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