Income Distribution

A focal point of common interest among social scientists, policy makers, and economists is whether the middle class is disappearing given the evidence of a widening gap between the rich and the poor on socioeconomic status. Income distribution is a topic in economics that warrants further attention. One of the formidable challenges in this field is to achieve an equitable, or more equal, distribution of income, in the absence of parameters that define exactly what degree of inequality is acceptable. Furthermore, consensus may be difficult to attain until there is an agreement on which underlying factors determine a worker's wages. A philosophical divide runs deep as one group of economists subscribes to the view that a self-regulating labor market determines wages and an opposing group holds the view that labor unions and other organizations create market imperfections and therefore a need for governmental interventions. Putting those philosophical foundations aside, there are some important tools available to analysts as they seek to understand and describe in a quantifiable manner trends and international comparisons with respect to income distribution. The Lorenz curve expresses the relationship of a percentage of income to a percentage of households and the Gini coefficient accompanies the curve as a measure of the degree of income equality. Though those tools have some limitations, this essay provides some methods and statistics that readers can use to compare Europe and the United States and examine domestic trends. The primary purpose of this essay is to provide readers with basic information for initiating and pursuing their own inquiries and for achieving a better understanding of income distribution and redistributive policy complexities.

Keywords Demand; Demand Schedule; Distribution of Income; Equilibrium; Equilibrium Price; Equilibrium Quantity; Gini Coefficients; Gini Index; Income Inequality; Labor Market; Law of Demand; Law of Supply; Lorenz Curve; Marginal Revenue; Market; Market Failure; Output; Price; Price Controls; Producers; Quantity Demanded; Quantity Supplied; Resource Market; Revenue; Supply; Supply Schedule; Transfer Payment

Economics > Income Distribution

Overview

Undergraduate students in economics courses learn quite early about poverty levels and income dispersions. Most undergraduate textbooks and courses introduce the notion of an equitable distribution of income alongside a few other goals for a nation's economy. Absent is a consensus on what precisely defines an equitable income distribution for any given country; a common interpretation is that equity improves with a movement toward equality over time and/or when one country exhibits a distribution closer to equality relative to other countries. Eventually, that basic information paves the way for learning how government policies attempt to redistribute income and provide relief to the poor.

Let us begin by considering some facts about income distribution. In 2002, 50 percent of the total income in the United States went to the richest 20 percent of households and 3 percent went to the poorest 20 percent; keep in mind that households differ in size and those differences lead some analysts to focus instead on individuals. Furthermore, income inequality in the United States has grown since the 1960s. In 1967, 44 percent of income went to the richest fifth of households and 4 percent went to the poorest fifth. A comparison of those two years reflected a growing inequality and suggested that the middle class might be falling to the wayside as the richest got richer and the poorest poorer. A further comparison of the years 1979 and 2007 shows that the top 1% of earners experience income growth of 275%, whereas the bottom 20% of earners saw household income growth of only 18% (Serwer, 2013). Frequently, income distribution of a given country becomes a major topic in discussions about the socioeconomic welfare of its citizens.

Income distribution essentially provides a reference point for comparing welfare and poverty across nations and over time. Casting issues of justice and fairness aside for the moment, one of the reasons many scholars and students find this topic appealing and/or fascinating is the challenges associated with securing a more equitable, or ideal, distribution of income while stopping far short of arguing for equality in the distribution of income. Consistent with that line of reasoning, Horn (1993) prefers to interpret perfect equality as a benchmark knowing it is perhaps the best target available until scholars and policy makers establish a socially-acceptable normal level of income equality.

It is uncertain whether a normative measure will ever become a reality. Nonetheless, there exists a real need for readers to become familiar with two types of income distribution:

• Personal distribution;
• Functional distribution.

Personal distribution explains that individual abilities, characteristics, and preferences and possibly discriminatory hiring practices determine income. Functional distribution describes income as a payment to resource owners. Each resource receives income in the form of a payment for its use in production as follows: Labor receives wages, capital receives interest, land receives rent, and the business owner or entrepreneur who assembles those resources receives profit. This essay's primary interest resides with the personal distribution, but a basic model depicting the flows of money and quantities and referencing these functionalities appears later.

