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Introduction to Economics Seminar, Day 4- Editable Booklet

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Introduction to Economics Seminar, Day 4- Editable Booklet

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Click on the image above to access an editable booklet of the Introduction to Economics Seminar, Day 4.

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Introduction to Economics Day 4 - Editable Booklet

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Create worksheets in Economics using the Frayer Model

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Create worksheets in Economics using the Frayer Model

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The Frayer Model is a vocabulary development tool. In contrast with a straight definition, the model helps to develop a better understanding of complex concepts by having students identify not just what something is, but what something is not. The center of the diagram shows the concept being defined, while the quadrants around the concept are used for providing the details. Topics that work well with the Frayer Model include quadrilaterals, insects and forms of government. We have included two variations of the model that we have seen used in school settings.

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Senior Cycle is being redeveloped following a comprehensive review process. This important work will seek to enhance the educational experience and ensure meani…

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Junior Cycle & Leaving Certificate Examinations 2023

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Junior Cycle & Leaving Certificate Examinations 2023

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Home - National Council for Curriculum and Assessment

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At NCCA, we work with learners, teachers, practitioners and parents to develop research-based curriculum and assessment.

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Key Economic Indicators Dashboard | CSO Ireland

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This is a set of key economic indicators produced by the CSO. It is divided into three themes - Macroeconomic, Business and People. This is a live dashboard which regularly updates with the most recent information available for each indicator.

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The Oireachtas - Data Visualisation Tools

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The Oireachtas - Data Visualisation Tools

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This page displays interactive and static data visualisation resources published by researchers in the Oireachtas Library & Research Service (L&RS) and the Parliamentary Budget Office (PBO).

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A new survey from the Central Statistics Office shows that 96% of respondents are concerned about the current cost of living, with 56% being very concerned.

The CSO's "Our Lives Our Money" Pulse Survey also shows that 63% of respondents believe they are in a worse financial situation now than they were a year ago.

64% of people who took part in the survey believe their situation will get worse in the next 12 months.

It also reveals that 80% of people said they have experienced a decrease in disposable income in the last 12 months.

Meanwhile, more than 35% of people said they are just getting by financially while 19% said they are short of money every month to cover their expenses.

When asked if they had cut back on any essential cost in the last 12 months, the CSO said that 62% of people had reduced spending on electricity and heating, while 51% said they were not buying as much fuel.

Around 54% of households with children reported making cutbacks on food, the CSO said.

53% of all respondents also said they had reduced their trips to the cinema, theatre, or concerts while 58% had cut their expenditure on clothes, hairdressing and beauty.

41% of consumers surveyed also said they had reduced their spend on media subscriptions including the likes of Spotify, Netflix and newspapers, with 24% said they are no longer spending as much on club subscriptions such as gyms and social clubs.

The CSO said the results of the survey suggest that consumers are conscious of the current rate of inflation at 9.2%, with 72% estimating the rate of inflation to be between 7% and 11%.

It said that 97% of respondents had seen an increase in their weekly food shop, with a median or mid-point increase of €30 being reported by people.

The median increase for respondents with children in their household was €40 for their weekly food shop.

Aoife O'Neill, Statistician in the CSO's Social Data Collection division, said that more than half, or 56%, of respondents to the "Our Lives Our Money" CSO Pulse Survey said they are very concerned with the current cost of living.

"When asked what they are most worried about, 76% said utility costs are of greatest concern. Other areas of concern respondents highlighted from a maximum choice of three include healthcare (30%), no savings or pension (31%), credit card loan (19%), and mortgage/rent (24%)," Ms O'Neill said.

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96% of consumers worried about current cost of living

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A new survey from the Central Statistics Office shows that 96% of respondents are concerned about the current cost of living, with 56% being very concerned. The CSO's "Our Lives Our Money" Pulse Survey also shows that 63% of respondents believe they are in a worse financial situation now than they were a year ago.

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Euro zone wage growth could keep pushing up inflation for years but this does not signal a permanent shift in wage dynamics and current indicators underlying inflation may be misleading, European Central Bank chief economist Philip Lane said today.

Wage growth has been a key focus of policymakers this year.

This is due to fears that firms will be forced to boost compensation to offset rapid inflation, setting off a hard-to-break wage-price spiral that could force the ECB to keep rates high for long.

While no such spiral is evident for now, some, including board member Isabel Schnabel, have argued for preemptive action as undoing these wage pressures was more costly than acting early.

Professor Lane, who formally proposes policy measures to the rate-setting Governing Council, took a more measured view in a blog post.

Philip Lane argued that rapid wage growth may stay for years after the energy shock fades but that does not automatically mean a changed dynamics.

"The staggered nature of wage setting means that the adjustment of nominal wages to the cumulative increase in the cost of living will play out over several years," Professor Lane wrote.

"This means that, even after energy and pandemic factors fade out of inflation measures, wage inflation will be a primary driver of price inflation over the next several years," he said.

Still, this a time-limited catch-up and should not be misinterpreted to signal a more permanent shift in wage dynamics, he wrote.

He also warned against reading too much into current underlying inflation data, a key focus of several policymakers, because it may be skewed by the unusual economic shock of the pandemic and the energy shock.

"The current values of these measures may overstate the medium-term persistent component of inflation in this highly atypical environment," Philip Lane said.

"It is unlikely that the standard measures of underlying inflation are sending the same signals about the likely persistence of inflation dynamics than under more standard macroeconomic conditions," he added.

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ECB's Lane plays down wage, core inflation fears

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Euro zone wage growth could keep pushing up inflation for years but this does not signal a permanent shift in wage dynamics and current indicators underlying inflation may be misleading, European Central Bank chief economist Philip Lane said today. Wage growth has been a key focus of policymakers this year.

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The CSO figures are based on its residential property price index, which is adjusted to allow for the fact that different types of property are sold in different periods.

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Building on Experience - Interactive thinglink on The Research Process

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Building on Experience - Interactive thinglink on The Research Process

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View the interactive image by Regina Casey

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National Council for Curriculum and Assessment (NCCA)

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Focus on Learning. Assessment at junior cycle places the student at the centre of the learning process allowing for new ways of learning and a broader range of…

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Advice to students on writing extended answers 

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Advice to students on writing extended answers 

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Thinking about a contentious issue in the Economics Classroom

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Thinking about a contentious issue in the Economics Classroom

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Planning a Unit of Work when considering contentious issues

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Planning a Unit of Work when considering contentious issues

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Topical Talk gives you free teaching resources for weekly classroom discussions about current affairs. Our trustworthy, ready-to-use resources are made by expert teachers in collaboration with world-leading journalists and fact-checkers from The Economist newspaper.

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Topical Talk gives you free teaching resources for weekly classroom discussions about current affairs. Our adaptable activities help the news make sense for learners aged 9+.

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Economic disparities are mostly a matter of where you were born, who your parents are, and (in some countries) your gender. Well-designed policies and institutions can reduce inequalities without lowering average living standards

Having declined for most of the twentieth century, inequality of income then increased in the US, the UK, India, and many other countries.

Nonetheless, because of the rapid economic growth of China and India, countries with very large populations, income inequality among all people in the world has declined since the end of the twentieth century.

Discrimination based on race, gender, or religion, and other forms of unequal opportunity mean that otherwise identical people will have different incomes and economic opportunities, contributing to inequality.

Income disparities among people are due to what they own (for example, a piece of land), are (male or female), or have (particular skills) that enable them to receive income.

The institutions and policies in force in a society and the technologies used in production influence these determinants of income.

Some inequalities provide incentives to study and work hard, and to take the risks associated with innovation and investment.

But inequalities also restrict economic opportunities of the less well off and may also result in a more conflict-ridden society and impose costs, impairing economic performance.

Well-designed and implemented government policies can limit unfair economic inequality while raising average living standards, as has been done in many countries.

It is 1975. Renfu is the child of a local Communist Party leader. In 10 years, he will attend Tsinghua University, an elite engineering university in Beijing, and will join the Communist Party himself. In 20 years, he will run a state-owned enterprise. In 30 years, he will be CEO of the company after it is privatized, and be highly ranked within the Party.

However, Yichen, whose parents have no party connections, will not go to university, but instead work the land alongside her parents until she is 16, and then work at a state-owned enterprise making car parts for export to the US and Europe. When she is 30 years old, she will take a job in the new Motorola factory opening in nearby Tianjin, paying double her current wage. She will not be able to migrate legally to Tianjin and leaves her daughter behind with her parents.

Yichen and Renfu are hypothetical people. We could have inserted a disclaimer: 'All characters appearing in this work are fictitious...' But that would not be entirely true-they illustrate the divergent histories of real people alive today.

Let's also consider two other hypothetical people living in the US, also in 1975. Mark and Stephanie, both 17, live in Gary, Indiana. Mark is about to finish high school and start working in the local unionized steel mill with his father, where the pay is good and he doesn't have to spend four years in further education before earning a wage.

In the 1981 recession, Mark will lose his job. He will try to use his mechanical ability to open a car parts business. With little wealth of his own to post as collateral, he will not be able to obtain a bank loan, so he will move south to another factory. This one is non-unionized, and he will make less money than he did in Gary. In 2008, during the recession, his factory will replace him with a KUKA Robotics Corporation Titan industrial robot.

Stephanie, both of whose parents are doctors, decides she will attend Indiana University Bloomington, majoring in psychology. Afterwards she will work for a large financial corporation in Chicago and, after a series of promotions, becomes a vice-president for human resources. She will invest her savings in the stock market, which yields an average return of more than 10% for many years, and will benefit from government tax cuts that favour high earners.

These four people had very different life outcomes. Is there anything wrong with that? Each of the four made good choices knowing what they could have known at the time, everybody worked hard, and yet they had very different lives. We might say that they simply drew different hands in the card game of life.

Their parents are an important difference in the hands that they drew. This starts with the fact that Yichen and Renfu were born in China, and Mark and Stephanie in the US. The parents of the two in China were likely to be equally poor, although Communist Party members enjoyed a higher level of social prestige and education. The gap in wealth between the two sets of American parents would probably have been larger. If Mark was black the gap would be greater than if he was white, but his family would still have been far better off in material terms than both the Chinese families.

In 2017, the children of Stephanie and Renfu, who have been relatively successful in each country, will have access to a variety of opportunities not available to the children of Yichen and Mark. In China, Renfu's children will attend better schools and have better job prospects because of their father's connections. With luck, they may attend a US university, gain valuable work experience in the university-trained, English-speaking global labour market, and return to China with salaries many times those of the average Chinese citizen.

Yichen's daughter will not obtain a high-quality primary or secondary education. This is because the hukou restrictions mean she must go to school in Yichen's rural home district and not in Tianjin, where her mother works. Nevertheless, most likely she will be better off over her lifetime than her parents, and will certainly be better off than her grandparents.

