The Joy of
Economics: Making Sense out of Life
Robert J. Stonebraker, Winthrop University
What's Fair is Fair
Life isn't fair. It's just fairer than death, that's all.
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.).
* * * * * * * * * * * * * * * * * * *
Shares of Total U.S. Income
Household 1970 1980 1990 20101
Poorest 20% 4.1% 4.3% 3.9% 3.2%
2nd quintile 10.8% 10.3% 9.6% 8.4%
3rd quintile 17.4% 16.9% 15.9% 14.3%
4th quintile 24.5% 24.9% 24.0% 23.0%
Richest 20% 43.3% 43.7% 46.6% 51.1%
Richest 5% 16.6% 15.1% 18.6% 22.3%
* * * * * * * * * * * * * * * * * * * *
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 fact, almost all of the recent income gains in the U.S. have been cornered by the richest one percent of U.S. households. 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.
Immigrants provide another possible culprit because they tend to be concentrated in the very top and bottom of the distribution. Some enter with very little education and poor English skills. They subsist with meager wages earned by cleaning motel rooms, harvesting seasonal crops, and trimming hedges. Others, however, come from among the best and brightest of their countries. They teach astrophysics at MIT, head medical research teams at Johns Hopkins, and play first base for the Los Angeles Angels; and they rake in enormous salaries. One recent study suggests they account for about five percent of the increased inequality.5
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.6
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.7 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 Lady Gaga'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.8
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.
Should we care?
Is it unfair? Should we worry about increasing inequality? To some degree, concerns about fairness involve value judgments that we are free to reject. For example, many would argue that those who work harder should "fairly" earn more than those who choose to loaf; that equality of opportunity is more important than equality of outcomes. While many economists would agree with this notion, opportunities themselves are quite skewed in America. Where one starts in life is critically important to where one ends up. In fact, it is more difficult for someone who starts in a low-income family in the U.S. to escape poverty than it is in many other countries. We like to think that America is the land of opportunity, but the data suggest otherwise.
Inequality from any cause can breed a variety of problems. Several scholarly studies link inequality to social instablity and conflict9 while others find that it inhibits the development of human capital (especially for those at the bottom of the income distribution) and, therefore, leads to slower economic growth.10 For example, Golden and Katz maintain that much of the U.S. success during the 20th century resulted from our early provision of free public education to all children.11 Inequality also seems to increase the number births to unwed teenage girls. Apparently those stuck at the bottom rungs of the distribution see little chance of economic advancement and, as a result, see no reason to stay in school and develop their human capital. For such girls, early childbearing becomes the path of choice.12
Finally, inequality can create health problems as well. Some biologists contend that inequality can lead to chronic stress that, in turn, can lead to hormonal imbalances damaging to both the brain and the immune system. Inequality also has been linked a drop in the secretion of hormones associated with interpersonal trust and bonding . If these views prove to be correct, we could be heading for a meaner and sicker society.13
If we choose to do 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.14 What does it take to be rich? In 2011, median U.S. household income was approximately $50,000. Households with incomes below $20,000 fell into poorest 20 percent or quintile. Those with incomes above $101,500 broke into the richest quintile. Households with incomes in excess of $186,000 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.
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 those who live like Donald Trump should be squeezed, hopes for significant change are dead in the water.
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/data/historical/inequality/index.html, Table H-2 (all races).
3. See Murphy, Kevin J. and Ján Zábojník, "CEO pay and appointments: A market-based explanation for recent trends," American Economic Review Papers & Proceedings, May 2004.
4. See "The Polarization of the U.S. Labor Market," by David Autor, Lawrence Katz and Melissa Kearney, American Economic Review, volume 96, number 2, May 2006, pp. 189-194.
5. Card, David, "Immigration and Inequality", American Economic Review, volume 99, number 2, May 2009, pp. 1-21.
7. Frank, Robert H. and Philip J. Cook, The Winner-Take-All Society, The Free Press, 1995.
8. Vonnegut, Kurt, Bluebeard, Delacorte Press, New York, 1987, page 75.
9. For example, see Estaban, Joan and Debraj Ray, "Linking Conflict to Inequality and Polarization", American Economic Review, volume 101, number 4, June 2011, pp. 1345-1374.
10. See Perotti, R., "Growth, Income Distribution, and Democracy: What the Data Say", Journal of Economic Growth, volume 1, 1996, pp.149–187; Galor, Oded and O. Moav, "From Physical to Human Capital Accumulation: Inequality and the Process of Development", Review of Economic Studies, volume 71 (2004), pp. 1001–1026; Herzer, Dierk and Sebastian Vollmer, "Inequality and Growth: Evidence from Panel Cointegration", Journal of Income Inequality, February 2011, (published online at http://dx.doi.org/10.1007/s10888-011-9171-6)
11. Golden, Claudia and Larry Katz, The Race Between Education and Technology, Harvard University Press, Cambridge, 2008.
12. Kearney, Melissa S. and Phillip B. Levine, Why is the Teen Birth Rate in the United States So High and Why Does It Matter?", Journal of Economic Perspectives, volume 26, number 2, Spring 2012, pp. 141-166.
13. "Unbottled Gini", The Economist, 1/22/2011, pp. 71-72.
14. See http://www.census.gov/hhes/www/income/data/historical/inequality/index.html, Table H-1(all races).
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. Critique the claim that "foreigners" have caused the increase in inequality.
4. Explain how skill-based technological change might cause increased income inequality.
5. Explain the concept of a winner-take-all market and why relative rather than absolute ability matters in them.
6. Explain how changing technology can create more winner-take-all markets and how this might affect the distribution of income.
7. Describe and explain some of the problems caused by increased income inequality.
Return to Contents