introduction to income distribution

8/4/2019 Introduction to Income Distribution

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Introduction to Income Distribution

In a market economy, individuals' choices and consumption patterns are limited by howmuch money they have. No one (or very few) people are able to buy everything theywould like to have, and so they have to make choices in tradeoff situations in order to

best use what money they have. Obviously, the very poor have very limited choices,while the very rich have a wide range of choices. This discrepancy attracts the interest ofsocial activists, the government, the general public, and economists alike. Economistsstudy this inequality of means using measures of income distribution.

Economists look at several different statistics when studying income distribution,including the amount of income earned by segments of the population, the differencebetween actual and equal income distributions, and income mobility.

In this unit, we will look at the various ways of measuring and studying incomedistribution using Lorenz curves and Gini coefficients, and we will briefly look at

different ways that the government tries to address issues in income distribution.

Terms

Buyer - Someone who purchases goods and services from a seller for money.Competition - In a market economy, competition occurs between large numbers ofbuyers and sellers who vie for the opportunity to buy or sell goods and services. Thecompetition among buyers means that prices will never fall very low, and the competitionamong sellers means that prices will never rise very high. This is only true if there are somany buyers and sellers that none of them has a significant impact on the marketequilibrium.

Equilibrium Price - The price of a good or service at which quantity supplied is equalto quantity demanded. Also called the market-clearing price.Gini Coefficient - Numerical measurement between 0 and 1 of income equality;calculated by dividing the area between the Lorenz curve and the equal distribution curveby the area beneath the equal distribution curve.Goods and Services - Products or work that are bought and sold. In a market economy,competition among buyers and sellers sets the market equilibrium, determining the priceand the quantity sold.Income Distribution - Refers to how evenly the total amount of income in an economyis divided between members of the workforce.Income Mobility - Refers to the ease with which members of the workforce can move

between levels of economic prosperity.In-kind Transfer - Indirect means of redistributing income; gives low income workersgoods or vouchers for goods instead of giving them direct cash payments.Lorenz Curve - Curve that plots out the cumulative percentage of income earned bysegments of the workforce, as compared to a straight-line curve that represents perfectlyequal income distribution. Used to calculate the Gini coefficient.Market-Clearing Price - The price of a good or service at which quantity supplied isequal to quantity demanded. Also called the equilibrium price.


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Market Economy - An economy in which the prices and distribution of goods andservices are determined by the interaction of large numbers of buyers and sellers whohave no significant individual impact on prices or quantities.Market Equilibrium - Point at which quantity supplied and quantity demanded areequal, and prices are market-clearing prices, leaving no surplus or shortage.

Seller - Someone who sells goods and services to a buyer for money.Shortage - Situation in which the quantity demanded exceeds the quantity supplied fora good or service; price is below equilibrium price.Surplus - Situation in which the quantity supplied exceeds the quantity demanded for agood or service; price is above equilibrium price.

Income Distribution

Defining and Measuring Income Distribution

Income distribution is the smoothness or equality with which income is dealt out amongmembers of a society. If everyone earns exactly the same amount of money, then theincome distribution is perfectly equal. If no one earns any money except for one person,who earns all of the money, then the income distribution is perfectly unequal. Usually,however, a society's income distribution falls somewhere in the middle between equaland unequal.

How do we measure this degree of equality or inequality? Economists often measureincome equality by measuring how much income is earned by different segments of thepopulation. For instance, if we break down all workers into five segments in terms ofhow much money they make: the top 20%, the second 20%, the third 20%, the fourth

20%, and the bottom 20%, and we obtain data on how much money they make, we canthen create a chart detailing how much income each segment earns out of the totalamount of income for all workers. The bigger the difference between the differentsegments, the greater the income inequality.

Let's say that the average incomes for five segments in a society are $10,000, $24,000,$50,000, $80,000, and $110,000. In order to look at income distribution, we need to seewhat percentage of total income each segment makes, rather than the actual amount ofmoney each makes. Since each of the segments is equal in size, we don't need to worryabout weighting the average incomes, and can do a straightforward part-over-wholecalculation of each segment's earnings.

For total income we will use the sum of the five average incomes:

Total Income = 10000 + 24000 + 50000 + 80000 + 110000 Total Income = 274000Next we find the percentage of total income that each segment of the population earns, bydividing their income by the total income:Bottom segment percentage = 10000/274000 = 0.036 = 3.6%Second segment percentage = 24000/274000 = 0.088 = 8.8%


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Third segment percentage = 50000/274000 = 0.182 = 18.2%Fourth segment percentage = 80000/274000 = 0.292 = 29.2%Top segment percentage = 110000/274000 = 0.401 = 40.1%

What these figures indicate is that the bottom fifth of the population gets less than 4% of

the total income, while the top fifth of the population gets over 40% of the total income,indicating a large degree of income inequality.