In the US, Stephanie's children will attend either a public school in her expensive neighbourhood, well funded by local property taxes, or an expensive private school. They will get early access to a much larger vocabulary, form lifelong friendships with other kids from their privileged background, and engage in a variety of interesting extracurricular experiences that help their educational performance and will help them get admission to elite universities. This will translate into average lifetime earnings of close to $800,000 greater than the earnings of those whose education finishes at high school level.

Mark's children will have to deal with poorly funded public schools, the absence of union jobs, a minimum wage that will be worth less in real terms than it was in their parents' generation, and changes in technology and trade that will amplify the effects of these problems. The life trajectories of these four people illustrate just a few of the global changes in the distribution of income that have occurred in the past 40 years.

Inequality exists across many dimensions, including income, wealth, education, health, and other opportunities. In this unit, we will focus primarily on inequalities in wealth and income, both because they have been studied extensively by economists and because they are strongly related to other forms of inequality. We begin with three sets of facts:

We then ask why inequality is widely seen as a problem, and provide a way to approach the question of whether there is too much (or too little) inequality. We present a model of the causes of economic inequality in order to understand how public policies and other changes can alter the degree of economic inequality. And we then use this model to explain both recent changes in the levels of economic inequality in a number of countries, and the effects of government policies on the degree of inequality.

Exercise 19.1 Income variation across and within countries

In Unit 1, Figure 1.2 showed the distribution of income across and within countries in 2014. The height of each bar in the chart varies along two axes. The first axis of variation, from left to right of the figure, is a ranking of countries according to gross domestic income per capita from the poorest on the left (Liberia), to the richest on the right (Singapore). The second axis, from the front to the back of the figure, shows the distribution of income from poor to rich within each country.

You can find an interactive version of this figure at https://tinyco.re/7434364.

Go back over the stories of Mark, Renfu, Stefanie, and Yichen and make your guess about which decile fits each of the fictional characters. Briefly justify your choice.

19.1 Inequality across the world and over time

As you know from Unit 5, we can use Lorenz curves to estimate Gini coefficients, which measure the degree of inequality in wealth, income, earnings (income from work in the form of salaries and wages), years of schooling, and other indicators of economic or social success.

Wealth, earnings, market income and disposable income

Figure 19.1 shows data on three dimensions of inequality (wealth, earnings, and disposable income) in three economies. Recall that wealth is the value of the assets owned by a household (net of their debts). Earnings are income from labour, including from wages, salaries, and self-employment. Market income is the sum of:

all income received as earnings

all income received from business owned by the household or from investments

Finally, disposable income is the income that a family can spend

after paying taxes

after receiving any monetary transfers from the government such as unemployment benefit and pensions

Two things stand out in Figure 19.1:

Income inequalities over time and among countries

Another way to measure inequality focuses on the very rich, providing an answer to the question: what fraction of total income or wealth belongs to the richest 1% or 10% of the population? This indicator has the advantage that it can be measured over hundreds of years, because the very rich have long been required to pay taxes, and hence we have reasonably good information on their incomes and wealth. Figure 19.2 shows the fraction of all wealth held by the richest 1%, for all countries on which long-run data is available.

There appear to be three distinct periods: the eighteenth and nineteenth centuries up to about 1910 show increasing wealth inequality (excepting Norway and Denmark), the twentieth century until 1980 shows decreasing wealth inequality, and the period since shows a modest increase in wealth inequality.

Figure 19.3 presents similar data for the share of income before taxes and transfers (rather than wealth) received by the top 1% of income earners. As in Figure 19.2 there are cross-country differences. For example, in recent years the US is much more unequal than China, India, or the UK. But there are also common trends, similar to the second and third periods in the distribution of wealth: a trend towards less inequality in much of the first three quarters of the twentieth century, followed by an increase in inequality since about 1980.

Explore the top incomes in countries that you are interested in the World Wealth and Income Database.

But this sharp U-turn towards greater inequality did not occur in all countries, including most of the major economies of the continent of Europe. These are shown in Figure 19.4.

Looking at Figures 19.2 to 19.4, one can see that:

We used data created by Thomas Piketty and his collaborators to create Figures 19.3 and 19.4. He is an economist and author of the bestselling economics book Capital in the Twenty-First Century. In our 'Economist in action' video, he examines economic inequality from the French Revolution to today, and explains why careful study of the facts is essential.

Inequalities between and within nations

At the beginning of Unit 1 you read that prior to the emergence of capitalism, the income a daughter or a son received depended on where their parents were on the economic ladder. It mattered much less in which part of the world the son or daughter was born.

The economic take-off of the first capitalist economies changed this.

The 'great divergence' in Unit 1 resulted because the kink in the hockey stick for per capita income came early for some countries (Britain, Italy, and Japan in Figure 1.1a), later for others (China and India), and has not yet occurred for others (Nigeria and Argentina) (see also Figure 1.11). The result of the uneven timing of the capitalist revolution around the world was a widening of inequalities among the people of the world, which occurred over the nineteenth and twentieth centuries until very recently. Even the poor in North America and Europe became richer than the rich elsewhere.

How do we measure global inequality? Think about the Lorenz curve constructed by lining up all the individuals in the world from lowest to highest income, irrespective of the country people live in. You know from Figure 1.2 that the poorest 20%-the part of the Lorenz curve extending from zero to 0.20 on the horizontal axis-would be very flat: this would represent most of the populations of Liberia and Nigeria, and middle and lower income people in Indonesia and India for example. If we construct the entire Lorenz curve, we can calculate the Gini coefficient for the whole world. This is shown for market income in Figure 19.5. For example, in 2003 the worldwide Gini coefficient was 0.69. We can see that inequality among the world's individuals is high but has fallen very recently.

The other series in Figure 19.5 (the red line) presents global inequality in a different way. It focuses on the income differences between countries. Imagine that everyone in each country earned the average income for that country. In this thought experiment, everyone in the UK would earn exactly the UK's average income, whereas everyone in China would earn exactly the Chinese average income. What would income inequality look like in this hypothetical example?

The red line shows the result of performing this calculation. In our thought experiment, the only source of inequality in the world would be inequality across countries. Inequality is reduced, but substantial inequalities still exist due to the vast differences in income between countries.

You can see that the Gini coefficient for all individuals in the world in 1950 (the beginning of the blue line) was 0.71, and this number would have been 0.64 had there been perfect equality within each country (the red line). As a result, we see that 90% of global inequality in income is accounted for by our measure of inequality between countries (that is because 0.64/0.71 = 0.9, or 90%).

The figure also shows that between-country inequality has been falling rapidly: by 2018, 74% of global inequality was between-country inequality (0.45/0.61 = 0.74).

The most recent Gini coefficient for the whole world is 0.62. You know that this is closer to 1 (one person has all the income in the world) than to 0 (no income differences in the world). But how much inequality does this really indicate? To see how to interpret the Gini coefficient, read the Einstein: 'The Gini Coefficient and worldwide income differences', which is at the end of this section.

Figure 19.5 has three main messages for us:

A glimpse into the future of the rich economies: The missing middle?

The increased inequality that has occurred within many developed countries has been associated with a changing distribution of jobs. Low-paying jobs and high-paying jobs have increased in number while middle-income jobs have become scarcer. The result-more jobs at the top and the bottom of the economic ladder, and fewer on the middle rungs-has been termed 'the missing middle'.

The data in Figure 19.6 illustrate both trends for the US economy. We have used the US economy as an illustration because of the quality of the available data, but similar trends are evident in other high-income countries.

Figure 19.6 arranges jobs from the highest paid (in hourly wages) at the top to the lowest paid jobs at the bottom, and estimates growth or contraction of employment on the horizontal axis.

Notice these things about the data:

The missing middle: Both high-wage and (especially) low-wage occupations are adding many jobs, but employment gains among the occupations with wages in between are more limited.

Jobs replace work once done by family members: The biggest increases are in human services, most of them in health-related professions. These growing occupations substitute for work once done primarily by family members, such as personal care aides and home health care aides.

Machines do routine work: Digitalization reduces the demand for jobs that involve routine tasks, such as postal mail sorters and machine operators. The tasks that machines are not replacing tend to be either well paid (personal financial advisors, nurse practitioners) or poorly paid, such as those taking care of the elderly at home.

High-wage job gainers work with information technologies: Growing occupations with high wages (outside human services) such as operations researchers, statisticians, and web developers are those in which digital information processing has greatly increased the productivity of workers with the right kinds of skills.

Workers with average wages are the losers: Occupations with job losses tend to have near-average wages or less.

Figure 19.6 only showed occupations for which gains or losses are projected to be at least 20% of their 2014 level and change by at least 10,000 employees. But as Figure 19.7 shows, this pattern holds when we look at all jobs in the US economy. The projected trends shown in Figures 19.6 and 19.7 have been underway in the US since at least the 1970s.

Exercise 19.2 Inequalities among your classmates

1. Using this Gini coefficient calculator, calculate the degree of inequality of height among your classmates.

2. Why is this Gini coefficient so much smaller than it was for wealth in Figure 19.1?

3. Now use the calculator to compute the Gini coefficient for another measure (for example, age, weight, commuting time to university, number of siblings, or grade in the last exam).

4. Explain any differences between this Gini coefficient and that for wealth.

Question 19.1 Choose the correct answer(s)

Figure 19.1 shows the inequality in wealth, earnings, and disposable income in the US, Sweden, and Japan using the Gini coefficient.

Based on this information, which of the following statements are correct?

Question 19.2 Choose the correct answer(s)

In Thomas Piketty's 'Economist in action' video, which of the following were NOT among the reasons that Piketty gave for the fall in the incomes of the very rich during the twentieth century?

Question 19.3 Choose the correct answer(s)

Figure 19.6 is a scatterplot of occupations for the US economy, with the 2015 mean hourly wages on the vertical axis and the 2014-24 projected job growth on the horizontal axis:

Based on this information, which of the following statements is correct?

Einstein The Gini coefficient and worldwide income differences

In Unit 5 you learned that the Gini coefficient is a measure of inequality that is defined as half of the relative mean differences in incomes between all pairs of people in a population.

Recall that the mean difference in incomes among all pairs in the population which we denote as Δ can be expressed as the income of the richer of the pair ( y r) minus the income of the poorer of the pair ( y p) summed over all of the pairs in the population, and then divided by the number of pairs in the population ( n). The relative mean difference is this quantity divided by mean income, y.

So half of the relative mean difference is:

By rearranging this equation, you can see that the average difference between the two paired people will be the mean income times twice the Gini coefficient:

But there is a more interesting interpretation of the Gini coefficient. If we have drawn all possible pairs from the world's population, the mean income in the world () will be:

where we defined and are the average incomes of the richer and the poorer of each of the pairs, respectively. So we can now rewrite the expression for the Gini coefficient in terms of and :

By rearranging and dividing through by , we have:

Using this final expression, if the Gini coefficient for the world is 0.62, then:

This says that if the Gini coefficient is 0.62, then across all of the pairs in the population or across a large random sample of the population, the better off of the two is on average 4.26 times richer than the less well off.