Additional complexities make their way into the analysis as one enters the issue of whether an equal distribution of income removes incentives for entrepreneurs. Those individuals assemble the resources necessary in producing goods and services. In the absence of those incentives and presumably fewer producers, consumers may find themselves facing fewer choices, smaller quantities, and higher prices in the marketplace. Some downstream consequences of those outcomes include fewer workers, higher unemployment rates, and lower incomes. As the reader might guess, the topic can become quite complex especially when philosophies on income determination and redistribution are brought into the mix.

A natural extension of this topic delivers readers onto a discussion of methods for redistributing income after they get a better sense of whether income distributions are equitable or inequitable. As its major focal point, this essay avoids many complexities by limiting its breadth and depth. Consequently, the reader will receive practical guidance on measuring and interpreting income distributions in addition to brief coverage of some economic perspectives. We will return later in this essay to a discussion of whether wages are the result of this concept, market structure, or a combination of both. In addition, this essay offers some key explanations for income inequality and it presents a common measure that helps analysts to assess the degree of inequality in the distribution of income. Discussions of those components follow the next section, which outlines some economic concepts that facilitate mastery of the income distribution topic.

Conceptual Foundations: Markets, Employments & Incomes

Economics as a field of study contains two divisions. Macroeconomics is the branch that focuses on the economy as a whole and microeconomics examines the interactions between firm actions and consumer behaviors as they pursue exchanges in a market. Physical quantities of resources, goods, services and monetary payments flow between consumers and households as they interact through their marketplace transactions.

There are two sectors (households and businesses) and two markets (goods and resources) that comprise the circular flow model. Readers are encouraged to consult their textbooks for a graphical presentation of the model. It depicts the business sector using resources such as labor, land, and capital to produce goods and services for the household sector. Each receives a physical quantity of something and issue money in payment. Respectively, businesses pay wages, rent, and interest as they acquire those resources. Households are the source of those quantities and they purchase goods and services issuing dollars from their personal incomes in exchange for an item.

Supply & Demand

Both markets contain a demand component and a supply component. In the goods market, a household demands quantities of items and pay the price for each item bought; businesses supply those quantities and receive revenues from each item sold. In the resource market, specifically the labor market, households supply quantities of labor and receive incomes in payment for those quantities; businesses demand quantities of labor and pay wages for them. More precisely, consumers are willing and able to purchase a specific amount at any given price according to a demand schedule that records various combinations of prices and quantities. Likewise, businesses are willing and able to provide a specific amount at any given price according to a supply schedule. Curves or lines in a graph, which are available elsewhere, display those schedules.

Whether one examines the resource market or the goods market, a direct relationship exists between price and quantity according to the Law of Supply; that is, large quantities will be supplied at high prices and small quantities at low prices. An inverse relationship exists between price and quantity according to the Law of Demand; in other words, large quantities will be in demand at low prices and small quantities at high prices. The intersection of the supply curve and the demand curve is the point of equilibrium for price and quantity, which establishes the market price.

Equilibrium Adjustments

Sometimes there are distortions or imperfections in the market that affect price. Occasionally, quantity demanded is higher or lower than quantity supplied resulting in prices temporarily above or below the market price. Usually, the price will adjust tending toward an equilibrium point. However, government may intervene by establishing a price control that is higher or lower than the market would dictate when left alone; the minimum wage, for example, is a price for labor that is set above the equilibrium price in the labor market. In this instance, actual wages paid to employees must be greater than the market wage.

Another distortion arises from the ability of an individual or a group to exert pressure on market prices for goods or resources. For example, the employer in a one-company town may hire workers at a low rate of pay. An opposite example is the case of a labor union that restricts the supply of labor through apprenticeship programs or a licensure process effectively increasing the price of labor. By altering the price for labor, these market imperfections often determine the amount of employment, output, and income. In brief, market structures can determine what payments employees receive from their employers.

Labor Income

Persons receive labor income from their gainful employments. However, personal income is the result from adding labor income, asset income, and transfer payments and subtracting taxes (Arnold, 2005). The last two items result from government actions, but the first two result primarily from individual actions and sometimes family history. Asset income accrues from savings accounts, inheritances, and other types of investments, which is really what economists refer to as wealth. Income is a flow variable and wealth is a stock variable. One can view it as the accumulation of savings, income, or assets over time whether it originates from an individual or another member of the household in which the individual resides.

Household Income

Household income is the sum of personal income from all those individuals who reside at the same address, with some slight modifications beyond the scope of this paper. The reader should keep in mind that household income will be larger than personal income for obvious reasons and that it adds some amount of distortion and complexity to income distribution analyses. The distribution of household incomes varies significantly in aggregate and more so when one examines along the dimensions (education level, race, gender, and age).

