Saturday, January 25, 2014

The Topic for Spring 2014: Income Inequality, Income Mobility and the Minimum Wage

N.B. This is the item I mentioned in Friday’s class that I’d written but forgotten to post.


Part of ECON 3020 “Macroeconomics for Business Decisions” is keeping abreast of current events. Each semester it’s something new.

For Spring 2014, the big current event is somewhat contrived. Politicians and the media around the world are pushing two related topics:

  • Income inequality (is the distribution of the flow of income across people at a point in time “fair”
  • Income mobility (are the chances of a poor person moving to a better part of the income distribution “fair”)

In the U.S., this is tied up with a third issue:

  • Should the minimum wage be raised (since it isn’t raised often, it is usually raised in huge steps … and frankly, it’s not unreasonable to think we’re due)

And there’s a fourth issue that gets confounded with the others:

  • Wealth inequality (is the distribution of the stock of wealth across people “fair”)

The confounding of the last issue is a big deal: it’s a common dodge to argue that differences in wealth are a reason to adjust incomes. This isn’t necessarily a dumb thing to do, but like any comparison relating stocks and flows, we’d better be careful.

Note that I’ve also put fair in quotes above. This is because fairness is not something that economists use as a criterion. Fairness is a subjective criterion: you either feel something is fair, or you don’t. This doesn’t make it unimportant, but it does make it hard to pin down. It also makes it very hard to compare across people. Think about it: every argument about fairness in your life has existed because one side thought something was unfair and the other side didn’t. Solutions to these arguments frequently involve making the aggrieved party happier at the expense of the party satisfied with the current situation. This is a problem.

Economists talk much more about efficiency. An allocation of stuff is efficient if we can’t improve upon it, in an objective sense. For example, perfect competition is efficient in the sense that the sum of consumer and producer surplus is maximized. We can set the price at something other than the equilibrium value (as in ceilings or floors), or the quantity at something other than the equilibrium value (as in monopoly). But if we do so, we know that while one of the surpluses might be larger, the sum of the them must be smaller.

Economists also talk about things by adding the word Pareto as a modifier to some adjective: as in Pareto optimal, Pareto efficient, Pareto improving, and so on. (Pareto is always capitalized, because the idea was conceived by the Italian economist Pareto). Pareto argued that because we can’t make interpersonal comparisons of things whose value to us is subjective (and that’s pretty much everything), that fairness could only be conceived of in one way: situation A is a Pareto improvement over situation B because A makes at least one person better off, and makes no one worse off. For example, if you have french fries and can’t finish them, offering them to others at the table is Pareto improving. This is not the same as offering french fries that you do want to your friends out of friendship: that’s called a reciprocal gift exchange because there’s an expectation that you’ll be treated the same way some other time. And it’s definitely not the same as sneaking/taking/”borrowing” a french fry off of someone else’s plate.

FWIW: you should be very suspicious when you see someone make an argument in public based on “fairness” rather than Pareto improvement. For my part, the mere fact that the Pareto concept is not used often in discussions of inequality is a sign there’s something wrong with the argument being put forward.

Having said that, do note that the Pareto condition is very strong, and unlikely to be easily satisfied. So you might view it as a gold standard, rather than something that should be achievable in all situations.

In turn, Pareto efficiency is related to the two fundamental theorems of welfare economics, summarized here:

  • First Fundamental Theorem of Welfare Economics: perfectly competitive equilibrium are Pareto efficient
  • Second Fundamental Theorem of Welfare Economics: any allocation that is (desirable because it is known to be) Pareto efficient can be achieved by a perfectly competitive market.

Of course, the problem here is competitive market. The conditions for a market to be perfectly competitive are very strict, so essentially no market meets them in practice. But, we also know in reality that most markets are well characterized by the outcome of a competition (in short, if you can understand it with supply and demand, it’s competitive). Nobel Prize winner Joseph Stiglitz has criticized the importance of these theorems, arguing that most markets have imperfect information, and thus aren’t perfectly competitive. Others argue that we just need to be close enough. This is an open case, so there’s no right answer.

Anyway … the Obama administration has always been interested in pushing towards income equality, improved income mobility and wealth equality … as well as a boost in the minimum wage. They’ve been pushing these heavily since last Fall, and they will be a centerpiece of his State of the Union address this week.

And … world financial and social leaders are meeting in Davos at something called the World Economic Forum this weekend. (No one calls it the World Economic Forum; if someone says Davos, you’re supposed to know what that means). A major topic for discussion this year is global income inequality, global income mobility, and global wealth inequality.

The last two may be happening because progressives recognize that this may be their moment, and that it may be slipping away. Political winds shift rapidly, and most political gains are made fairly quickly, and then defended. Consider conservatism in the U.S. It was close to non-existent in the early 1970’s, it rose rapidly, but peaked early in Reagan’s second term. The twenty years that followed that were largely defending the turf that had been won, rather than advancing it further. Progressives aren’t talking this way yet, but if they’re smart they’d recognize that they may be peaking right now, and will be fighting a rear guard action to defend their ideas over the next generation.

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