Exercise 19.3 Another way to interpret Gini coefficients

Use Figure 5.16 to estimate the Gini coefficient for disposable income in Denmark and South Africa. In explaining the difference in income inequality between these two countries, you could use the information in the Gini as follows: if two people are chosen at random from the population of the country, what is the average ratio of the richer person's income to that of the poorer person's? To allow you to translate data on the Gini coefficient into this ratio, use the formula in the Einstein to construct a table of the richer/poorer ratio for Gini coefficients ranging from 0.0 to 0.9 (in increments of 0.1). Graph your results. Explain the difference in inequality between Denmark and South Africa using your results. What does the formula imply if the Gini coefficient is equal to 1?

19.2. Accidents of birth: Another lens to study inequality

Much of the inequality in the world today can be traced to differences among people in things over which they have virtually no control, such as their race, sex, nation, or parents. We call these differences 'accidents of birth'.

To see how important accidents of birth can be, try the following thought experiment. Go back to Figure 1.2. Suppose that all you care about is income, and you can choose either:

the income decile you are in, but the country you are born in will be decided by chance

the country you are born in, but the decile you are in within the country will be decided by chance

Did you choose option 1 (the decile) or option 2 (the country)?

If you chose option 1, you would of course choose to be in the top decile, so you would be somewhere at the back of Figure 1.2. But where? You would have an equal chance of being born in Nigeria on the left-hand side or in the UK on the right-hand side.

If you chose option 2, you could select one of countries at the right-hand end with the highest average income. You are as likely to be in the lowest decile, at the front of the figure, as in the highest decile, at the back.

One's citizenship is one of the great accidents of birth affecting income. Passports and borders limit the economic opportunities people from different countries face. People with the same education, capacities, and ambition but born on different sides of a national border face very different life chances, whether that is the border between Mexico and the US, The People's Democratic Republic of Korea (North Korea) and South Korea, or the Mediterranean Sea that divides North Africa from Europe. Even where migration is allowed, migrants are often denied access to political and labour rights, as in the Gulf States and some East Asian countries.

Gender and other forms of categorical inequality

Inequalities based on accidents of birth also exist within countries:

categorical inequality

Inequality between particular social groups (identified, for instance, by a category such as race, nation, caste, gender or religion). Also known as: group inequality.

Inequalities based on one's ethnic identity or caste are examples of categorical inequality (also known as group inequality), meaning economic differences among people who are treated as being in different social categories as defined by more powerful social classes. The Indian castes are categories, as are those of 'African', 'White', 'Coloured' and 'Asian' in South Africa. Categorical inequalities are for the most part based on accidents of birth, because one is born into membership in one of the categories, and switching category is typically difficult if not impossible.

To understand how easily segregation by race or some other categorical characteristic arises, take two minutes to play the online game The Parable of the Polygons.

The most common form of categorical inequality is that between men and women. There are many economic differences between men and women on average. This is a bit puzzling because other than differing biological roles in reproduction, men and women are so similar: similar parents, similar schools (in most countries), similar genetic inheritance on matters affecting intellectual skills and so on. But it is clear that the economy treats men and women differently. This is much more true in some countries than in others, but it is true for all countries.

Income disparities between men and women among otherwise similar individuals are one measure of this inequality. Figure 19.8 shows the expected lifetime earnings (labour income) of men and women in the US, who work full time from the time they leave school until retirement. As a result, any differences in the figure are not due to women having more time out of the labour force (on average) because of child rearing.

Because the quality of schooling does not differ between males and females on average (and girls tend to do as well on most tests), the gender differences in pay are not due to differences in cognitive ability or quality of schooling. Yet for every level of schooling, women can expect to earn much less than men.

The figure also shows, however, that additional schooling contributes to higher lifetime incomes, and that those women who complete university (a bachelor's degree) can expect to earn much more than men who ended their schooling after secondary school.

In many parts of the world girls receive considerably less schooling than boys, but as Figure 19.9 shows, girls go to school for the same number of years on average as boys in both the US and France, and longer in Brazil. Countries in which women have historically suffered extraordinary social and economic disadvantages, such as China and Indonesia, have virtually eliminated the gender gap in years of schooling, and India, though far behind, is rapidly closing it.

Intergenerational inequality

In addition to categorical differences such as nation, gender, race, or ethnic group, a second source of economic inequality within a nation is inherited. You may be rich or poor simply because your parents were rich or poor.

Two hundred years ago, in most countries it was taken for granted that somebody would expect a life of poverty simply because her parents had been poor, or that someone else would inherit the ownership of his father's company and social status, without having to prove that he was the best person for the job. The inheritance of inequality from one generation to the next seemed to be part of the natural order of things.

But this has changed with the spread of public education and, in many countries, with the decline in discrimination against poor people due to their race, religion, or simply their humble origins. In some countries, the economic status of one's parents matters a great deal for the economic success of their children; in other countries, differences among parents are only weakly transmitted to their offspring.

The expression intergenerational transmission of economic differences refers to the processes by which the economic status of the adult sons and daughters comes to resemble the economic status of the parents. The transmission process takes many forms:

Children inherit the wealth of their parents.

The genetic makeup of the children is similar to the parents.

Through parental influence in child rearing, parents and children tend to share similar preferences, social norms, and knowledge, skills and social connections acquired outside formal schooling.

intergenerational inequality

The extent to which differences in parental generations are passed on to the next generation, as measured by the intergenerational elasticity or the intergenerational correlation. See also: intergenerational elasticity, intergenerational mobility, intergenerational transmission of economic differences.

Intergenerational inequality occurs where these processes result in similarity between the economic status of parents and their children: the children of the well off become rich themselves, while the children of the less well off stay poor.

Economists and sociologists measure intergenerational inequality by ranking parents by their incomes or wealth, and then looking at what income or wealth their kids end up with when they become adults. They confirm that there is substantial intergenerational inequality. Kids whose parents had a high income are likely to grow up to have high incomes themselves, and kids from low-income families are likely to have low incomes as adults.

This is what we see in Figure 19.10, which gives measures of the intergenerational inequality of men in the US (left panel) and Denmark (the right panel), based on their labour earnings (wages or salaries). The tall bar on the left in the US panel means that among those whose fathers were in the bottom fifth of the earnings distribution, 40% were themselves in the poorest fifth, while 7% ended up in the top fifth of the earnings distribution. By contrast, 36% of those born to the richest fifth were themselves in the richest fifth-the tall purple bar on the right.

One of the reasons that children of the rich tend to be richer than the children of the poor is the financial support that rich parents give to their children, both during the parents' lifetimes and at death in the form of inheritances. The data in Figure 19.10, however, is based on labour earnings, not inherited wealth. The earnings of parents and their children appear to be similar in the US, partly because children of well off parents receive more, higher-quality, schooling. They also benefit from the networks and connections of their parents, which improve access to the labour market.

The data from Denmark in the right panel suggests a more level playing field. Only 25% of those born to parents in the poorest fifth of the population end up in the poorest fifth themselves, compared to 40% in the US. This suggests that those born to relatively poor parents are less disadvantaged in Denmark. Similarly, 33% of those born to parents in the richest fifth end up in the richest fifth themselves, compared to 36% in the US. Based on this data, we would conclude that intergenerational inequality is lower in Denmark than in the US, though it still does not appear to be a completely level playing field.

intergenerational elasticity

When comparing parents and grown offspring, the percentage difference in the second generation's status that is associated with a 1% difference in the adult generation's status. See also: intergenerational inequality, intergenerational mobility, intergenerational transmission of economic differences.

A measure that can summarize the overall rate of intergenerational inequality in a society is the intergenerational elasticity of income or wealth. To see what this measures, consider two pairs of fathers and children. The father in the first pair is richer than the father in the second. The intergenerational elasticity measures how much richer the child of the well off father will be than the child of the poorer father. An elasticity of 0.5, for example, means that if one father is 10% richer, then his child, when grown up, will be on average 5% richer than the other child. The higher the intergenerational elasticity, the greater the degree of intergenerational transmission of economic status and the greater the level of intergenerational inequality. In a society with a high intergenerational elasticity, intergenerational mobility is low.

The term intergenerational elasticity has nothing to do with the usual meaning of the word elastic. But, like the price elasticity of demand for a good, it concerns the percentage change in something that is associated with a percentage change in something else.

What is the relationship between a measure of intergenerational inequality such as the intergenerational elasticity and the extent of inequality among the members of a population at a given point in time? You can think of many reasons why the two would go together.

Figure 19.11 presents evidence on the relationship between intergenerational elasticity for earnings and earnings inequality at a particular time. We refer to earnings inequality at a particular time, which we measure using the Gini coefficient for income, as cross-sectional inequality. Note that we do not include the effects of taxes and government transfers in Figure 19.11 when we measure both income inequality and intergenerational transmission of earnings, because we are interested in the movements of these two dimensions of inequality that are independent of government policy.

The figure shows that for the countries considered, inequality in earnings at any particular point in time tends to be higher when intergenerational inequality is high. The US, UK, and Italy are examples of countries that have both high cross-sectional inequality and high intergenerational inequality. In other countries (Norway, Denmark, Finland) both intergenerational inequality and cross-sectional inequality are quite limited. But some countries differ according to which type of inequality is most pronounced. Compare, for example, Canada and Switzerland.

Does cross-sectional inequality cause intergenerational inequality, or the other way around, or both, or neither? We know that societies with a strong culture of fairness and equal treatment, such as Denmark, adopt policies to reduce inequality between people at a given moment, including offering generous benefits to unemployed and retired individuals through the welfare state. At the same time, they also attempt to limit intergenerational inequality by providing equal opportunities for high-quality education, and through other policies that would reduce intergenerational transmission of economic status. This is part of the explanation of the contrast between Denmark and the US in Figure 19.10.

Another likely source of the correlation in Figure 19.11 is that in any period (a generation for example), some individuals experience good luck-for example, living in a region that experienced an economic boom, while others experience bad luck-serious illness (their own or a family member), unplanned pregnancy, business failure, or because technological change or shifts in demand make their skills less valuable. These 'shocks' create more inequality in any given generation.

But if having high-income parents gives their sons and daughters economic advantages when they grow up, then these shocks live on even after the parents pass away. A person's father may have been rich just by good fortune, but his son and daughter will also be rich (or at least richer than they would have been) by inheritance.

Thus, in countries where intergenerational inequality is substantial, for example in the US, Italy, and the UK, high or low incomes resulting from good luck or bad luck are passed on to the next generation, and added to whatever shocks of good or bad fortune that the next generation experiences. As a result, intergenerational inequality contributes to cross-sectional inequality.

