What's Fair is Fair

            Life isn't fair.  It's just fairer than death, that's all.

                                                                        …..William Goldman

            Economists play games.  No, not games like baseball, Final Fantasy or Uncle Wiggily;¹ we play experimental games designed to analyze human behavior.

            In the well-known Ultimatum Game, an administrator gives a player temporary control of $1,000.  The player is told to offer a second player some part of the money in a take-it-or-leave-it ultimatum.  If the second player accepts the proposed split, the $1,000 is divided as per the agreement and both players walk off with a portion of the loot.  However, if the second player rejects the ultimatum, the game ends.  The administrator pulls the entire $1,000 off the table, and neither player gets a dime. 

            If you are the first player, what should you offer?  If you are the second, what should you accept?  The simple self-interest solution seems clear. Suppose you are the second player. Since you get nothing by rejecting an offer, you should accept any positive amount.  Even if the first player offers only $1; $1 is better than the nothing you would get by saying no.  Of course, the first player should understand this as well and, knowing that you are likely to accept any positive proposal, should offer as little as possible -- perhaps a mere dollar or even less. 

            Interestingly, when the game actually is played, the results differ markedly.  Players routinely reject offers they consider unduly lopsided or unfair.  Players willingly shoot themselves in the foot (or wallet) to keep another player from making a disproportionate gain.  Taking a small "free" payoff might be efficient, but most of us happily will sacrifice a small gain in efficiency to protect what we consider to be a more equitable distribution of dollars. 

            Economists love efficiency; efficient moves create new value.  But, what if that new value is distributed unfairly?  In theory, that new value could be redistributed in a more equitable fashion.  For example, it could be redistributed so that everyone shares in the gain.  However, in the real world such redistributions do not necessarily occur; especially when those getting the dollars wield disproportionate amounts of political clout.  In such cases, fairness might trump efficiency.

Distribution of income

            Regrettably, fairness is a slippery concept.  What seems fair to me might seem unfair to others.  Indeed, Republicans and Democrats routinely skirmish about how a fair distribution of tax burdens might look.  Like pornography, we insist that "we know it when we see it," but we all see it though different eyes.

            While economists have no monopoly on defining how a distribution of income should look, we at least can paint a picture of how it does look. The picture is not necessarily a pretty one.  With just a brief pause, the U.S. economy has grown steadily since the early years of the Clinton Administration, but fortune has smiled on some far more brightly than on others. Our economic tide keeps rising, but the seas have been rough.  Well-appointed economic boats have crested to record levels, but those less seaworthy have capsized.  Median incomes are up, but so is income inequality.

            Check out the following table.²  It lists shares of total U.S. income by quintile.  If income was distributed equally, each 20 percent of households would control exactly 20 percent of U.S. income.  What we find, however, is that the richest 20 quintile has cornered half of the U.S. income and that the richest five percent reaps almost twice the annual earnings of the bottom 40 percent.  U.S. income is distributed unequally; more unequally than in most other developed nations.  For example, the richest quintile in Japan controls less than 40 percent of national income (compared to almost 50 percent in the U.S.), while the poorest quintile in Japan receives more than eight percent of national income (compared to less than four percent in the U.S.).

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                                                       Shares of Total U.S. Income

            Households                      1970              1980                 1990               2006

            Poorest 20%                   4.1%               4.3%                 3.9%               3.4%

            2nd quintile                   10.8%             10.3%                 9.6%               8.6%

            3rd quintile                   17.4%             16.9%               15.9%             14.5%

            4th quintile                    24.5%             24.9%               24.0%             22.9%

            Richest 20%                  43.3%             43.7%               46.6%             50.5%

            Richest 5%                    16.6%             15.1%               18.6%             22.3%

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            And, the degree of inequality has increased.  Since 1980 the share of the poorest 20 percent has slid steadily while the share of the richest 20 percent has climbed.  Moreover, the entire gain in this top group has been cornered by the very richest five percent of households.  In other words, the richest five percent of U.S. households has been increasing its share of total income steadily at the expense of every other group. Pay packages of corporate chief executive officers (CEO's) have grown especially fast.  Cash compensation received by CEO's in 1970 averaged about 20 times what average production workers earned.  By 2000, CEO cash compensation had risen to almost 90 times what average production workers received.³ 

