📈Business Microeconomics Unit 12 Review

Income inequality describes how unevenly income is spread across a population. Economists care about it because the distribution of income affects everything from aggregate demand to social mobility to long-term growth. Measuring inequality precisely matters because it shapes which policies get adopted and how their effectiveness is evaluated.

Defining and Measuring Income Inequality

The Gini coefficient is the most widely used single-number measure. It ranges from 0 (everyone earns the same) to 1 (one person earns everything). The U.S. Gini coefficient is roughly 0.39, while Scandinavian countries tend to fall around 0.25–0.28. Higher numbers mean more inequality.

The Lorenz curve is the visual behind the Gini coefficient. It plots the cumulative share of income (y-axis) against the cumulative share of the population ranked from poorest to richest (x-axis). A perfectly equal society would produce a straight 45-degree line. The further the actual curve bows away from that line, the greater the inequality. The Gini coefficient equals the area between the 45-degree line and the Lorenz curve, divided by the total area under the 45-degree line.

Other useful measures include:

Income quintiles and deciles divide the population into five or ten equal groups by income, making it easy to compare how much the top 20% earns versus the bottom 20%.
Palma ratio compares the income share of the top 10% to the bottom 40%. It highlights the extremes of the distribution, which is where most of the action in inequality happens.
20:20 ratio compares the richest 20% to the poorest 20%, offering a straightforward snapshot of the income gap.

Poverty Measures and Additional Inequality Metrics

Poverty and inequality are related but distinct. You can have high inequality without widespread poverty, or widespread poverty without extreme inequality.

Absolute poverty uses a fixed threshold. The World Bank's international poverty line is $\$2.15$ /day (updated from $\$1.90$ in 2022). Anyone below that line counts as living in extreme poverty, regardless of what others earn.
Relative poverty is defined in relation to the rest of the population, typically as earning below 50% or 60% of the median income. This measure shifts as overall incomes change.

More specialized metrics include the Theil index (useful because it can be decomposed into inequality within and between subgroups), the Atkinson index (which builds in a social welfare judgment about how much society dislikes inequality), and percentile ratios like P90/P10 (comparing the income at the 90th percentile to the 10th) or P90/P50 (comparing the top to the middle).

Factors Contributing to Income Inequality

Economic and Technological Factors

Skill-biased technological change is one of the biggest drivers of rising inequality in developed economies. As technology advances, demand for high-skill workers (software engineers, data analysts) rises while demand for routine, low-skill jobs falls. Automation replaces assembly-line workers and clerical staff, widening the wage gap between those with and without advanced skills. The digital divide compounds this: workers without access to technology or training fall further behind.

Globalization reinforces these trends. Offshoring moves manufacturing jobs to lower-wage countries, putting downward pressure on wages for domestic workers in those industries. Increased import competition can shrink entire sectors. At the same time, globalization benefits high-skill workers and capital owners who can access larger markets.

Labor market institutions shape how the gains from growth get divided:

Minimum wage laws set a floor on earnings for low-wage workers. When the minimum wage doesn't keep pace with inflation, low-income workers lose purchasing power.
Unionization rates affect bargaining power. As union membership has declined in many countries, wage growth for middle- and lower-income workers has slowed relative to top earners.
Employment protection laws influence job security and how easily firms can adjust wages downward.

Defining and Measuring Income Inequality, Gini coefficient - Wikipedia

Education is the single strongest predictor of individual earnings. The college wage premium (the extra earnings from holding a bachelor's degree compared to a high school diploma) has grown substantially over the past few decades. But unequal access to quality schools means that children from low-income families often start at a disadvantage that compounds over time.

Inherited wealth and intergenerational transfers keep inequality persistent. Family background influences not just direct inheritance but also access to better schools, professional networks, and startup capital. Inheritance tax policies vary widely across countries and directly affect how concentrated wealth becomes across generations.

Fiscal policy is both a cause and a remedy. Progressive tax systems and social welfare programs can narrow income gaps, while regressive taxes (like sales taxes that take a larger share of low incomes) can widen them.

Demographic factors also matter. Age affects earnings (workers typically earn more in mid-career), household composition affects per-person income, and urbanization creates income gaps between rural and urban areas.

Consequences of Income Inequality

Economic Impacts

High inequality can drag on economic growth through several channels:

Reduced aggregate demand. Lower-income households spend a higher fraction of their income. When income concentrates at the top, overall consumption tends to fall because wealthy households save more of each additional dollar.
Suboptimal resource allocation. Concentrated wealth can lead to over-investment in financial assets and under-investment in productive capacity or public goods.
Lower social mobility. When income gaps are large, it becomes harder for people born into low-income families to move up. Limited access to quality education and professional networks creates persistent poverty cycles across generations.