Variations in Income Distribution

Variations in income distribution according to age exist, in part, because some households are poor for long periods of time and some only temporarily. In terms of the latter, it is reasonable to expect young households to earn a low income as they enter the early career phase. Consequently, analysts need to recognize the effect of age on income distribution. As one might suspect, labor income at the individual level also varies along the aforementioned dimensions.

On the one hand, some economists subscribe to the view that worker's wages are a consequence of their abilities and productivities. On the other hand, some hold the view that market characteristics influence product availability and workers find themselves in jobs receiving a wage determined largely by market forces. A key difference between these two perspectives appears to center on the determinants of income and on whether a worker's wage is a consequence of individual characteristics or market factors. The next section summarizes those two perspectives.

Economic Perspectives on Income Determination

Payments to workers are determined in several ways. One view is that structures and organizations operating within the labor market can and do exert an influence on wage rate determination. Another view draws from the concepts of marginal benefit and marginal cost, which weighs heavily in economics especially among some labor market economists. Furthermore, they assert that labor markets like other markets are self-regulating in the absence of structural or other artificial distortions. The marginal revenue product of labor doctrine holds that the hourly wage rate a worker receives is equal to the additional revenue that worker generates during one hour of work in producing a good or service.

In terms of the whole production process, labor is often a resource that has supplements from land and capital resources. Resource prices, of which wages are one, reflect demand and supply factors. By extension, production activities create a demand for labor and workers comprise the supply of labor. In addition, the quality and content of that supply varies because individual workers differ in many ways. Each person is unique and his or her abilities determine their value as a human resource in the labor market.

Without making any distinction here with respect to worker classifications (managerial, clerical, etc.), wage rates simply reflect the worker's abilities and earnings are the mathematical product of effective wage rates multiplied by the hours employed. Wages and incomes are different because workers are different. Accordingly, income inequality is primarily a result of differences among workers in their abilities and in their education and training levels. In essence, individual ability is the primary factor whether individuals or households place low or high in the income strata.

Up to this point, this section emphasized a view that wages and incomes are determined largely in a labor market that operates freely and is self-regulating. In contrast, another view holds that governments and organizations intervene in the labor market. Those interventions attempt to craft wage rates that are usually higher than the market would determine if left alone. Minimum wage laws are one example and labor union contracts are another example of methods of wage determination that fall outside the marginal revenue product doctrine. In addition, wages are likely to be different according to geographic location; for example, rural areas may have a sole employer around which villages of workers reside. In summary, wages are determined both by market and by artificial forces. It is clear that wages effect incomes and income distributions are relatively easy to discern through some common applications for analysis.

Applications

The Lorenz curve is a graph of the income distribution, which expresses the relationship of a percentage of income to a percentage of households. The Gini coefficient is used in conjunction with the curve as a measure of the degree of income equality. The Gini coefficient was developed by the Italian statistician Corrado Gini and published in his 1912 paper titled "Variability and Mutability" after its translation in English. Another form of that measure is the Gini index, which is the Gini coefficient expressed as a percentage multiplied by 100. The next section covers these measures and the curve in greater detail.

Analyses of Income Distributions: Lorenz Curves & Gini Coefficients

The Lorenz Curve

Common presentations of the distribution of money income in graphical form contain a Lorenz curve, which illustrates the total cumulative percentage of income that goes to each cumulative percentage of households. Its frame is a square-shaped by design. The horizontal or bottom side of the square shows the cumulative percentage of population, which ranges from 0-100, as one follows that axis from left to right. Bearing the same range, following the vertical axis from bottom to top of the square, the left side shows the cumulative percentage of income.

The reader should note that the Lorenz curve receives significant amounts of criticism, in part, because it suggests that a proven relationship exists between income distribution and social welfare. Nonetheless, readers should keep in mind that it is a useful tool for depicting changes over time within a county, differences at a specific time between countries, or some combination of the two. In the case of an equal distribution of income, the curve would actually take the form of a straight line that slopes upward to the right as a diagonal within a square; for example 25 percent of a country's population earns 25 percent of country's total income, 50 percent earns 50 percent, and so forth. In reality, the distribution of income is unequal making the Lorenz curve concave; for example, 50 percent of the total population earns less than 50 percent of total income.

