Inequality: The Uneven Distribution of Income and Wealth
What Are Income and Wealth?
It is important to understand the difference between income and wealth. They are related but measure different aspects of financial health.
| Concept | What It Is | Example (Sam's Family) | Example (Avery's Family) |
|---|---|---|---|
| Income | Money received over a period (month/year) from work, business, or investments. | Sam's parents earn a combined salary of $60,000 per year. | Avery's parents earn a combined salary of $200,000 per year and receive $50,000 in stock dividends. |
| Wealth | Total value of assets (house, savings, stocks) minus debts (mortgage, loans). | They own a house valued at $250,000 but have a $180,000 mortgage. Their wealth is $70,000. | They own a house worth $1.5 million (no mortgage), have $500,000 in stocks, and inherited a vacation home. Their wealth is over $2 million. |
As you can see, Avery's family has both a higher income and significantly more wealth. This gap is what we study as inequality. Wealth inequality is usually much larger than income inequality because it accumulates over generations.
Measuring the Gap: The Gini Coefficient
How do economists measure inequality? One common tool is the Gini coefficient. Imagine you have a pizza to share among 10 friends.
In a perfectly equal society, each of the 10 friends gets an equal slice: 10% of the pizza each. The Gini coefficient for this is 0.
In a perfectly unequal society, one friend gets the entire pizza (100%), and the other nine get nothing. The Gini coefficient for this is 1 (or 100% if expressed as a percentage).
Real societies are somewhere in between. If, in reality, two friends get half the pizza (25% each) and the other eight share the other half (6.25% each), the Gini coefficient would be around 0.4.
Mathematically, the Gini coefficient is calculated based on the Lorenz curve, which plots the actual cumulative share of income earned by the population. The formula is:
$Gini = \frac{A}{A + B}$
Where A is the area between the line of perfect equality and the Lorenz curve, and B is the area under the Lorenz curve. A higher number means more inequality. Countries like South Africa and Brazil often have Gini coefficients above 0.5, while many European countries have coefficients between 0.25 and 0.35.
Root Causes of Economic Inequality
Inequality doesn't just happen. It is the result of many factors working together over time.
1. Education and Skills Gap
Jobs that require higher education and specialized skills (like software engineering or medicine) generally pay more. Access to quality education is not equal. A child born in a wealthy family is more likely to attend better schools and universities, creating a cycle where high income and wealth lead to more opportunities for the next generation.
2. Technology and Globalization
Technology automates routine jobs (like manufacturing), reducing demand for those workers. Meanwhile, it increases demand for tech-savvy workers, widening the wage gap. Globalization means companies can hire workers in countries with lower wages, which can pressure wages for similar jobs in wealthier countries.
3. Wealth Begets Wealth: The Power of Compound Interest
This is a crucial concept. If you have wealth, you can invest it and earn returns. Those returns then earn more returns. This is called compound interest[3]. The formula is:
$A = P (1 + r)^t$
Where A is the future value, P is the principal (starting amount), r is the interest rate, and t is time. Someone who inherits $100,000 and invests it has a huge head start over someone who starts from zero.
4. Inheritance and Luck
A significant portion of wealth at the very top comes from inheritance—passing down assets from one generation to the next. This can create a "wealth aristocracy" that wasn't built on personal work or talent. Being born into a certain family, country, or even having a "lucky break" also plays a role.
A Tale of Two Lemonade Stands: A Practical Example
Let's follow two students, Mia and Leo, who both start a lemonade stand one summer.
Mia's Stand: Mia uses her allowance savings of $20 to buy a pitcher, lemons, and sugar. She sets up on her quiet street. She works hard and makes a $5 profit each week. After 10 weeks, she has $50 in profit.
Leo's Stand: Leo's parents give him a high-quality lemonade machine worth $200 and let him set up in their busy downtown bakery. He also gets an advance of $50 for supplies. Because of his prime location and better equipment, Leo makes a $30 profit each week. After 10 weeks, he has $300 in profit.
Initial Wealth (Capital): Leo started with much more "wealth" (the machine and advance), just like some people inherit money or assets.
Income: Leo's weekly profit (income) is six times Mia's because his wealth allowed him a better setup.
Wealth Accumulation: After 10 weeks, Leo's total wealth (profit + machine) is far greater. He can now easily open a second stand, while Mia is still saving. This mirrors how initial advantages lead to faster wealth growth in the real world.
This simple story illustrates how unequal starting points, due to family resources, lead to unequal outcomes, even with equal hard work.
Consequences of High Inequality
What happens when income and wealth gaps become very wide?
- Reduced Social Mobility: It becomes harder for someone born poor to become rich. The "rags to riches" story becomes less common.
- Unequal Access to Opportunities: Wealthier families can afford better healthcare, nutrition, and extracurricular activities (like music lessons or sports), giving their children a lifelong advantage.
- Political and Social Tension: Large inequalities can lead to feelings of unfairness and social unrest. People may lose trust in the system.
- Health and Well-being: Studies show that more unequal societies often have higher levels of stress, lower life expectancy, and more crime.
Important Questions
A: Yes, most economists agree that some inequality is necessary. It provides incentives for people to study, innovate, work hard, and take risks. If a doctor earned the same as someone who chose not to work, fewer people would spend years in medical school. The debate is about the level of inequality. Extreme inequality is generally seen as harmful.
Q: What can governments do to reduce inequality?
A: Governments have several tools, often debated in politics. These include:
- Progressive Taxation: Tax rates that increase as income increases. The wealthy pay a higher percentage of their income.
- Wealth and Inheritance Taxes: Taxes on the total value of assets or on large amounts of money passed to heirs.
- Public Spending on Education and Healthcare: Investing in high-quality, free public services gives everyone a more equal starting point.
- Minimum Wage Laws: Setting a floor for hourly wages to increase the income of the lowest-paid workers.
Footnote
[1] Economic Inequality: The unequal distribution of income and wealth among individuals or groups within a society.
[2] Gini Coefficient: A statistical measure of economic inequality ranging from 0 (perfect equality) to 1 (perfect inequality). It is derived from the Lorenz curve.
[3] Compound Interest: The process where the interest earned on an investment is reinvested, so that interest is earned on both the original principal and the accumulated interest from previous periods.