You now know some basic facts about inequalities around the world. Knowing these facts, we ask what, if anything, is wrong with economic inequality?

Exercise 19.4 How inequalities of birth persist between generations

1. Go back to the stories of Yichen, Renfu, Stephanie, and Mark and indicate all of the accidents of birth that affected their economic successes or failures.

2. Give some reasons why the intergenerational inequality and inequality between members of a population at a given moment in time are positively correlated.

Question 19.4 Choose the correct answer(s)

Figure 19.10 shows the proportion of children in earnings quantile conditional on their father's earnings quantile in the US and Denmark, respectively.

Based on this information, which of the following statements is correct?

The data provides support for the 'American Dream', a term coined in 1931 by James Truslow Adams that refers to 'a dream of social order in which each man and woman shall be able to attain to the fullest stature of which they are innately capable ... regardless of the fortuitous circumstances of birth or position' (in The Epic of America, 1931).

In the US, 7.4% of those from the poorest 20% of families managed to move up to become part of the richest 20%.

In Denmark, it is far more difficult for the richest families to preserve their status for the next generation than in the US.

The figure suggests that there is very little governments can do to reduce intergenerational transmission of economic status.

19.3 What (if anything) is wrong with inequality?

In November 2016, we asked students beginning economics at Humboldt University in Berlin, 'What is the most pressing issue that economists today should address?' Their replies are shown in the word cloud in Figure 19.12, in which the size of the word or phrase indicates the frequency with which that term was mentioned. Students in other universities around the world gave similar answers.

Perceived, ideal and actual inequalities

One of the reasons why inequality is seen as a problem is that many people think there is too much of it.

Michael Norton, a professor of business administration, and Dan Ariely, a psychologist and behavioural economist, asked a large sample of Americans how they thought the wealth of the US should be distributed: what fraction of it, for example, should go to the wealthiest 20%? They also asked them to estimate what they thought the distribution of wealth actually was.

Figure 19.13 gives the results, with the top three bars showing the distribution that different groups of respondents considered would be ideal, and the fourth bar the wealth distribution that they thought actually existed in the US. The top bar shows that Americans thought that, ideally, the richest 20% should own a little more than 30% of total wealth-some inequality was desirable, but not a lot. Now contrast this with the fourth bar ('Estimated'), which shows that they thought that the richest 20% owned about 60% of the wealth. The bottom bar shows the actual distribution. In reality, the richest fifth owns 85% of the wealth. The actual distribution is much more unequal than the public's estimate-and contrasts sharply with the lower inequality that people would like to see.

Different groups largely agree on the ideal distribution of wealth. Americans with an annual income greater than $100,000 thought that the share going to the top 20% should be slightly larger than those who earned less than $50,000 thought it should be. Not shown in the figure: Democratic Party voters wished for a more equal distribution than Republican Party voters, and women preferred more equality than did men. The differences between these groups, however, were small.

When is inequality unfair?

Although there seems to be a consensus on the ideal outcome in the US, policies that would redistribute income and wealth are controversial and debated passionately-as they are in most countries. Differences in self-interest contribute to the arguments. Richer Americans, for example, tend to oppose redistribution that favours the poor, while poorer Americans support it.

But, as the experiments in Unit 4 would lead us to expect, self-interest is just part of the explanation. People differ also because they hold different beliefs about why the poor are poor and how the rich became rich. In laboratory settings, people often express strong feelings of fairness, and give up considerable sums of money to ensure that outcomes are consistent with ideas of economic justice.

For example, Responders in the ultimatum game reject what they consider an unfair offer, preferring to receive nothing and to impose the same fate on the Proposer than to agree to being treated unfairly. Both rich and poor may think that high levels of inequality are unfair and that the government should reduce economic disparities, even if it means voting for policies that would reduce the disposable income of the voter.

In Unit 5, you read about contrasting ideas about fairness, not based on how people play in experimental games, but instead on moral principles. Procedural theories, which are ideas of fairness based on how the inequality came to be, focus not on how poor or rich someone is, but instead on why the person is poor or rich.

Christina Fong, an economist, wanted to know if people in the US think this way when it comes to their political support or opposition to policies to raise the incomes of the poor, financed by general taxation. She found that a person who thinks that hard work and risk-taking are essential to economic success is much less likely to support redistribution to the poor than one who thinks that the key to success is inheritance, being white, your connections, or who your parents are.

The results of her study are in Figure 19.14. Notice that white people who think that being white is important to getting ahead strongly support redistribution to the poor-evidently because they think that the process that determines economic success is unfair.

This suggests that for many people, the question 'how much inequality is too much?' cannot be answered unless we know why a family or person is rich or poor. Many people think it is unfair if income depends substantially on what we call an 'accident of birth' (categorical inequality)-your race, your sex, or your country. Inequalities based on hard work or taking risks are less likely to be seen as a problem.

Exercise 19.5 Estimated, ideal, and actual distributions of wealth

Use this Gini coefficient calculator to determine the Gini coefficients for wealth ownership given by the estimated, ideal, and actual distributions in Figure 19.13. Note: You will have to estimate the data visually from the chart.

Exercise 19.6 A level playing field

When people think about 'too much inequality', some think about the Gini coefficient measuring inequality at a point in time, while others are more interested in intergenerational inequality.

Use an example of two fictional families in each country to explain the combination of cross-sectional and intergenerational income inequality in Canada and Switzerland shown in Figure 19.11.

Now think about the indifference curves that you could draw in this figure that would indicate the combinations of inequality and intergenerational inequality that would be equally fair in your judgement.

1. If you cared only about the Gini coefficient and you disliked inequality, what would they look like?

2. If you cared only about the intergenerational elasticity and you disliked inequality, what would your indifference curves look like?

3. On Figure 19.11, draw indifference curves according to your personal preferences for cross-sectional and intergenerational inequality. Use your indifference curves to rank the countries from the fairest to the least fair.

19.4 How much inequality is too much (or too little)?

We know that accidents of birth matter. But even if the playing field were level (that is, accidents of birth did not matter), we would still face a question: how rich should the winners be compared to the losers?

A lens for looking at unfairness: The veil of ignorance.

To think about this question, transport yourself to a hypothetical world in which you (perhaps along with other fellow citizens) are asked to design your model society. There will be two groups or classes of equal size, one called 'richer' and the other 'poorer'. You will get to live in the society you design after you have answered the question 'how rich should the richer class be and how poor should the poorer class be?'

But there is a hitch: which class you get to be in will be determined by the flip of a coin after you have decided how unequal the society will be.

This thought experiment is what the American philosopher John Rawls, whom we encountered in Unit 5, termed choosing a social contract from behind a veil of ignorance. The 'veil of ignorance' ensures that we do not know which position we would occupy in the society we were designing.

Behind the curious device of the veil is an important concept. Rawls' fundamental idea is that justice should be impartial. It should not favour one group over another, and the veil of ignorance invites you to think this way (because you do not yet know which group you are going to be in). Rawls asked us to think about justice as if:

[N]o one knows his place in society, his class position or social status; nor does he know his fortune in the distribution of natural assets and abilities, his intelligence and strength, and the like. ( A Theory of Justice, 1971)

This does not tell us the answer to how much inequality there should be, but it does suggest a way to look at it.

Feasible inequality

Economics gives us tools for studying what combinations of the income of the rich and the poor are feasible, and how we might reason about which ones are preferable to others.

Let's try one way to answer the question of 'how rich should the richer class be and how poor should the poorer class be'. Let's say there should be no difference between the incomes of the rich and the poor. Suppose that, in this case, both classes would receive $100,000 annually (per adult). This is shown by point E (for Equality) in Figure 19.15, where the 45-degree line gives all of the points of equal income between the two classes (so there is really no meaning to 'rich' and 'poor'). The figure shows the annual income per adult of the poor and the rich on separate axes.

Would this be your choice? In this version of an ideal society, you would not run the risk of ending up poorer than others after the coin flip. But as an economist you might think that complete equality in the society would mean that there were insufficient incentives for people to work, study, and take risks innovating and investing, so that at least some inequality could actually be better for everyone.

In the figure, points between E and R show possible combinations in which the rich are richer than the poor, but where the poor also are richer than they would be under complete equality. To put it another way, from any one of these points, including point E, there is a win-win possibility: giving more income to the rich allows the poor to have more income as well.

Comparing the two points, you can see that E is Pareto inefficient because both the rich and poor are better off at R than at E. The income distribution at R is also the one at which the poor are as rich as they can possibly be in this economy, as indicated by the feasible frontier. This is the point that Rawls favoured (and why we called it point R).

Would you choose R? Notice that, above R, the frontier is very steep. This means that it's possible to make the rich much richer by making a small reduction in the income of the poor.

The red curved line passing through R and E (and the other points above R) is the frontier of the feasible set of income distributions for the economy in question. We assume that a government can adopt policies to bring about any one of these economically feasible points, but in Unit 22 we will introduce limits on the government's ability to do so, which would have the effect of shrinking the feasible set. As with all feasible frontiers, the slope is a marginal rate of transformation. In this case, the transformation is of income losses of the poor into income gains for the rich.

If the point R had been proposed, would you want to consider other points higher up on the feasible frontier? Remember, after the coin flip, you will get either the income of the rich or that of the poor with equal probability (one half), so you know that:

As long as income gains for the rich come at little expense of income losses for the poor, you would definitely do better to move above point R. If you were interested in maximizing your expected income and did not care about the degree of inequality, then you would choose point A, where the income gains of the rich are exactly offset by income losses by the poor, so the marginal rate of transformation is equal to one.

But after point A, the inequalities would become so severe that the average income would fall, and the rich would be getting a larger slice of a smaller pie. This might occur if the poor were not fed enough to work hard, or were angry enough about their condition to motivate the rich to divert some economic resources from goods and services production into protecting their wealth, which reduces total output. By looking ahead to Figure 19.30c, you will see data showing that more unequal societies (such as the US, UK, and Italy) devote more resources to workers employed in private and public security activities than do other more equal countries with similar GDP per capita.

Like the feasible set when Angela and Bruno were bargaining in Unit 5, there is a minimum level of income that the poor can get. This minimum could be set by their biological survival needs, or perhaps by the fact that if income fell below this level they would revolt. Notice that if the poor were to be even poorer than at point F, the rich would also suffer. So like point E (maximal equality), point D (minimal income of the poor) is not Pareto efficient.

In the figure we have considered the following income distributions:

E: complete equality

R: the distribution with the highest income for the poor

A: the highest average income of rich and poor

F: the maximum income of the rich

D: the distribution in which the poor are at their minimum feasible living standard

A preference for fairness

Which would you choose? Points between D and F are easy to eliminate from the running, as they are all inferior to point F for both classes. And the same goes for points between E and R. Eliminating all Pareto-inefficient distributions from consideration means that no points in the interior (inside) of the feasible set would be considered.

