consumption to the poor. Is this view valid? Perhaps. Does this mean that such redistribution schemes are misguided? Not necessarily. (d) This is a common conservative view, that civil and political liberties are more important than the universal eradication of poverty. Liberals are likely to contend that ensuring universal freedom from want does not necessarily detract from these fundamental freedoms. (e) The principles underlying the two systems can be summarized as follows: Each dollar has a vote in the marketplace, and each person has a vote at the ballot box. These principles are similar enough that the presence of one often leads to the other. They are dissimilar enough that the type of society that arises from a combination of the two represents a workable social compromise. (f) Incentives created in the attempt to bring about more equal distribution of income may cause a trade-off in decreased economic efficiency. Higher marginal taxes may reduce the efforts of those at the top to work harder and produce more. Greater benefits to those at the bottom may reduce their incentive to do the same as they receive benefits without the productive effort. Insofar as this trade-off occurs, there will be a reduction in economic growth and, therefore, damage to incentives leading to increased incomes. 9. Males under the age of 25 must pay far higher auto insurance premiums than females in this age group. How does this fact relate to statistical discrimination? Statistical discrimination implies that discrimination can persist indefinitely, while the taste-for-discrimination model suggests that competition might reduce discrimination in the long run. Explain the difference. LO16B.6 Answer: Statistical discrimination occurs when people are judged on the basis of the average characteristics of the group to which they belong. Insurance companies base auto insurance premiums on the statistical information available, and the consequent discrimination will continue as long as there is a difference in accident rates by gender in this age group. The taste-for-discrimination model suggests that competition will reduce discrimination in the long run. Firms that do not discriminate will have lower actual wage costs per unit of output and lower average total costs than will the firms that discriminate. These lower costs will allow non-discriminating firms to charge lower prices. This should eventually drive the discriminating firms out of the market. 10. Use a demand and supply model to explain the impact of occupational segregation or “crowding” on the relative wage rates and earnings of men and women. Who gains and who loses from the elimination of occupational segregation? Is there a net gain or net loss to society? Explain. LO16B.6 Answer: See Figure 16B-5. Discrimination against women in two of the three occupations will crowd women into the third occupation. Labour supply in the “men’s occupations” (X and Y) decreases, making them high-wage occupations. Labour supply in the “women’s occupation” (Z) increases creating a low-wage occupation. Eliminating occupational segregation would entice women into the high-wage occupations, increasing labour supply there and reducing it in the low-wage occupation. The wage rates in the three occupations would converge to B. Women would gain, men would lose. Society would gain because the increase in output in the expanding occupations would exceed the loss of output in the contracting occupation. . The Last Word How do poor people describe “well-being” and “ill-being”? Answer: Well being was described by the following: happiness, harmony, peace, freedom from anxiety, and peace of mind. “Ill-being” was described as lack of material things, as bad experiences, and as bad feelings about oneself. REVIEW QUESTIONS 1. Suppose that Canada has a Gini ratio of 0.41 while Sweden has a Gini ratio of 0.31. Which country has a more equal distribution of income? LO16B.1 a. Canada. b. Sweden. c. They are actually equal. Answer: b. Sweden The higher the Gini ratio the more unequal a country’s income distribution is. Thus, Sweden’s lower ratio implies that is has less inequality of incomes—which is the same thing as saying that is has more equality of incomes. 2. Some part of income inequality is likely to be the result of discrimination. But other factors responsible for inequality include (select as many as apply): LO16B.2 a. Differences in abilities and talents. b. Differences in education and training. c. Different preferences for work versus leisure. d. Different preferences for low-paying but safe jobs relative to high-paying but dangerous jobs. Answer: a, b, c, and d are all correct. 