Gini Coefficients

The size of the area between the actual income distribution curve and the diagonal equality line is a component for calculating a useful metric. Basically, the Gini coefficient is defined as a ratio of the area between that straight line and the convex curve present within a Lorenz curve diagram. The Gini ratio is a measure of the dispersion of the income distribution. Estimating the ratio involves dividing the area between the Lorenz curve and the diagonal by the entire area below the diagonal. Its numeric value ranges between 0 for income equality and 1 for inequality; the latter would occur if one person earns all the income. Avoiding all those calculations, readers of this essay need to know that the formula takes into account an approximate number of earners in each income class and that the mathematical product is widely useful in income analysis.

Income Distribution Comparisons

Analyses of income distribution are possible whether one compares the world to a nation or a country to a country at a specific point in time or examines a trend within a specific country. Comparisons are also available in terms of a population's health status, education level, and age group. Recent research on income inequality in the US suggests a growing divide in the socioeconomic status between college graduates and others. Research publications also report that the disparities in health status by educational achievement grew from 1982 to 2004 — more among older adults than among younger adults. One conclusion is that the trend of growth in health status disparities among older adults reflects disparities in economic resources, health promotion behaviors, health service access, or other factors that vary widely even among or within highly developed countries.

Worldwide Gini Coefficients

While most European nations tend to exhibit Gini coefficients between 0.24 and 0.36, the United States' Gini coefficient is above 0.40, which provides further evidence that the US is experiencing greater inequality in its distribution of income than other developed countries. Though this metric can help quantify differences in welfare and compensation, readers should bear in mind that Gini coefficients may be inappropriate for comparing small and large countries on political dimensions. Nonetheless, the metric can help describe the distribution of income at the global level in addition to inter- and intra-continental levels.

It is estimated that the Gini coefficients for the entire world range between 0.56 and 0.66. Some recent research points to movement toward a more equitable distribution of global income noting that inequality declined during the period between 1980 and 2000. Among their explanations for that significant decline is above-average income growth in highly populated developing regions including China and South Asia, where 40 percent of the world's inhabitants reside. They conclude this trend toward greater equality in the distribution of income is likely to continue into the near future as poor counties enter progressive phases in the economic maturation process.

Redistribution of Income

After learning statistics about income distribution and methods for measuring it, this essay winds down by informing readers that income redistribution is equal in importance to income levels and distributions. Greater equality in the distribution of income can occur through government policies that aim to provide relief to the poor. Transfer payments, in their most generic form, consist of payments to individuals unrelated to their production or an exchange of goods and services, favorable tax treatments, food stamps, subsidized housing, medical assistance, and Social Security benefits. As examples of methods used by governments to redistribute income, the explicit purpose of these efforts is to transfer income from the richer groups to the poorer groups. When considering the recent trends in income distribution within the United States, the effectiveness of income redistribution policies remains open for further investigation guided by applications of the Lorenz curve and the Gini metrics.

Conclusion

A lot of work remains in terms of the goal to establish an equitable, or more equal, distribution of incomes. One can begin to imagine what lies ahead in light of recent trends in the US that provide evidence of a widening division between the rich and poor. The underlying causes of that divide are elusive at best, but the jury is out as to whether the middle class of income recipients, as opposed to the upper echelons, are bearing a disproportionate burden of caring for the lower income classes. In conclusion, this essay attempts to provide the reader with a foundation on which to launch those and related inquiries. Hopefully, the reader gained a better sense of the complexities of income distribution and redistribution along with the advantages and disadvantages of using Gini coefficients as a measure of income inequality.

Terms & Concepts

Demand: The amount of a good or service an individual consumer or a group of consumers wants at a given price.

Demand Schedule: The actual quantities that consumers are willing and able to purchase at various prices.

Equilibrium: The price and quantity associated with the intersection of the demand and supply curve reflecting alignments among consumers and producers on an item's price and quantity.

Equilibrium Price: The price at which demand and supply curves intersect reflecting an agreement among consumers and producers.

Equilibrium Quantity: The quantity at which demand and supply curves intersect reflecting an agreement among consumers and producers.

Gini Coefficient: The ratio that results from dividing the area between income equality and the Lorenz curve by the area underneath the diagonal line representing income equality.

Gini Index: The Gini coefficient multiplied by 100.

Income Inequality: An arbitrary degree to which an actual income distribution deviates from equality.

Labor Market: Consists of the demand for and supply of workers and equilibrium wage rate.

