Exam Questions and Answers
1. Discuss the main patterns in the evolution of income inequality over the past century as well
as cross-national differences in these patterns. Make a distinction here between measures of
personal income distribution (Gini, national income shares) and functional income
distribution (labour income share).
A rise in income inequality means that income is being distributed from poor households to rich
households.
There exist different measures of income inequality:
The personal income distribution is the distribution of income between the various individuals or
households in the country.
The Gini index (= measure of personal income distribution) measures the extent to which the actual
distribution of disposable household income (= income remaining after it has been deduced from taxes
and social security charges) deviates from the situation in which every household has the same income.
It ranges from 0 (‘perfect equality’) to 1 (‘perfect inequality’).
To understand the Gini index, we must look at the Lorenz-curve, which shows the interplay between the
cumulative percentage of households (from poor to rich) and the cumulative income share of these
households. The Gini index is calculated by the ratio of the area between the line of perfect equality and
the observed Lorenz curve to the area between the line of perfect inequality (= A/A+B).
If we look at the Gini index of OECD countries between 1985 and 2017, we can observe that Anglo-Saxon
countries tend to have higher levels of income inequality than most continental European countries and
Japan. Inequality also rose faster in the Anglo-Saxon countries (Sweden and Finland are an exception to
this but started very low). The Gini indexes of Belgium and France and Hungary remained the (+/-) same
during this period. We can conclude that the rise in income inequality was an almost universal
phenomenon in the advanced capitalist world, but there are substantial cross-national differences
between OECD countries in terms of both the level of inequality and the pace at which it has increased
since the 1980’s.
One problem with statistical indices like the Gini index is that they summarize the entire income
distribution in one single number, making it a relatively abstract measure of inequality.
That is why national income shares are more interesting to analyze income inequalities. The data
collected presents the shares of different income groups in the total income that is earned every year in
a particular country and how these shares evolve over time. Piketty (& co) looked at the historical data
on the evolution of the share of the ‘top 1 percent’ in total income. The share of income going to the top
decile or centile is a useful index for judging how unequal a society is, because it reflects not just the
,existence of extremely high incomes or extremely large fortunes but also the number of individuals who
enjoy such rewards.
There is a considerable difference between the Anglo-Saxon countries and other rich OECD countries in
terms of the income share of the top 1 %. The Anglo-Saxon countries all show a U-shape over the period
between 1920 - 2012. Over the period between 1980 – 2012, the top 1 % income share (+/-) doubled in
these countries. And according to this measure income inequality is highest in the U.S. In continental
Europe and Japan, the pattern is closer to an L-shape curve. The income shares of the top 1 % have also
risen in recent years, but they are not extremely far away from their levels in the late 1940’s. The same
cross-national differences can be observed in the evolution of the income shares of people in the bottom
50 %.
Measures of functional income distribution measure the distribution of income between the two factors
of production: capital & labor and represent the labor share and capital share of GDP (Gross Domestic
Product). Since labor and capital are both needed to produce goods and services, the share of labor and
capital indicates how much of the profits goes to either labor or capital.
The labor income share has been falling in the advanced capitalist world since the 1970’s. A falling labor
share implied that workers have been getting a shrinking piece of the pie and capital-owners a growing
peace. The fall in the labor income share has been more pronounced in continental European countries
than in the U.S and the U.K.
2. The rise in income inequality in the advanced capitalist world can be seen as a structural
cause of the global financial crisis of 2008. Explain the mechanisms behind this.
4.3. Rising Inequality as a Structural Cause of the Global Financial Crisis
- Link between inequality and financial instability according to IMF-study (2012):
- “The US has experienced two major economic crises during the last century – 1929 and
2008 – which have remarkable similarities. Both were characterized by a sharp
increase in income inequality, and by a similarly sharp increase in household debt.”
- →not only a left-wing claim, also neoclassical economist
- Fault Lines (Raghuram Rajan, 2010):
- “Cynical as it may seem, easy credit has been used as a palliative throughout history
by governments that are unable to address the deeper anxieties of the middle class
directly … if [middle class people] can afford a new car every few years and the
occasional exotic holiday, perhaps they will pay less attention to their stagnant
monthly pay checks. ”
→ Expansion of credit to lower income households in order to (a) maintain the legitimacy of the
economic order and (2) support economic growth in the face of rising income inequality
,!! Since the 1980s the gains of economic growth have been distributed unequally, especially in rich
countries. Rise in income inequality in the western world was due to the neo-liberal transitions in
different policy domains 1) Macroeconomic Policy: transition towards low inflation and low public
deficits; 2) Social Policy: flexibilization of labor markets and downsizing of the welfare state; 3)
Corporate Governance: rise in shareholder capitalism; as a structural cause of the global financial
crisis.