            Some dispute that inequality has grown.  The table includes only money income; non-money income in the form of food stamps, housing subsidies and medicare/medicaid benefits is ignored.  Including these would reduce both the amount of and trend in inequality.  Lower tax rates also might have distorted the data.  When tax rates fell through the 1980's, the incentive for wealthy citizen's to hide income from Uncle Sam also fell.  If so, much of the apparent increase in upper-level incomes could be illusory.  If financial fat cats suddenly pull earnings out from under the table, reported income inequality may rise even though actual inequality is unchanged.

Increased wage differentials

            But these are minority impressions.  Most analysts agree that the expanding gap between the rich and the poor is very real.  And most agree that increased wage inequality is the cause.  According to recent research, increased wage differentials account for almost all of the increased income differentials between the rich and the poor.  Highly skilled and educated workers have prospered; less-skilled and less-educated workers have not.⁴  Why? 

            Can we blame those foreigners?  Some have.  Globalization forces countries to specialize in those sectors in which they have a comparative advantage.  For the U.S. that means concentrating on products that make intensive use of skilled labor while importing goods and services produced primarily by unskilled labor.  The result?  Increased globalization and trade should create increased demands and wages for skilled workers in the U.S., and decreased demands and wages for unskilled workers. 

            It does sound reasonable. Unfortunately, the evidence will not cooperate.  If trade is the culprit, unskilled workers in industries besieged by imports should be especially hard hit.  They are not.  Do we travel to Venezuela to shop for chewing gum or swimsuits?  Do we call Malaysian contractors when soliciting bids to re-roof our garage?  No.  Sectors such as retail trade and construction are relatively immune to foreign competition.  Yet unskilled workers in these sectors have fared no better than those producing traded manufactured goods.  Moreover, unskilled workers in other countries have fared just as poorly as those here at home.  We cannot trace any significant part of the blame to international trade.

Changing technology

            Technology offers a more satisfying answer.  Much of the technological change in recent decades has been skill-based; it impacts skilled and unskilled workers differently.  For example, the computer revolution has increased the productivity of skilled workers, but blown unskilled ones out of the water.  Skilled, computer-literate applicants job hop to ever-increasing salaries.  Former clerks and assembly-line workers, now displaced by computers and robots, pound the pavements unable to replace their former wages.  In almost every market and occupation, those workers with the education and skills to adapt and take advantage of new technologies have prospered relative to those who cannot.⁵

            Cornell's Bob Frank suggests that technology might increase inequality through other channels as well; it might increase the importance of winner-take-all markets.⁶  In most markets, a worker who is five percent more productive than another might expect to earn a salary which is five percent higher.  But in winner-take-all markets, very small differences in absolute productivity translate into enormous pay differentials.

            Professional sports are an obvious example.  Think of the tennis player who loses the U.S. Open final in a fifth set tie-breaker or the golfer who loses the Master's by a stroke as his final putt rolls an inch past the cup.  The performance gap between them and the winners is insignificant, yet who remembers the runners-up?  The gap in fame and fortune is enormous.

            In the Darwinian struggle for survival, a small relative edge can make all the difference.  The rabbit who survives doesn't have to be very fast, as long as he is faster than the fox in pursuit.  My attorney doesn't have to be very talented, as long as she is more talented than the one who represents my adversary.  The local baker might turn out only average bagels, but still can corner the market if those of its competitors are worse.

             Winner-take-all markets breed inequality, and technology breeds winner-take-all markets.  In the not-too-distant past, most markets were local.  Because travel and communication were both time-consuming and expensive, comparison shopping was relegated to visiting a few local suppliers.  A vendor in the next town might offer a better product or a better deal, but with limited transportation and information very few consumers knew about them or could take advantage of them.  Not any more.  Technology has transformed markets.  People, products and information now flow easily across physical and electronic space.  With a few strokes on a keyboard consumers have the world at their fingers.  Are shoes cheaper in Baltimore?  Order them on-line and have them delivered tomorrow.  Are graphic artists better in New York?  Check their web pages for samples and have them e-mail you new designs.  Why watch the local minor-league baseball team when the major league champion beams its games over satellite TV?  Why pay to hear a local singer when Beyonce's latest hit is available on a compact disk?

