The Economics of Income Inequality

I am a firm believer of meritocracy.  For a very long time, I accept that income inequality is a natural by-product of meritocracy. If a person could make more money than I do and lives a luxurious lifestyle, it is really because of his ability to earn that much money and my inability to do the same. However, it has recently dawned upon me that in the presence of this high-income earner, the money that I earn also drops in purchasing power. If both of us demand the same goods, because of his ability to pay more or consume more, the price rises. While it is true that high-income earners and low-income earners do not usually consume the same goods, prices for the higher-end goods could have some effects on prices for the lower-end goods through the workings of market forces. An example would be the private and public housing prices. 

From economics theory, could the purchasing power of lower-income earners be affected by those of high-income earners? If this is true, how then could we mitigate its effects? 

Consider a hypothetical country that has only 2 families, Family A and Family B, with both initially earning the same low income. Their demand curves would be the same and they would pay the same price and receive the same amount of goods. See the first row of charts in Figure 1 below. Now, assume that the income of Family A stays the same while that of Family B rises. The demand curve of Family B would increase, leading to an increase in the aggregate demand of the country. Both price and the total quantity of goods produced increase. However, the distribution of goods between the 2 families differs in unexpected ways. For Family B, the amount of goods received increases as expected. However, for Family A, the amount of goods received reduces because of the increase in price, even though their income stays the same.  See the second row of charts in Figure 1. The purchasing power of the lower-income Family A decreases in the presence of the higher-income Family B.

Figure 1: Purchasing Power of Lower-Income Earners Drops in Presence of Higher-Income Earners

Consider another hypothetical country which also has only 2 families, Family A and Family B, with both initially earning the same high income. Their demand curves would be the same and they would pay the same price and receive the same amount of goods. See the first row of charts in Figure 2 below. Now, assume that the income of Family A reduces while that of Family B stays the same. The demand curve of Family A would decrease, leading to an decrease in the aggregate demand of the country. Both price and the total quantity of goods produced decrease. However, again, the distribution of goods between the 2 families differs in unexpected ways. For Family A, the amount of goods received decreases as expected. However, for Family B, the amount of goods received increases because of the decrease in price, even though their income stays the same.  See the second row of charts in Figure 2. The purchasing power of the higher-income Family B increases in the presence of the lower-income Family A.

Figure 2: Purchasing Power of Higher-Income Earners Rises in Presence of Lower-Income Earners

Taken together, in a country with income inequality, the purchasing power of lower-income earners would be lower while that of higher-income earners would be higher than that in a country with perfect income equality. 

Now, the intent of this blog post is not to incite a class war between the higher-income and lower-income groups. We all have incomes that are higher than some people and lower than some other people, so we are all at the giving and receiving ends at the same time. The intent of this post is to raise awareness so that we all could do something about it. I am very sure that my higher-income friends do not purposely go out to lower my purchasing power. Very likely, they are not even aware of this. Economists and economics classes in schools are more concerned about aggregate demand and supply and do not consider economics at the individual level.

No society in the world achieves perfect income equality. How then do we correct the effects of this transfer of purchasing power from the lower-income earners to the higher-income earners due to free-market forces? On the income side, we have government transfers through taxes and subsidies as well as individual and corporate acts of philanthropy. Now that we know more about purchasing power transfers, we could, and should, do more tax transfers and acts of philanthropy.

On the consumption side, perhaps companies could adopt socially equitable pricing such as tiered or differential pricing for their goods and services. By tiered pricing, goods that are consumed beyond a certain threshold could be charged at a higher price to discourage excessive consumption. By differential pricing, the same goods could be differentiated by quality and marketed as premium, standard and basic goods catering to the high-, middle- and low-income groups respectively. If the cost of such differentiation is, say, 10% of the price of the standard goods, the price charged for the premium goods could be 50% more and the excess profit could be used to subsidise the price of the basic goods. Would high-income earners consciously pay more for their goods and services? I believe some would, just as some people do not mind paying more for goods that are more environmentally friendly. All they need is awareness.

I still believe firmly in meritocracy. I believe given our meritocratic society, we should be able to bring our best talents together to find and implement solutions that can correct the negative effects of income inequality and bring about a better life for everyone.


See related blog posts:

• Capitalism, Consumerism & The Distribution of Wealth

The Grades Matrix

Many years ago, a friend brought me to watch the movie “The Matrix”. I’m not sure if you could still remember the story, but Neo, the main character in the movie, was told that humans were reared as “batteries” to supply energy to the machine world. I pondered about this for a while, wondering whether the story could be true. While I found no plug behind my head to plug me into the Matrix, I did realise that we were all “batteries”. Since young, we went to school with the intended aim of gaining knowledge and getting good grades so that we could have a good-paying job and comfortable life. The exams that we took served to certify how good we were, whether we were an “A” or “AAA” battery. So, when we graduated with our “A” or “AAA” certification, we competed with each other to find a high-paying job and “power” the company in return. And when we have exhausted all our energy, we get “retired”, usually without much appreciation for the years of hard work put in. After all, when was the last time you said “thank you” to the batteries that powered your MP3 player which gave you so much entertainment?