Income distribution also shapes market demand patterns. Highly unequal societies tend to see booming luxury goods markets alongside weak demand for everyday consumer products.

The effects of inequality extend well beyond economics:

Health outcomes correlate strongly with income. Lower-income groups face shorter life expectancy, higher rates of chronic disease, and more limited access to healthcare. In the U.S., the gap in life expectancy between the richest and poorest 1% of men is roughly 15 years.
Social cohesion erodes as inequality grows. Research links high inequality to increased social tensions, political polarization, and declining trust in institutions.
Educational outcomes suffer when low-income students lack resources. This creates a feedback loop: inequality reduces educational attainment, which in turn perpetuates inequality.
Crime rates tend to be higher in areas with significant income disparities, particularly property crime. This generates additional social costs through law enforcement and the criminal justice system.

Effectiveness of Redistribution Policies

Tax and Transfer Policies

Progressive taxation is the most direct tool for redistribution. Higher marginal tax rates on high-income earners generate revenue that funds public services and transfers. Tax credits targeted at low-income workers, like the Earned Income Tax Credit (EITC) in the U.S., effectively boost after-tax income for those at the bottom of the distribution. The EITC is widely considered one of the most effective anti-poverty programs because it rewards work rather than discouraging it.

Social transfer programs provide a safety net:

Unemployment benefits maintain income during job loss, preventing temporary setbacks from becoming permanent poverty.
Welfare programs like Temporary Assistance for Needy Families (TANF) assist families in poverty, though they often come with work requirements and time limits.

Conditional cash transfers tie payments to specific behaviors. Mexico's Prospera program (now restructured) provided cash to families who kept children in school and attended health checkups. These programs address inequality while also building human capital for the next generation.

Public education and healthcare are long-run equalizers. Free or subsidized education reduces disparities in human capital, and universal healthcare systems ensure that illness doesn't become a financial catastrophe based on income.
Minimum wage laws directly raise earnings at the bottom. The trade-off is that if set too high, they can reduce employment for the workers they're meant to help. Most empirical evidence suggests moderate minimum wage increases have small employment effects.
Asset-building policies target wealth inequality specifically. Programs like FHA loans help low-income families build equity through homeownership. Individual development accounts encourage savings by matching contributions from low-income participants.
Universal basic income (UBI) proposals would provide unconditional cash to all citizens. Proponents argue UBI could reduce poverty and provide economic security; critics worry about cost and potential work disincentives. Pilot programs in Finland and Stockton, California have provided early evidence, though results are still debated.

Efficiency vs. Equity in Redistribution

Economic Trade-offs

The equity-efficiency trade-off is central to any redistribution debate. The core tension: policies that make the income distribution more equal can sometimes reduce the total size of the economic pie.

Tax disincentives. Higher marginal tax rates on top earners may discourage additional work effort, risk-taking, or investment. The magnitude of this effect is debated, but it's a real consideration in tax design.
Welfare traps. If social benefits phase out sharply as income rises, recipients face very high effective marginal tax rates. Earning an extra dollar of wages might cost them nearly a dollar in lost benefits, discouraging work. This is sometimes called the "poverty trap."
Deadweight losses. Taxes, subsidies, and price controls all distort market signals to some degree. These distortions reduce allocative efficiency, meaning resources don't flow to their highest-value uses.

Policy Considerations and Long-term Effects

The trade-off isn't always negative. Some redistribution can actually improve efficiency over time:

Human capital investment. When redistribution funds education and healthcare for low-income populations, it builds productive capacity that wouldn't otherwise exist. A talented student who can't afford college represents wasted potential for the whole economy.
Social stability. Extreme inequality breeds instability, which deters investment. Moderate redistribution that maintains social cohesion can create a better environment for long-term growth.
Administrative costs are real, though. Running complex tax systems and social programs requires bureaucracy. Compliance costs for businesses and individuals add up. Simpler programs (like the EITC or a potential UBI) tend to have lower administrative overhead than means-tested programs with extensive eligibility requirements.

The practical question isn't whether to redistribute at all, but how much and through which mechanisms. The goal is finding policies that reduce inequality without creating large enough efficiency losses to shrink the overall economy. Getting that balance right is one of the central challenges in public economics.

📈Business Microeconomics Unit 12 Review