3. Suppose that a society contains only two members, a lawyer named Monique and a handyman named James. Five years ago, Monique made $100,000 while James made $50,000. This year, Monique will make $300,000 while James will make $100,000. Which of the following statements about this society’s income distribution are true? LO16B.3 Select one or more answers from the choices shown. a. In absolute dollar amounts, the entire distribution of income has been moving upward. b. In absolute dollar amounts, the entire distribution of income has been stagnant. c. The relative distribution of income has become more equal. d. The relative distribution of income has become less equal. e. The relative distribution of income has remained constant. f. The rich are getting richer while the poor are getting poorer. g. The rich are getting richer faster than the poor are getting richer. Answer: a. In absolute dollar amounts, the entire distribution of income has been moving upward. d. The relative distribution of income has become less equal. g. The rich are getting richer faster than the poor are getting richer. The following three statements about this society’s income distribution are true. In absolute dollar amounts, the entire distribution of income has been moving upward. We know this to be true because each person in this society has seen his or her income rise over the past five years. The relative distribution of income has become less equal. This is true because Monique’s share of total income has been rising. Five years ago, Monique’s $100,000 of income represented 2/3 of the society’s total income of $150,000 (= Monique’s $100,000 + James’ $50,000). But this year, Monique’s $300,000 of income will represent ¾ of the society’s total income of $400,000 (= Monique’s $300,000 + James’ $100,000). Thus, income inequality has risen because the share of income earned by the richest member of this society has increased. The rich are getting richer faster than the poor are getting richer. This is true because while James and Monique have both gotten richer, Monique’s increase in income is larger than James’ increase in income. In particular, Monique’s income has tripled from $100,000 to $300,000 while James’ income has only doubled from $50,000 to $100,000. So the rich are getting richer faster than the poor are getting richer. 4. Suppose that the last dollar that Victoria receives as income brings her a marginal utility of 10 utils while the last dollar that Fredrick receives as income brings him a marginal utility of 15 utils. If our goal is to maximize the combined total utility of Victoria and Fredrick, we should: LO16B.4 a. Redistribute income from Victoria to Fredrick. b. Redistribute income from Fredrick to Victoria. c. Not engage in any redistribution because the current situation already maximizes total utility. d. None of the above. Answer: a. Redistribute income from Victoria to Fredrick. If our goal is to maximize the combined total utility of Victoria and Fredrick, we should redistribute income from Victoria to Fredrick. This is true because the marginal utility of 15 that Fredrick receives from the last dollar of his income is higher than the marginal utility of 10 that Victoria receives from the last dollar of her income. So, if we took one dollar away from Victoria and redistributed it to Fredrick, the combined total utility of Victoria and Fredrick would rise because while Victoria’s total utility would fall by 10 utils when we took that dollar away from her, Fredrick’s total utility would rise by 15 utils when he was given that dollar. Thus, there would be a net increase of 5 utils (= 15 utils gained by Fredrick minus 10 utils lost by Victoria). In a similar fashion, if our only goal is to maximize their combined total utility, then we should continue to take dollars away from Victoria and give them to Fredrick just as long as Fredrick’s marginal utility remains greater than Victoria’s marginal utility. 5. If women are crowded into elementary education and away from fire fighting, wages in fire fighting will tend to be than if women weren’t crowded into elementary education. LO16B6 a. Higher. b. Lower. Answer: a. Higher. Crowding women into elementary education and away from fire fighting will raise wages in fire fighting because the supply of labour flowing to fire fighting will be reduced relative to what it would have been if women were not crowded away from fire fighting and more women were attempting to become fire fighters. 6. In the taste-for-discrimination model, an increase in employer prejudice against visible minority workers would cause the discrimination coefficient to and the demand curve for visible minority labour to shift. LO16B.6 a. Decrease; right. b. Decrease; left. c. Increase; right. d. Increase; left. Answer: d. Increase; left. In the taste-for-discrimination model, an increase in employer prejudice against Visible minority workers would cause the discrimination coefficient to increase and the demand curve for Visible minority labour to shift left. The discrimination coefficient increases because it puts a dollar amount on the disutility felt by racist employers when confronted with the possibility of hiring Visible minority workers rather than white workers. Increased employer prejudice translates into higher disutility and therefore a higher discrimination coefficient. The demand curve for Visible minority labour shifts left when