That leaves points between F and R. How will you choose among them? To answer this, you need to consult your indifference curves. In this case, an indifference curve gives combinations of the incomes of the two classes that you value equally.

Curves further away from the origin are preferred (more income for both groups is always better). The slope of these indifference curves is the marginal rate of substitution between income for the rich and income for the poor.

You would then maximize your utility by finding the point on the feasible frontier at which the marginal rate of transformation is equal to the marginal rate of substitution. If you wished to maximize your own expected income, then you would place an equal value on the income of the rich and the poor because you are equally likely to be one or the other.

inequality aversion

A dislike of outcomes in which some individuals receive more than others.

But you might care about the condition of the poorer class even if you were lucky enough to be assigned to the richer class in the coin flip (remember, you have to make your choice before you know your assignment). That is, you might be inequality averse, caring about your own payoffs but also disliking inequality across groups. In this case, you would have an indifference curve like the blue one shown in the figure. You would choose point B, somewhere between Rawls' ideal (the highest feasible income of the poor) and point A, the highest average income.

The familiar graph of the feasible set and a family of indifference curves helps to clarify the choices about inequality and fairness that a citizen or group of citizens may wish to make. But it does not tell us how any of the points on the feasible frontier might actually be implemented. Changing the level of inequality in a society requires altering one or more of the causes of the current state of inequality. To understand income inequality, we first have to understand the factors that determine an individual's income.

Question 19.5 Choose the correct answer(s)

Figure 19.15 shows the feasible frontier of the incomes of the rich and the poor.

Which of the following statements is correct?

19.5 Endowments, technology, and institutions

Income and endowments

In this section, we provide a framework that helps explain why different individuals receive different incomes.

endowment

The facts about an individual that may affect his or her income, such as the physical wealth a person has, either land, housing, or a portfolio of shares (stocks). Also includes level and quality of schooling, special training, the computer languages in which the individual can work, work experience in internships, citizenship, whether the individual has a visa (or green card) allowing employment in a particular labour market, the nationality and gender of the individual, and even the person's race or social class background. See also: human capital.

An individual's income depends on things that they own, or are, or have that allow them to receive income. These things affecting a person's income are called endowments and include:

human capital

The stock of knowledge, skills, behavioural attributes, and personal characteristics that determine the labour productivity or labour earnings of an individual. Investment in this through education, training, and socialization can increase the stock, and such investment is one of the sources of economic growth. Part of an individual's endowments. See also: endowment.

Their financial wealth: Their savings or stocks or bonds that they own, on which they receive interest or dividends.

The physical assets they own: For example, land or the buildings and machinery of a company on which they may receive profits or rents, and which they can use as collateral.

Their schooling and work experience, which affects their value to an employer and therefore their earnings on the labour market (sometimes termed their human capital).

Their race, gender, age, and other aspects that may affect wages, access to credit, or other exchanges.

Their citizenship and whether the individual has a visa, which determine whether they can legally work in a particular country and therefore their earnings on the labour market.

Any other attribute, or possession, or capacity that affects the income an individual will receive.

As a result, we can think of an individual's income as depending on:

their endowments

the income resulting from each item in the set of their endowments

So, for example, consider a person, Ella, whose endowment is the ability to work full time (1,750 hours) at a wage based on her skill as a medical technician (€30 per hour). She also receives a child benefit of €2,000 as an entitlement from the government for her child. Her endowment would be the following list:

ability to work 1,750 hours of labour per annum as a medical technician

the right to a child benefit to assist in caring for her child

She has been able to secure only half-time work (875 hours) so the annual income she derived from all sources is: (875 hours × €30) + (1 child grant × €2,000) = €26,250.

Now consider Kamal, who recently inherited a sum from his late father sufficient to start a small business. He was previously working as the manager of a similar small firm for €120,000 per year. Kamal's endowment is:

ability to work full time using skills and experience as a manager

ownership of the buildings, equipment, and other assets of his firm, worth €8 million

If he did not manage the firm himself, he would have to hire a full time manager with similar skills and experience, costing him €120,000. Last year, his firm's (accounting) profit was €600,000 without counting Kamal's own efforts as a manager, worth €120,000 a year. So his income is the €600,000 in profit, which we divide into the returns to his managerial efforts (€120,000) and the returns to the ownership of assets (€480,000).

By studying why people have differing endowments, and what determines the income associated with each of the endowments, we can understand income inequality.

The factors influencing individual income can be understood using the model of cause-and-effect relationships in Figure 19.16. The arrows point from a cause to an effect.

Both institutions and technologies are part of the explanation of differing endowments among individuals. Inherited wealth gave Kamal a valuable asset, while subsidized higher education helped Ella qualify as a medical technician. Both are examples of the effect of institutions on endowments.

We have seen that intergenerational inequality will be greater where inheritances are not heavily taxed and where educational policies allow the wealthy to acquire more and better education for their children. If marriage customs result in spouses having similar levels of wealth-called 'positive assortment'-this will contribute to inequalities in endowments. Elite private universities, for example, contribute to positive assortment because like exclusive social clubs, they provide meeting and matching opportunities for the sons and daughters of the wealthy. These are also examples of institutions influencing differences in endowments.

Technology matters, too. Where there are strong economies of scale such as in the technology of digital platforms, these will support the winner-take-all forms of competition that we explain in Unit 21. In this setting, a few people-the winners-will end up with substantial endowments in the form of valuable financial or real assets, while the rest end up with little.

The value of a particular endowment, say a programming skill or ownership of a 3D printer, depends on both technology and institutions, as well as on other factors, including supply and demand. The demand for Ella's skill was limited, perhaps due to cuts in health care spending, so she was unable to work full time. Next year Kamal's firm may face competition from a new competitor, making the 7.5% rate of return ($600,000/$8,000,000) that he made this year impossible. Both are examples of how institutions affect the income provided by an asset.

Technology matters, too. Being physically strong was a valuable endowment in agriculture-at least until mechanization made it less important in determining earnings. In that case a change in technology (mechanization) reduced the demand for a particular kind of skill, and so its value (relative to other skills) fell. The value of land, for example, will depend on how productive it is in growing marketable crops (technology) and whether it is zoned for commercial or residential uses (institutions).

Using the model to review inequality from previous units

In previous units, we studied how differences in endowments determined economic outcomes, including inequality. Figure 19.17 summarizes these situations, starting with the interaction in Unit 5 between Bruno, the landlord, and Angela, the farmer he employed.

Recall that how much Bruno got and the inequality between them depended on:

The endowments of the pairs of individuals in Figure 19.17 appear in the second column of the figure. In the first example, Bruno owns the land and Angela only owns her time and capacity to work. This inequality in land ownership matters because it determines who has to work for whom, and who can earn income from allowing others to work with their capital goods or their land.

Endowments matter in another way, because they change Angela's reservation option. If Angela owned land that she could work herself, then Bruno would need to pay her at least enough to ensure that she would rather work for him than work on her own land.

Recall that a change in institutions and policies can change Angela's reservation option. Before the rule of law, the institutions were such that Bruno could simply coerce her to work, and the only thing that constrained the size of the surplus he could get was the need to keep Angela healthy enough to work the next day.

The institutional change, which gave her the right to say no, improved this reservation option. Bruno had to offer Angela a deal that would make her better off working for him than not working. Angela's new 'right to say no' raised the value of her labour endowment.

In the last column of Figure 19.17 we consider the way that changes in technology affect the degree of inequality. In the row concerning the firm's owners and employees, a labour-saving technology, as we saw in Unit 16, can-at least initially-reduce the number of workers a firm needs, making employees more vulnerable to job loss and reducing the likelihood of getting another job at the same wage for those who have been fired.

Like technology, institutions and policies affect the value of endowments. In the example of Ella, the medical technician, her specialized skills are part of her endowment but their paid value (€30 per hour in the example) will depend on institutions. If gender discrimination is a common practice of employers, then her skills might be worth less. If a license is required to do this work, then the value of her skills will be greater if she is licensed. These are examples of institutions and policies affecting the value of endowments.

The credit market in Unit 10 is another example. Recall that Julia's endowment is $100 next year. What she can consume now depends on her wealth (what is in the bathtub), and that depends on the institutions and policies determining whether she can borrow, and the interest rate at which she can borrow.

If her only option is the village moneylender in Chambar or a payday lender in New York, she faces a high interest rate and her wealth (now) is much lower than $100. If she can borrow at a low interest rate, her wealth is quite close to $100. If she can't borrow at all, then there is nothing in the bathtub and her wealth now is zero.

How endowments, technology, institutions, and inequality interact over time

Endowments and the income that they provide are constantly changing as people acquire more skills or as the value of some endowment-such as a piece of land or a rental apartment-falls. Figure 19.16 illustrated the causes of economic inequality. In Figure 19.18, we illustrate inequality as a cause of changes in institutions, technology, and differences in endowments.

The arrow from economic inequality to differences in endowments in the next period captures the fact that the children of richer parents may end up with more and higher quality education, or with greater inherited wealth.

Economic inequality may also influence institutions and policies. An example we shall see in Unit 22 is that in most countries-even democracies-a wealthy person typically has more influence on what the government does than does a poor person. A greater gap between the rich and the poor could increase the political advantage of the wealthy, resulting in policies favouring those with higher incomes.

Exercise 19.7 Yichen, Renfu, Mark, and Stephanie

Consider the economic situation of Yichen, Renfu, Mark, and Stephanie, discussed at the start of this unit. Give examples of how technology, institutions, and differences in endowments explain economic inequality between these actors, and how inequality between them could change over time.

19.6 Inequality, endowments, and principal-agent relationships

Recall that the labour and credit market models in Units 9 and 10 provided the background for our macroeconomic models of the functioning of the whole economy and for the study of how shocks and policies affect economy-wide employment, incomes, and inflation. We used the Lorenz curve to summarize the effects on inequality. And in explaining the model of inequality in Figure 19.16, we used examples from the labour and credit markets.

principal-agent relationship

This relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract. Also known as: principal-agent problem.

The principal-agent models also give us a new way to study an important dimension of inequality: differences in power affect the type of choices that a person may feasibly make. Principals are in a position to exercise power over agents, but agents rarely can exercise power over principals. Here is why.

The employer (the owner or the manager who is the principal in the labour market) has the power to determine what the firm will produce, using what technology, and in which country to locate production. They also have the power to set the wage and the tasks that a worker is directed to perform, and can also fire the worker. The worker chooses how to go about her work within limits that the employer sets.