It should not be this way. Going to school should be to gain knowledge so that it could be applied in a useful manner. It should not be for the sole purpose of getting the certificate, so that we could be certified as an “AAA” battery and “power” some companies in return for high pay. I look forward to the day that when our students graduate, they do not ask each other whether they have “found a job” with their certification, but whether they have “founded a business” with their knowledge. Many years ago, I recall there was a hue-and-cry in the newspapers over 2 graduates who set up a stall in a coffeeshop selling porridge instead of finding a high-paying job. I find nothing wrong with the choice that they made. They chose to “power” their passion with their knowledge and skills and gaining new experience in return. Whatever the outcome of their business venture, it would have been something gained for the 2 of them.

It is also not necessary that everybody must be a business owner (aka “battery driver”) rather than being an employee (aka “battery”). Just like the final episode of ”The Matrix” trilogy, everybody is allowed to choose whether to stay in the Matrix and enjoy the “succulent steak and sparkling red wine”, or leave the Matrix for the “bland but nutritious porridge”. There is also no escaping the fact that we are all “batteries”. However, we could choose what we power; it could be our family, religion, passion, and yes, even the company. Channel your energy to the area that is most dear to you.

A Knowledge-Based Economy is not a Grades-Based Economy

For a knowledge-based economy to thrive, it needs knowledge workers. However, the knowledge that commands a sustainable premium in the economy cannot be fully taught in schools. The knowledge that schools impart represents basic knowledge that allows a person to learn further, beyond examinations, to acquire new knowledge that gives him an edge. This new knowledge can also be about knowing what, where, when and how to apply in real-life situations, which can never be fully replicated in a school or examination environment. Any knowledge that is available in a textbook, is commoditised and taught to millions of students over the world. If a person does not keep on learning, he can only compete on price alone and is vulnerable to younger graduates and foreign workers who can do the same work at a lower price. Salaries stagnate, while the cost of living continues to go up. The good life “promised” by a good education then becomes a rat race.

Big emerging countries produce graduates by the millions. A sizable number of them are unemployed and are hungry to jump at any job opportunities that come along. By this, I do not mean them coming to Singapore to compete for jobs, I mean them competing for jobs to go to their countries rather than to Singapore.

Fortunately, the way to acquire new knowledge is not difficult. Through learning by doing, a person can discover for himself the conditions that textbook knowledge works or does not work and the improvements required to overcome the challenge. An inquisitive mind to understand beyond what is needed to complete the job will also create new knowledge. Some of these knowledge are already institutionalized in companies. What is required to acquire niche knowledge is to continually learn, either by doing or by learning from the experience of others. For this reason, fresh graduates should work from the ground up rather than step into management positions immediately. Similarly, local companies should in-source rather than out-source the part of work that presents opportunities to create new knowledge and value.

Since niche knowledge cannot be fully taught in school, the over-emphasis on grades then becomes misplaced. While a student with good grades might also make a good knowledge worker, we should not emphasize grades over knowledge and the need to continually learn. Besides parents, educators and students, we should also call upon employers not to place too much emphasis on the grades of job applicants. Rather, assess a job applicant based on his knowledge and his desire to learn. Do not mistake a grades-based economy for a knowledge-based one. Grades should just be an objective assessment of how much knowledge the student has learnt. And schools should be a place where not only knowledge is taught, but life-long learning is also cultivated.

The fixation on grades also comes from the allocation of school places to students. It is difficult to find an alternative set of objective criteria that can completely replaces grades. However, if the outcome of a person in life depends more on what he knows rather than which school he comes from, then the emphasis on grades could be lessened. We should strive to create the same conducive environment for learning in all schools.

From another perspective, I think schools can play a major role in forging a common identity in the community. There should be efforts to create a greater sense of belonging between schools and the community they are in, much like what Nantah University was to the people, which went beyond school-parent relationship. When this happens, parents would think first about sending their children to their community schools rather than to some faraway schools. 

It is the wish of every parent and educator for a child to have a good future. Do not let this turn into a rat race. The fixation on grades must end.

A Dumping Ground for Thoughts

This is a dumping ground for wild thoughts. Since I had spent countless hours thinking about them, I might as well publish them on a blog. Who knows, maybe someone will stumble upon it and give me some comments for new thoughts!

Happy surfing around :)