Economists also look at cumulative figures for income distribution. To do this, simplyadd the percentages together at each level, giving the amount of income earned by allpeople at or below a certain level. In our example, it would work as follows:

Bottom segment cumulative percentage = 3.6%Second segment cumulative percentage = 3.6% + 8.8% = 12.4%Third segment cumulative percentage = 12.4% + 18.2% = 30.6%Fourth segment cumulative percentage = 30.6% + 29.2% = 59.8%

Top segment cumulative percentage = 59.8% + 40.1% = 99.9%

Note that the total cumulative percentage, which should be equal to 100%, since itrepresents the total income earned by all workers, is only 99.9%. This sometimes happensdue to rounding of numbers.

These two figures, percentage and cumulative percentage, are usually placed in a tablefor easier reading:

Figure %: Income Distribution Table

Lorenz Curves and Gini Coefficients

While the data of percentage and cumulative percentage can provide a rough idea of howequal or unequal income distribution is, sometimes it is easier to see how they line up ona graph, so that we can get a visual sense of income equality. To do this, plot out how


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much each of the population segments earns (cumulatively), and compare the resultingcurve to a perfectly equal income distribution, which would be a straight-line graph:

Figure %: Lorenz curveThis type of graph, showing income distribution among population segments, is called aLorenz curve. Using the Lorenz curve, we can also generate a numerical representation ofincome equality called the Gini coefficient. The Gini coefficient, which ranges between 0and 1, is equal to the area between the actual and equal distribution curves divided by thetotal area under the equal distribution curve. In the figure above, the Gini coefficient isequal to the area of A divided by the area of (A + B). The greater the Gini coefficient, thegreater the degree of income inequality. A perfectly equal income distribution will have aGini coefficient of 0, while a perfectly unequal distribution will have a Gini coefficient of1.

Income Mobility

Another factor to consider when studying the degree of inequality in a society is theamount of income mobility. Income mobility refers to the ease with which workers canmove up and down in the hierarchy of earning power. If the rich always stay rich and thepoor always stay poor, then an unequal income distribution is a permanent and seriousproblem. If workers easily shift from middle class to upper class or from lower class tomiddle class, however, then the degree of inequality becomes less serious, since theinequality is fluid and temporary (on an individual basis).

What can be done to improve income inequality?

When the income distribution gets very skewed, with a small number of people getting alarge portion of the income, many politicians and social activists start looking for ways tojustly redistribute some of the income so that the poor aren't as poor and the rich aren't asrich. Some of the options that they consider include taxes, in-kind transfers, housingsubsidies, welfare, and unemployment benefits. While we won't go into these in detail,we will take a brief look at them and how they are used to redistribute income in askewed economy.


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Taxes

Taxes can be used to redistribute income to the poor. For example, the U.S. uses aprogressive income tax that takes a larger percentage from higher incomes and a smallerpercentage from lower incomes, meaning that the poor keep a larger percentage of their

income than the rich do (though the amount that the poor take home is still lower thanthat of the rich). The government uses the tax money to fund many different programs,including some that target poverty and inequality.

In-kind Transfers and Housing Subsidies

In-kind transfers give essential goods (or coupons for these essential goods) to the poor.These are a relatively paternalistic policy option, since the government limits what goodsthe poor can obtain with their governmental aid, under the assumption that the poor maynot make the "best" choice if given cash instead of good-specific benefits. Food stampsare an example of in-kind transfers.

Housing subsidies give the poor money toward obtaining adequate housing, since rentand upkeep make up a large portion of spending in lower income families. This, too, is apaternalistic option that limits the use of the benefits provided to one specific goal.

Welfare and Unemployment Benefits

Welfare provides actual money to those with very low incomes. This is the option thatgives the recipients the most leeway when deciding how to use their benefits, which isfine if we are assuming that all people are rational and make decisions in their bestinterests, or not so fine if we are assuming that people are not rational and need guidance

when making their consumption decisions in the face of extreme economic hardship.

Unemployment benefits give a monetary cushion to those workers who are unable to findjobs, and, like welfare, are also in the form of money. Some argue that unemploymentbenefits provide a deterrent to finding "real work," since it is easier to stay unemployedand receive benefits. It is difficult to find a solution to this dilemma: it seems unjust todeny unemployed workers their benefits, since without the benefits the unemployedwould have no means for survival, but it is equally difficult to find jobs for every singleunemployed worker who is receiving benefits.

introduction to income distribution

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