Recall that in order to motivate the worker to work hard and well, the employer sets a wage so that the employee is better off with the job than she would be without it, receiving an economic rent. The employer can fire the worker and deprive her of the employment rent she would otherwise receive. The fear of losing this rent is an important reason for the worker to carry out the employer's wishes. It is also the reason why the employer has power over the employee.

The worker could, of course, quit. But this does not make the relationship equal when it comes to power. If she is receiving an economic rent she would penalize herself by quitting, and her employer would just replace her with someone currently unemployed.

We can contrast this with the relationships among price-taking buyers and sellers at the equilibrium of a competitive market. None of these traders is in a position to demand that any other trader act in one way or another. Think about the buyer, for example, who orders the seller to make the good available at a lower price, threatening not to buy otherwise. What would the seller do? Nothing. The seller can sell as much as she wishes at the going price (remember, the demand curve facing an individual firm is flat).

A second contrast is with the interactions we studied in Unit 4 where the actions open to all parties were identical-for example, either use integrated pest management or chemical fertilizers, either learn C++ or Java.

Like the relationship between the employer and employee, the other principal-agent models we have seen reflect the unequal relationships between groups of people with differing endowments, such as landlords and tenant farmers, and borrowers and lenders.

Figure 19.19 illustrates how the credit and labour markets influence the relationships among the groups of lenders and borrowers, and employers and employees.

Starting at the upper left of the figure, wealthy individuals can use their wealth to purchase the capital goods to become employers and they can also lend to others. Among the less wealthy, there will be some successful borrowers who can as a result also become employers. Those with even less wealth cannot borrow (they are the credit market excluded that you studied in Unit 10, or can only borrow where the house provides the collateral for the mortgage), and must seek work as employees. Employers then hire employees from among the less wealthy, with some remaining unemployed (due to the workings of the labour market that you studied in Units 6, 9, and 15).

Horizontal arrows indicate a principal-agent relationship. Lenders and employers are the principals in the figure; their common red colour indicates this similarity. Agents-successful borrowers, and employees-are coloured green to distinguish them from would-be agents (credit market excluded and unemployed) who are coloured purple. You definitely do not want to be in the purple boxes. But even if you are an agent lucky enough to be in one of the green boxes, the principal can put you back in the purple box just by refusing to deal with you. This is why lenders and employers have power over borrowers and employees.

Figure 19.19 helps us understand why some people end up as principals (employers, for example) while others end up as agents (employees). If one is wealthy, one can be both a lender and an employer. There is some truth to the saying that 'people are born into their position in the economic order'. This was literally true in some economies of the past. For example, the position of the slave was perpetuated by the enslavement of their children as a matter of law.

Something similar can occur in places where wealth is inherited from parent to child. The children of employees (who inherit little wealth) are also more likely to become the next generation's workers than are the children of employers. You already saw that the children of well off parents in the US also tend to have high incomes when they become adults (Figure 19.10).

But look again at that figure: there is some mobility among the income groups even in the US and there is very little intergenerational inequality in Denmark. Becoming an employer requires that one has sufficient wealth. But inheriting wealth from a parent is not the only way, and in some countries not even the most important way to acquire wealth. The wealth necessary to become an employer may be acquired by saving. It may also be acquired by developing a great project and persuading investors called 'venture capitalists' to fund it.

We have also seen in Units 13 and 16 that there are transitions by individuals between boxes over their life-time. A younger person may initially be a borrower and then be a lender later in life; a spell of unemployment can be followed by one of employment.

Question 19.6 Choose the correct answer(s)

Which of the following statements are correct?

19.7 Putting the model to work: Explaining changes in inequality

The model presented in the previous section helps us to understand why individuals have different incomes. To understand inequality, however, we need to consider the changes across the entire income distribution. In this section, we will apply the labour market model from Unit 9, in combination with our understanding of the determinants of individuals' income, to look at the effect on inequality of:

an increase in the educational level of the workforce

a reduction in discrimination against a segment of the workforce

automation of production reducing the demand for some skills and increasing others

You may wish to review the workings of the labour market model described in Unit 9 before proceeding.

A more educated and more productive workforce

What will be the consequences if workers have acquired more schooling? We expect additional schooling to increase productivity, meaning that a unit of effort by a more educated worker produces more goods per hour using the same technology. The direct effect of additional schooling on an individual is therefore to improve their endowment of labour. Holding everything else equal, the increased productivity means that any individual can get paid a higher wage for their labour.

However, what if the entire workforce becomes more educated? This could be the result, for instance, of an increase in the compulsory schooling age. At the pre-existing real wage, the result of higher productivity will be a higher profit for the firms. This shifts the price-setting curve upwards, as shown in the left panel of Figure 19.20. With higher profits, new firms enter and existing firms hire additional workers, which reduces the unemployment rate. Lower unemployment in turn makes it easier for a dismissed worker to find a new job. It therefore increases the workers' reservation position, raising the wage. Workers both possess a better, higher-productivity endowment of labour time and enjoy better prices for their endowment.

The effects on inequality are shown in the right panel of Figure 19.20. There are now fewer unemployed workers. The segment of the Lorenz curve representing employed workers is now flatter because even though the real wage has risen, a larger fraction of the work force (85% instead of 80%) receives the same 60% of the (now increased) total output.

The line segment for the owners is unaffected because the same 10% of the population continue to receive 40% of the output; like the wages of workers, their profits are up because more is being produced. In this example, the effect of the increased education and productivity of the workforce on inequality is to reduce the Gini coefficient from 0.36 to 0.33.

A reduction in labour market segmentation

Until now we have assumed that all workers receive the same wage in a single labour market, but in reality there are many distinct labour markets. In what is termed the primary labour market, workers may be represented by trade unions, and enjoy high wages and job security. 'Job ladders' allow promotion to better paying and more secure jobs. Primary labour market jobs are frequently referred to as 'good jobs'.

Workers in the secondary labour market are on short-term contracts with limited wages and job security, and tend to be young or from populations discriminated against by race or ethnic group. In many European countries, these are called 'zero-hours contracts' because the employer does not commit to providing work for any particular number of hours. The secondary labour market is also referred to as the 'gig economy' in which freelance work or very short-term contracts are the norm, rather than permanent jobs. For any given endowment of skills, these workers will usually receive a lower income than the workers in the primary labour market. Institutions therefore benefit the workers in the primary labour market and disadvantage workers in the secondary market, increasing income inequality.

Figure 19.21 shows a Lorenz curve for an economy with labour market segmentation, with a low-wage segment and an equal number of high-wage primary segment workers. The owners are not segmented because they can easily invest their wealth in firms in either or both sectors and, as a consequence, the rate of return will be the same in both sectors. The elimination of labour market segmentation means that all workers receive the same wage, but unless this affects the relative bargaining power of workers and owners, it does not alter the share of the output going to workers as a whole. This demonstrates how institutional change can reduce inequality by aligning the wages individuals receive for their endowments.

The figure illustrates the fact that much of the inequality in modern economies is among employees (from secondary labour market workers to very highly paid professionals), and that reducing these inequalities can significantly reduce the Gini coefficient. Where trade unions have reduced labour market segmentation and narrowed the wage differentials among workers, inequality is lower. An example is the so-called solidarity wage policy introduced in Sweden, which we will discuss in Unit 22.

Automation

automation

The use of machines that are substitutes for labour.

Automation is a term used to describe new technologies that allow machines to do the work that people used to do. Technological innovations that replace labour have been an essential part of the capitalist economy since the introduction of the spinning jenny in the eighteenth century, which we described in Unit 2. As we saw in Unit 16, new technologies typically put some people out of work, while increasing the demand for the skills of other workers. We can study these effects using the Lorenz curve and the Gini coefficient derived from it.

To see how, consider a hypothetical economy in Figure 19.22, before and after it introduces machines that perform routine operations that had always been done by humans. We'll call these machines 'robots'. The solid blue Lorenz curve depicts the distribution of income between five employers and 95 workers before the introduction of the robots. Five of the workers are unemployed, and among the 90 who are employed, all receive the same wage, whether they do routine or non-routine work.

The slope of the flatter of the two upward-sloping lines is an indication of how much workers are paid relative to their productivity. We see that the 90 employed workers receive 60% of the income of the economy. So each receives 0.60/90 or two-thirds of a per cent of what the economy produces. The slope of the steeper solid line shows that five owners receive 40% of the income, so that each receives 8% (= 0.40/5) of the output of the entire economy.

To understand the short-run impact of the plan to introduce robots, think about the skill endowments of the workers. Sixty of them are doing routine jobs that were once relatively well paid, such as machine tending or mail sorting, that can now be done by robots. Others have the training to not just operate machinery, but to design, repair, and calibrate machinery, and manage its deployment.

The short-run effects depend on the kinds of work a worker does:

These two effects are shown in the new (dashed) Lorenz curve depicting the short-run effects of the new technology on workers who previously earned two-thirds of a per cent of output each. At least some of the 60 workers for whom the robots are labour-replacing lose their job. Five of them have now joined the unemployed; the machines have replaced their labour. Those who remain employed have suffered a fall in their bargaining power (because they too can be replaced). These 55 workers now receive 10% of the output of the economy, and their earnings fall to 0.18% of the total output each.

On the other hand, the 30 workers with skills that are complementary to the robots have gained. They now receive 50% of the output of the economy, or a little more than 1.67% each.

The effect of automation thus can be similar to the effect of labour market segmentation, but in the case of robots, the segregation of workers depends on whether their skills are easily substituted by machines (the losers) or instead are complementary to the machines (the gainers).

The result is that the Gini coefficient increases from 0.38 to 0.66, shown by the new Lorenz curve falling further below the perfect equality line.

An example of the effect of automation is the introduction of automatic teller machines (ATMs) by banks. Surely this would have increased unemployment among human bank tellers?

James Bessen, an economist, looked at the employment levels in the US and found that the number of bank tellers continued to rise even after the machines were installed. Rather than doing mechanical tasks, they were now providing other services such as advice to customers.

Bessen also found employment increased among bookkeepers and retail sales staff despite automation of some of their tasks, but on the other hand, technology did displace the jobs of travel agents. Automation was complementary to the skills of some bookkeepers and bank tellers, but it was a substitute for the skills of travel agents.

Listen to James Bessen talk about his book in a May 2016 episode of the EconTalk podcast.

What determines whether automation increases or decreases wages and employment? We can use an analysis similar to the one we did in Unit 16. There are two contradictory effects.

On one hand:

On the other hand:

As we saw in Unit 16, adjustment of local labour markets to labour-saving technology and competition from imports may take a very long time.

The model cannot determine whether the new Nash equilibrium in the labour market will result in a more equal distribution of income or a less equal one. Inequality among workers will be greater due to the fact that the robots created winners and losers among employees, by raising the value of some labour endowments (the engineers) and lowering the value of the labour endowments of others (the routine workers). If the level of unemployment goes back down to its pre-automation level, and if the firm's markup on costs is unaffected, then the only durable effect will be greater inequality among workers, resulting in an increase in the Gini coefficient.