employer prejudice increases because racist employers will be less willing to higher Visible minority workers relative to white workers. With a higher discrimination coefficient, only those Visible minority workers whose productivity is high enough to compensate for the increased disutility felt by racist employers will still be demanded by those racist employers. Those Visible minority workers with lower productivity will no longer be demanded. Thus the total demand for Visible minority labour will fall. PROBLEMS 1. In 2012, Forbes magazine listed Bill Gates, the founder of Microsoft, as the richest person in the United States. His personal wealth was estimated to be $66 billion. Given that there were about 309 million people living in the United States that year, how much could each person have received if Gates’ wealth had been divided equally among the population of the United States? (Hint: A billion is a 1 followed by 9 zeros while a million is a 1 followed by six zeros.) LO16B.1 Answer: $213.59 Feedback: Simply divide Bill Gates’ wealth, $66 billion, by the number of people in the United States, 309 million. The answer is $213.59 (=$66,000,000,000/309,000,000). 2. Imagine an economy with only two people. Larry earns $20,000 per year while Roger earns $80,000 per year. As shown in the following figure, the Lorenz curve for this two?person economy consists of two line segments. The first runs from the origin to point a while the second runs from point a to point b. LO16B.1 a. Calculate the Gini ratio for this two?person economy using the geometric formulas for the area of a triangle (= ½ x base x height) and the area of a rectangle (= base x height). Hint: The area under the line segment from point a to point b can be thought of as the sum of the area of a particular triangle and the area of a particular rectangle. b. What would the Gini ratio be if the government taxed $20,000 away from Roger and gave it to Larry? (Hint: The figure will change.) c. Start again with Larry earning $20,000 per year and Roger earning $80,000 per year. What would the Gini ratio be if both their incomes doubled? How much has the Gini ratio changed from before the doubling in incomes to after the doubling in incomes? Answers: a. The Gini ratio is 0.300. b. The Gini ratio here is 0.100. c. The Gini ratio will remain as it was in part (a) at 0.300; the ratio has not changed. Feedback: Part a: First, we find the area under the equality line. Using our formula for the area of a right triangle we have an area of 5,000 (= (1/2) x 100 (base or x-axis) x 100 (height or y-axis). Second, we find the area between the two curves. To do this we start by finding the area UNDER the Lorenz curve (we have easy to use formulas for triangles and rectangles). See the graph below. The area of triangle A is 500 (= (1/2) x 50 (base) x 20 (height)). The base of the triangle is 50 (at 50%) because there are only two people in the economy. The height of the triangle is 20 (at 20%) because the lowest income is $20,000, which is 20% of the total income earned in society (= ($20,000 / $100,000) x 100). The area of rectangle B is 1,000 (= 50 (base) x 20 (height)). The area of triangle C is 2,000 (= (1/2) x 50 (base) x 80 (height). The total area under the Lorenz Curve is 3,500 (= 500(area of triangle A) + 1,000 (area of rectangle B) + 2,000(area of triangle C) . We can now find the area between the two curves, which is 1,500 (= 5,000 (the area under the equality curve) – 3,500 (the area under the Lorenz curve)). The final step of this procedure is to take the ratio of the area between the two curves and the area under the equality curve, which gives us the Gini ratio. The Gini ratio for this example is 0.3 (=1,500/5,000). Part b: After the tax and redistribution program Larry's new income is $40,000 and Roger's new income is $60,000. This implies that Larry (50% of the population) now controls 40% of society's income rather than the 20% before the program. To calculate the new Gini ratio we use the same procedure as above. However, we use 40% rather than the 20% shown in the diagram. With this new value we have: The area of triangle A is 1,000 (= (1/2) x 50 (base) x 40 (height)). The area of rectangle B is 2,000 (= 50 (base) x 40 (height)). The area of triangle C is 1,500 (= (1/2) x 50 (base) x 60 (height). The total area under the Lorenz Curve is 4,500. We can now find the area between the two curves, which is 500 (= 5,000 (the area under the equality curve, note this does not change) – 4,500 (the area under the Lorenz curve)). The Gini ratio for this income distribution is 0.1 (= 500 / 5,000). Part c: If incomes double, Larry earns $40,000 and Roger earns $160,000. The total income in society is now $200,000. Larry still only controls 20% of the society's income ((=$40,000/$200,000) x 100). Since the doubling of incomes does not change the percentage of income controlled by Larry (or Roger) the Gini ratio will not change. The answer will be the same as in part a. 16B-10 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.