While neoclassicists believe that rise in income inequality boosts long-term growth as individuals
develop skills and experience, it has been empirically proven that a rise in income inequality actually
hampers long-term economic growth and increases financial instability. Why?
● supply-side interpretation:
Looks at the negative effects of rising inequality on educational opportunities for children in lower
income households, leading to a decline in human capital development that reduces long-term
productivity growth. According to this view, higher income inequality translates into higher educational
inequality, which low-income children ending up in low-quality schools and have less access to higher
education. This slows the rate of economic growth relative to a counterfactual scenario where all
children have equal educational opportunities, given that children of poor households accumulate less
human capital and will become less efficient and productive future workers. => increased income
disparities depress skills development among individuals with poorer parental education background,
both in terms of the quantity of education attained and in terms of its quality.
● demand-side interpretation:
Individuals with higher incomes are believed to have lower marginal propensities to consume than
individuals with lower incomes, an upward redistribution of income from poor households to rich
households reduces the level of aggregate consumption in the economy. The lower level of aggregate
consumption, in turn, pushes firms to curtail their investment expenditures, as weaker consumer
demand offers a signal to businesses that there is less need to raise their capital stock to meet demand
for their goods and services. Conversely, rising income inequality since 1980 generated a large increase in
saving by the top of the income distribution “the saving glut of the rich”
Because of the previous arguments we can see a connection between rising inequality and the global
financial crisis of 2008. Many lower and middle class households in the United States and other
Anglo-Saxon economies became increasingly dependent on credit to finance their consumption in the
face of stagnating incomes because of fiscal austerity which cut public spending. With the liberalization
and deregulation of the financial sector in the 1980s, banks were allowed to take more risks. They
enabled themselves to give out loans to lower-income households (by democratizing credits) a riskier
endeavor than high-income households since they’re less likely to be able to pay back the loan—through
“securitization”: splitting up big loans into a bunch of little loans and selling those loans to a bunch of
investors to diffuse risk while making the same amount of money. They eventually made so much money
in the US that the government would’ve been unable to bail them out if something went horribly wrong.
, Moreover, since globalization made the economy so globally integrated, a crisis in one economy led to a
crisis in its peers, and so on.
3. Discuss the neoclassical interpretation of rising income inequality in the advanced capitalist
world since the 1980s. What are the main shortcomings of neoclassical interpretation?
→ Inequality as normal
1.2. Rising Inequality: Neoclassical Explanation (1)
- Rising income inequality reflects price mechanism in labour markets: two structural
developments have reduced demand for low-skilled workers and increased demand for
high-skilled workers:
- “Skill-biased technological change”
- Paul Krugman (2007): “The hypothesis that technological change, by raising the
demand for skill, has led to growing inequality is so widespread that at
conferences economists often use the abbreviation SBTC – skill-biased technical
change – without explanation, assuming that their listeners know what they are
talking about.”
- Increased demand for skilled labor pushed up wages of highly educated
employees
- → worker's wage should be equal to the marginal product of labour
- Goldin & Katz’s book: The Race Between Technology and Education
- Technology raced ahead of education
- Economic globalization (same line of thinking)
- Economic globalization reduced demand for low-skilled workers and boosted
demand for high-skilled workers in advanced capitalist countries
- Economic globalization has also simultaneously reduced demand for low skilled
(machines) workers and increased demand for high skilled labor.
- → Increased wage differential between these 2 types of workers.
→ Rising inequality mainly results from “natural” market-related processes that are desirable in and of
themselves
→ While globalization also opened up opportunities for firms and led to the creation of new jobs in
competitive industries and business service sectors of the advanced economies, these jobs
predominantly went to high skilled workers.
SO, economic globalization reinforced the effects of SBTC on income inequality.
1.3. Rising Inequality: Neoclassical Explanation (2)
- Inequality is unavoidable / Normal
- In decentralized and competitive labor markets wages of workers should reflect the
“marginal product of their labour”