A government observing the process of automation might respond with levying taxes on the enhanced profits of the owners and on the incomes of the workers with increased wages. In designing the taxes, it would need to take into account their effect on the behaviour of workers and employers. The revenue from these taxes can be used to finance:

Exercise 19.8 How automation affects employment

Return to Figures 19.6 and 19.7. Use what you have learned in this section about robots as substitutes or complements to employees' endowments to explain some of the patterns in job growth shown in these figures.

Question 19.7 Choose the correct answer(s)

Which of the following statements regarding segmented labour markets are correct?

19.8 Predistribution

redistribution policy

Taxes, monetary, and in-kind transfers of the government that result in a distribution of final income that differs from the distribution of market income. See also: predistribution policy.

predistribution policy

Government actions that affect the endowments people have and their value, including the distribution of market income and the distribution of privately held wealth. Examples include education, minimum wage, and anti-discrimination policies. See also: redistribution policy.

statutory minimum wage

A minimum level of pay laid down by law, for workers in general or of some specified type. The intention of a minimum wage is to guarantee living standards for the low-paid. Many countries, including the UK and the US, enforce this with legislation. Also known as: minimum wage.

Governments influence the degree of inequality in the economy. They do this in two ways:

Redistribution: By taxes and transfers that result in a distribution of disposable income that differs from the distribution of market income (as we saw in Figure 19.1) and by expenditure that provides public services to households.

Predistribution: By affecting the endowments that people have and the value of those endowments, leading to a change in the inequality in market income (going back to Figure 19.1 again, here governments affect the distribution of earnings before taxes and transfers or the distribution of privately held wealth).

Examples of predistribution that you have already seen include:

Other aspects of predistribution affect the basic institutional structure of the economy. By defining and enforcing the legal framework in which the employers, banks, employees, unions, borrowers, and other key economic actors interact, governments affect the distribution of market income. Using the legal system, governments can also alter which property rights are protected, for example banning slavery, legalizing unions (Units 9 and 16), establishing trading rights in emissions (Unit 18), or setting the duration of intellectual property rights and patents (Unit 21). All of these measures can change the relative bargaining power between groups as well as their reservation options, which in turn will change the distribution of income.

Finally, governments can change the set of contracts that are allowed, which alters the distribution of income. We discussed one example in Unit 5, when we saw the effect of legislation that limited the maximum hours that employees could work.

Another important example of predistribution by limiting the kinds of contracts that are allowed is a statutory minimum wage, which prohibits contracts with wages below a certain level. This affects the value of a worker's endowment of labour, but it may also affect the likelihood that the worker will be able to find a job. The costs of the minimum wage could be fewer jobs.

Arin Dube, an economist, studied differential changes in minimum wages in bordering local areas in the US. In our 'Economist in action' video he explains that he found that raising the minimum wage had a little negative impact on employment but increased the income of poor workers on average.

Ensuring high-quality early childhood education is another predistribution policy. In our 'Economist in action' video, James Heckman, a Nobel-prize-winning economist from the University of Chicago, shows how economists can learn from experiments and other data about how to level the playing field for children growing up poor.

Figure 19.23 lists a set of policies that can reduce inequality in market incomes, drawn from this and other units.

non-compete contract

A contract of employment containing a provision or agreement by which the worker cannot leave to work for a competitor. This may reduce the reservation option of the worker, lowering the wage that the employer needs to pay.

Exercise 19.9 Non-compete contracts in the labour market model

Legislation can rule out particular kinds of contracts, such as those that prohibit employees from leaving their firm to work for a competitor. The justification offered for these non-compete contracts is that workers leaving a firm may take with them industrial or trade secrets that would benefit the competition. But in the US, non-compete clauses are even included in contracts of fast-food workers. Use the labour market model to explain why employers would introduce non-compete contracts in sectors where industrial secrets are not an issue.

19.9 Explaining recent trends in inequality in market income

Can these policies or other changes help explain the trends in market income inequality? Figure 19.24 indicates three of these trends and suggests possible explanations based on the models you have learned.

To explain the reduction in between-country inequality (and the associated reduction in between-household inequality) in the world, think of the world as a single capitalist economy with a labour market that is segmented along national lines. To do this, we propose a very simple economy of the 'world' with just two 'countries': China and Europe-and-North-America. So instead of two labour market segments in the same country, there are two countries, a low-wage country and a high-wage country, a little like China and the US in Unit 18.

Just as it is not easy for workers to move up from the secondary to the primary labour market within a country, the global economy has nationally segmented labour markets because of the barriers facing workers who would like to relocate from one country to the other. And, just as in the national economy, owners are not segmented. They invest their wealth wherever it will get the highest return. As we saw in Unit 18, globalization is only partial: the world labour market is far from integrated while capital mobility is high, because money does not need a green card or a work visa to be allowed to 'work' in a country.

The process of globalization has been associated with a reduction in global labour market inequality, as the once-low wages in successful exporter countries like China begin to catch up with wages in the higher-wage economies like France. A second effect has been a vast increase in the amount of labour that is now available for employment in the global capitalist economy, and this has been associated with an increase in the share of income going to owners of firms rather than employees.

19.10 Redistribution: Taxes and transfers

Differences among economies in the extent and nature of redistribution

Our models of wages and profits try to explain market income. But that is not the amount of income that people have to spend, nor does it include things essential to our livelihoods that we do not purchase, but instead acquire as a matter of citizenship.

Disposable income, as you know, is the income a person has after paying any income taxes and social security contributions, and after receiving any government transfers. But this is not an adequate measure of a household's living standard because it does not include the effects of indirect taxes, such as value added tax, and the extent to which free or subsidized public services such as public education and health are available to households.

in-kind transfers

Public expenditure in the form of free or subsidized services for households rather than in the form of cash transfers.

These public expenditures are called in-kind transfers because they are a transfer to households in the form of free or subsidized services, rather than in the form of cash. When we take into account both indirect taxes and in-kind transfers, we arrive at a third income concept, called final income. Final income is the most complete measure of the living standard of a household. It tells us the value of all the goods and services that the household is able to consume. Figure 19.26 summarizes the relationship between these three income concepts.

Figure 19.27 shows the Gini coefficients for market income, disposable income, and final income for three large middle-income countries. In South Africa, direct taxes and transfers reduce the Gini by 0.08, from 0.77 to 0.69. Indirect taxes and public services reduce the Gini by a further 0.09 to 0.60 for final income, but it remains exceptionally unequal. Brazil had much higher inequality than Mexico in both market income and disposable income, but the Gini coefficient for final income falls to almost the same level as Mexico's, at 0.44 compared to 0.43.

The welfare state

welfare state

A set of government policies designed to provide improvements in the welfare of citizens by assisting with income smoothing (for example, unemployment benefits and pensions).

The policies that turn market income into final income are often referred to as the welfare state. These policies can be broken down into the taxation side and the expenditure side. The taxation side is any policy that collects revenue for the government, while the expenditure side is any policy that either gives money to households, or spends money on their behalf. We will see more about the composition of government expenditures in Unit 22.

In countries where redistribution reduces inequality by a lot, most of this work is done by expenditures, rather than taxation.

In the 28 countries in the European Union, the average Gini in 2015 for market income is 0.46, which taxes and transfers reduce to 0.27 for disposable income. But taxes only achieve 0.04 of that redistribution, with the remaining 0.15 driven by transfers to households. This doesn't mean that they have low tax rates, but instead it means that rich and poor pay similar shares of their incomes in taxes. On the other hand, poorer households benefit proportionally much more from expenditures.

Data on the Gini coefficient for the EU was taken from 'Effects of tax-benefit components on inequality (Gini index), 2011-2015 policies', which you can access on the Euromod statistics website.

Transfers, both in cash and in kind, have a large impact on inequality. But in most cases this is not their purpose. Most transfers are justified for other reasons, and reducing inequality is just a desirable side effect. Public education, for instance, has many justifications, including as an investment in human capital that makes the country more productive. Public health subsidies are often justified on the basis of a basic human right to life and to good health.

The welfare state is often represented and debated as a system of redistribution from the rich to the poor. But it is equally seen, and often defended, as redistribution from the lucky to the unlucky. Parts of the welfare state also redistribute from the young to the old.

social insurance

Expenditure by the government, financed by taxation, which provides protection against various economic risks (for example, loss of income due to sickness, or unemployment) and enables people to smooth incomes throughout their lifetime. See also: co-insurance.

In countries with large welfare states, much of the expenditure is on forms of social insurance, which includes assistance to poor households, but also includes public pensions, unemployment benefits, social housing, child benefits, and other expenditures that are targeted at groups that are not defined by low income. Public pensions transfer income to the old. Child benefits, like expenditures on public education, transfer income to the young (or those who care for them). Since they are paid for by taxes contributed by working adults, they are a way for society to enable people to smooth incomes throughout their lifetimes. We receive income from the government when we are very young and very old, when our incomes are low or zero, and we pay some of it back to the government when we are of working age and receiving a salary.

Similarly, public unemployment insurance is a way for people of working age to smooth their incomes in the face of the risk of unemployment. We pay while we are working, and we receive payments if we are out of work.

These forms of social insurance are not targeted specifically at poor people. But they have a large impact on inequality because most retired people and unemployed people would be very poor if they did not receive social insurance payments. In fact, in the European Union, public pensions are the policy with the greatest impact on inequality. They reduce the average Gini coefficient by 0.11, more than all other transfers combined.

Figure 19.28 shows the average household market income and disposable income in the UK in a single year, by age of the household's primary earner. Households whose primary earner is less than 25 years old have an average household market income of £24,108 and an average household disposable income of £24,735. The richest group of households is those whose primary earner is aged 40-44 years old, and incomes decline rapidly after 60-64 years, as primary earners tend to retire. Disposable income is higher than market income for the under-25s and the over-65s, when market income is at its lowest, and conversely for those aged 25-64, when household income is at its highest.

If we hypothetically imagine that there is one household at each age group, the Gini coefficient for market income would be 0.249 while for disposable income it would be 0.139-the tax and benefit system as a whole reduces inequality because it effectively redistributes from richer households to poorer households. But the figure demonstrates that much of this result could be due to redistribution from those of working age to the retired.

How economists learn from facts What is the best way to give money to the poor? Randomize and find out.

Most countries adopt some policies to raise the living standards of the poor. But what is the best way to do this? If governments would like to transfer funds to individuals or families, should it go to the very poor, or only those who are working, or only those attempting to find work? Should the transfer be given to just the poor, or everyone?

The questions are controversial, and the answers will depend on more than economics. But economists have been using experiments to illuminate at least the costs and benefits of different mechanisms.