            The effects on income are predictable.  In the past a better manager or a better product might have given us a small relative edge that allowed us to corner the local market.  Now that better manager or product can bring us national or even international dominance.  The stakes have changed.  The potential values of the very best managers and designers and athletes and singers have soared.  Instead of many moderately-successful and moderately-wealthy stars in distinct local or regional markets, we now have a handful of fabulously successful and filthy-rich stars in national markets.  This small group of "winners" has outdistanced the pack 

            Rabo Karabekian, the protagonist of Kurt Vonnegut's Bluebeard put it brilliantly.  Reflecting on ancient days in which each community had its own story-tellers, its own artists, and its own musicians, Karabekian laments: 

                        .....a scheme like that doesn't make sense anymore, because simply moderate giftedness has been made worthless by the printing press and radio and television and satellites and all that.  A moderately gifted person who would have been a community treasure a thousand years ago has to give up, has to go into some other line of work, since modern communications put him or her into daily competition with nothing but world champions.  The entire planet can get along nicely now with maybe a dozen champion performers in each area of human giftedness.⁷

Of course, as Vonnegut's handful of world champions begins to grab a disproportionate share of our markets, it also grabs disproportionate share of income.

Solutions?

            Is it unfair?  Should we worry about increasing inequality?  If so, we can moderate these effects through increased government transfers to low-income families.  Many U.S. taxpayers do favor government assistance to low-income families, but resist those that tax the middle class to do so.  Many feel that taxing the rich is acceptable; squeezing the middle class is not.  Of course, that's because most families are convinced that they are middle class and that someone else is rich.  Redistributing someone else's wealth always is more popular than redistributing your own.

            Unfortunately, many of us have distorted notions about what it means to be rich.  Look at the data.⁸ What does it take to be rich?  In 2006, median U.S. household income was $48,201. Households with incomes below about $20,000 fell into poorest 20 percent or quintile.   Those with incomes above $97,000 broke into the richest quintile.  Households with incomes in excess of $174,000 ranked in the richest five percent. 

            Hmmm.  These are not disgustingly large numbers.  Some of my teaching colleagues at Winthrop University earn enough to propel them into the richest quintile.  Others with lower salaries make into the top group with the help of a working spouse.  The average salary for a high school teacher in the U.S. is close to $50,000.  That means that my neighbors down the street, both of whom teach in the public schools, probably rank among the richest 20 percent of households in America.  Since college students are drawn disproportionately from families with above-average incomes, many come from families that rank in this same top 20 percent.  I often tell my colleagues and students that they are rich.  I explain they are among the richest households in the richest country the world has ever seen.  They are not amused.  They do not feel rich.  They do not want to be thought of as rich.  Yet they are rich.  So are, or will be, many of you.

            Is income inequality increasing?  Yes.  Is such inequality a problem?  Probably; but that is a value judgment which you are free to reject.  Can we assist the poor without squeezing the middle class?  It depends on whether we define "middle class" honestly.  If we persist in assuming that only candidates for Robin Leach's Lifestyles of the Rich and Famous should be squeezed, hopes for significant change are dead in the water.

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Notes:

1.         Uncle Wiggily is an underappreciated children's board game in which I inevitably fall prey to the bad  Pipsisewah.

2.         The data are from http://www.census.gov/hhes/www/income/histinc/ineqtoc.html, Table H-2 (all races).

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.         Describe the Ultimatum Game; explain the self-interest solution to the game, and explain why we seldom observe this solution.

2.         Describe the major changes in the U.S. distribution of income since 1980.

3.         Explain how skill-based technological change might cause increased income inequality.

4.         Explain the concept of a winner-take-all market and why relative rather than absolute ability matters in them.

5.         Explain how changing technology can create more winner-take-all markets and how this might affect the distribution of income.

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