Law of Demand: Specifies the inverse or negative relationship that exists between an item's demand quantity and its price; quantity and price move in opposite directions.

Law of Supply: Specifies the direct or positive relationship that exists between an item's demand quantity and its price; quantity and price move in same direction.

Lorenz Curve: a line graph illustrating the actual distribution of income across a given population.

Marginal Revenue: The contribution to total revenue from the sale of one additional item.

Market: A virtual space where consumers and producers interact while exchanging a specific item in accordance with their demand and supply schedules.

Market Failure: The results stemming from imperfect or unavailable information for consumer and producer decisions; from an individual or group hold and bring a disproportionate amount of influence into a market transaction; and/or from an imposition of costs on or harm to third parties and those outside the exchange or transaction.

Output: The quantity of items or services produced by a firm or group of firms in a market.

Price: The amount of money that is required to obtain an item.

Price Controls: Prevent prices from rising above or falling below a specific dollar amount.

Producers: Firms that supply or provide goods or services desired by consumers.

Quantity Demanded: The amount of goods or services that consumers desire at given prices.

Quantity Supplied: The amount of goods or services that suppliers are willing and able to produce at given prices.

Resource Market: Consists of the demand for and the supply of labor, land, capital and their equilibrium respective payments in the form of wages, rent, and interest.

Revenue: The proceeds from the sale of an item; the mathematical product of quantity of item sold times the price of item.

Supply: The amount of a good or service an individual producer or a group of producers will provide at a given price.

Supply Schedule: The actual quantities that producers are willing and able to purchase at various prices.

Transfer Payment: A payment from a governmental entity for the benefit of low-income persons and households.

Bibliography

Armour, P., Burkhauser, R. V., & Larrimore, J. (2014). Levels and trends in U.S. income and its distribution: A crosswalk from market income towards a comprehensive Haig-Simons income approach. Southern Economic Journal, 81, 271–293. Retrieved November 17, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=99015537&site=bsi-live

Arnold, R.A. (2005). Economics (7th ed.) Mason, OH: Thomson South-Western.

Assous, M., & Dutt, A. (2013). Growth and income distribution with the dynamics of power in labour and goods markets. Cambridge Journal of Economics, 37, 1407–1430. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91828467&site=ehost-live

Colvin, G. (2013). America's 400 richest: Not a club but a collective (really!). Fortune, 167, 51. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86435845&site=ehost-live

Dagsvik, J., Jia, Z., Vatne, B., & Zhu, W. (2013). Is the Pareto-Lévy law a good representation of income distributions? Empirical Economics, 44, 719–737. Retrieved November 17, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86170221&site=bsi-live

Guell, R. C. (2007). Issues in economics today (3rd ed.). Boston, MA: McGraw-Hill Irwin.

Horn, R.V. (1993). Statistical Indicators for the economic and social sciences. Cambridge, UK: Cambridge University Press.

McConnell, C. R. & Brue, S. L. (2008). Economics (17th ed.). Boston, MA: McGraw-Hill Irwin.

Serwer, A. (2013). The income gap. Fortune, 168, 10. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89771060&site=ehost-live

Suggested Reading

Danziger, S., Haveman, R. & Plotnick, R. (1981). How income transfer programs affect work, savings, and the income distribution: A critical review. Journal of Economic Literature, XIX, 975–1028.

Firebaugh, G., & Goesling, B. (2004). Accounting for the recent decline in global income inequality. American Journal of Sociology, 110, 283–312. Retrieved October 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=14637951&site=ehost-live

Goesling, B. (2006). Getting rich: America's new rich and how they got that way. Administrative Science Quarterly, 51, 314–316. Retrieved October 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21789491&site=ehost-live

Goesling, B. (2007). The rising significance of education for health? Social Forces, 85, 1621–1644. Retrieved October 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25527577&site=ehost-live

Kleiber, C. (2013). On moment indeterminacy of the Benini income distribution. Statistical Papers, 54, 1121–1130. Retrieved November 17, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90574712&site=bsi-live

Liebman, J. B. (1998). The impact of the earned income tax credit on incentives and income distribution. In J. M. Poterba (Ed.), Tax policy and the economy 12. Cambridge, MA: MIT Press, 1998

Rector, R. and Hederman, R. (2004). Two Americas: One rich, one poor? Understanding income inequality in the United States. Retrieved October 3, 2007, from The Heritage Foundation. http://www.heritage.org/Research/Taxes/bg1791.cfm