Economists have explored the effects of simply giving away cash to the poor, without requiring that they work or make any repayment. In theory, cash payments that one receives whether or not one is employed should have little impact on labour supply. Experiments have found that cash grants are a remarkably cost-effective way of reducing poverty on many dimensions, from increasing consumption to decreasing stress levels. These results have led policymakers to rethink their programs, for example, by comparing the anti-poverty effect of a dollar spent on, say, job training programs, with the effect of simply giving that dollar away.

Some have proposed to expand the cash payment to everyone, not just the poor, in what has been called Unconditional Basic Income Grants (UBI or BIG). Some Silicon Valley groups are funding initial experiments in these more universal cash grants in Oakland, California, randomizing access to cash. Some of them believe that technology is accelerating at such a rate, reducing labour demand to such an extent that universal income grants are going to be needed to keep the vast bulk of humanity from destitute unemployment.

Another proposal in Finland randomly selects betwen 2,000 and 3,000 people to receive monthly lump-sum payments of $600 to see if basic income grants can lower poverty as well as simplify the administration of programs to help the poor. Experimenting with a policy before adopting it wholesale is allowing economists to study some of the effects of particular policies, as well as letting policymakers use evidence to decide whether or not to adopt a policy.

Progressive and regressive redistribution

progressive (policy)

An expenditure or transfer that increases the incomes of poorer households by more than richer households, in percentage terms. See also: regressive (policy).

regressive (policy)

An expenditure or transfer that increases the incomes of richer households by more than poorer households, in percentage terms. See also: progressive (policy).

distributionally neutral

When the direct effect of a tax or transfer policy (compared to what would happen in the absence of the policy) is a reduction in inequality, it is called progressive. We have just seen that expenditures are more progressive than taxes. If a policy's direct effect is a rise in inequality it is called regressive. Policies that are neither progressive nor regressive are called distributionally neutral.

For an expenditure or transfer to be progressive, it has to increase the incomes of poorer households by more than richer households, in percentage terms. This guarantees that it will reduce the Gini coefficient, and lead to a shift upwards in the Lorenz curve. Note that this policy might mean that in absolute terms (in units of currency), the richer households are receiving more.

Consider Bruno, the landlord, and Angela, the farmer. Suppose that the outcome of their bargaining is that Bruno's income is three times as large as Angela's, with Bruno receiving 3,000 pesos per year and Angela receiving 1,000. Suppose also that Angela has two children and Bruno three, all of whom go to publicly funded schools, and that the government spends 200 pesos per year per child. This means that Angela receives in-kind transfers worth 400 pesos per year and Bruno 600. For Angela this implies an increase in her final income of 40%. For Bruno, it is an increase of only 20%. So the transfer is progressive, and the Gini coefficient for final income will decline.

If it seems odd that the Gini will decline even if Bruno receives more than Angela, the explanation is that the Gini coefficient depends on relative incomes, or the ratios of incomes between households. Bruno's market income is three times Angela's market income. A policy that reduces that ratio will reduce the Gini coefficient. In the second case above, Bruno's final income was 3,600 pesos while Angela's was 1,400, which gives a ratio of 2.57 compared to 3 for market income. Even though Bruno received more in absolute terms, relative inequality between them declined, so the Gini coefficient declined.

Primary schooling is usually very progressive. A case of education expenditure that can be regressive is publicly funded university education. This is because children from richer families are much more likely to go to university. So if Bruno's and Angela's children were all of university age, but Bruno's children were attending university while Angela's were working, then public university spending would be regressive: Angela's family would receive nothing, while Bruno's would receive something.

When it comes to taxes, an analogous principle applies. A tax is progressive if richer households pay a larger share of their incomes than poorer households, and regressive if poorer households pay a larger share of their incomes than richer households. So if Bruno paid 300 pesos in tax and Angela paid 150 pesos, then the tax would be regressive, even though Bruno is paying more in absolute terms: Bruno's tax is 10% of his income while Angela's is 15% of hers. Again, this is explained by the effect on the ratio of their incomes. Their after-tax incomes of 2,700 and 850 have a ratio of 3.18, which is higher (more unequal) than the ratio of their market incomes.

Taxes and expenditures can be analysed separately, but it is important to remember that expenditures are only possible because taxes pay for them. When a government spends money on public schools that benefit some households, they are financed by taxes that are paid by all households. This is why fiscal policy is redistributive: all households both give and receive, but some give more than they receive, and vice versa for others. The net effect is to transfer income from some households to other households.

Figures 19.29a and b show the distribution of taxes and public spending in Mexico. Figure 19.29a gives the figures in absolute terms while Figure 19.29b gives them as a percentage of market income. People in the bottom decile each received total benefits worth Mex$6,682 (Mexican pesos) on average per year, compared with Mex$5,557 received by those in the top decile. As Figure 19.29b shows, when represented as a share of market income, these transfers increase the lower the decile, with the bottom decile receiving benefits worth 135% of their market income and the top decile receiving only 13%. Therefore the transfers are progressive, reducing inequality.

For taxes, on average those in the bottom decile paid Mex$594 each, compared with Mex$25,902 for those in the top decile. But since the market incomes of the top decile were 40 times as high as those of the bottom decile, for both groups these taxes represented 12% of income, indicating that taxes are neither regressive nor progressive.

Figure 19.29a shows that the net effect of taxes and transfers is that the lower the decile, the more they receive-with deciles 9 and 10 being net contributors, rather than beneficiaries. This implies that the overall fiscal system is progressive, reducing the Gini coefficient. It also means that fiscal policy effectively redistributes income from the top two deciles (mainly the top decile) to the bottom eight deciles. However, the benefits to deciles 1 through 8 are larger than the cost to deciles 9 and 10. This is partly because the Mexican government also receives revenues from the production of oil. These oil revenues are distributed, but are not re distributed-they represent income the government receives without taxing households and businesses.

Figure 19.29b shows clearly that expenditures are more progressive than taxes: while richer households tend to pay a slightly larger share of income in taxes than poorer households, public expenditures are a much larger share of income for poorer households than richer households.

Exercise 19.10 Regressive and progressive taxes

1. A poll tax is a tax where everyone pays the same absolute amount to the government. Is it progressive, regressive, or distributionally neutral?

2. A basic income is a benefit where everyone receives the same absolute amount from the government. Is it progressive, regressive, or distributionally neutral?

3. Suppose you learn that the richest 10% of people pay 30% of income tax. Does it mean that the tax system is progressive?

4. Some governments of developing countries give scholarships for some of their best students to go to graduate school abroad. If there are no eligibility restrictions, is this policy likely to be progressive or regressive? What might justify this policy?

19.11 Equality and economic performance

The success of Operation Barga in raising productivity in farming (Unit 5), of Oportunidades in Mexico, and of pensions in South Africa in raising school achievement and child health may help explain the fact that more equal countries do as well as (or better than) unequal countries, in terms of standard economic performance.

We saw in Figure 17.15 that the low levels of inequality, the enhanced power of trade unions, and the growth of pro-poor tax and transfer policies during the golden age of capitalism were associated with the most rapid growth of income per capita in modern history. Investment, too, occurred at levels not seen before, raising the capital stock at an unprecedented rate of growth.

Earlier in this unit (Figure 19.3) we showed the centuries-long U-turn of top incomes in many countries including the US and the UK. By this measure, late twentieth-century inequality had risen to levels not experienced since before the Great Depression. But this U-turn pattern is far from universal, as Figure 19.4 showed.

Most of the countries in Figure 19.4-where the U-turn towards greater inequality did not occur or was far less pronounced-are high performers. These countries achieved both rapid growth in income per capita and modest levels of inequality of disposable income, as you can see in Figure 19.30a. In this case, we measure inequality in income after taxes and transfers (disposable income) because this is the best available measure of inequality available across all countries. The conclusion from Figure 19.30a is that countries differ a lot in how equal their living standards are, and that the growth in productivity (GDP per capita) seems unrelated to the level of equality.

There have also been high and low performers among the catch-up economies. Figure 19.30b shows that South Korea and Taiwan were able to achieve high growth with relatively low inequality over the past 30 years, whereas the performance of Latin American economies along both of these dimensions was typically much worse.

Figures 19.30a and 19.30b are initially surprising because economists have often claimed that high taxes and transfers depress incentives for people to work hard and take the kinds of risk necessary for innovation to occur. Explanations of why egalitarian economies such as Japan, South Korea, and Taiwan in Asia, and Nordic and other northern European countries have done so well economically include:

High levels of cooperation and trust: An economy based on services such as the production of knowledge and care of others cannot perform well if people are entirely self-interested. Cooperation and trust are essential for much of the modern economy, but they are difficult to sustain among people paid vastly different sums of money. Societies that are more equal create more trust among citizens and therefore enjoy better economic performance.

Policies that enhance the endowments of the poor: High-quality health services and education contribute to the more productive use of an economy's resources. This is also true of policies that raise the value of the endowments of the poor, as illustrated by the land reform (Operation Barga) in West Bengal.

Less use of guard labour: The construction of secure environments for the rich, such as gated communities, and other guarding activities that protect the assets of and provide security to the wealthy divert resources that could be used for productive investment.

Figure 19.30c illustrates this last point: the US, Italy, and the UK are countries with highly unequal disposable incomes that hire three times as many guards (public and private security personnel, excluding armed forces) than do the more equal nations of Finland, Denmark, and Sweden. An unequal society may expend a lot of resources on protecting property rights and enforcing the rule of law.

Exercise 19.11 The U-turn countries

Look again at the difference between the U-turn countries in Figure 19.3, which showed a trend towards greater equality in the first three quarters of the twentieth century followed by an increase in inequality since about 1980, and the countries in Figure 19.4, in which inequality did not increase significantly, or at all.

Make a list of possible explanations as to why countries in the two groups took such different courses since 1980, making sure to check (using the Internet or other sources) that any technological or institutional changes you refer to are historically accurate.

Exercise 19.12 High and low performers

Above, we have arbitrarily drawn a line on Figure 19.30a to distinguish high from low performers. But what counts as 'high' performance depends on your preferences.

1. Sketch your indifference curves in the space given by Figure 19.30a, according to your preferences for inequality and growth. (Hint: is the slope of the indifference curve positive or negative?)

2. Use your indifference curves to rank the countries in Figure 19.30a, from the most to the least preferable.

Question 19.10 Choose the correct answer(s)

Which of the following statements is correct regarding policies on inequality?

Japan is a more equal society than the US in terms of wealth or earnings even before taxes and transfers.

Giving everyone access to education, regardless of wealth, is one way to make the human capital endowments of the rich and poor more equal.

The evidence so far suggests otherwise; the benefit of a wage increase more than offsets the cost of a possible (if any) decrease in employment by a wide margin (see the 'Economist in action' video of Arin Dube).

'Non-compete contracts' prohibit workers from leaving their firm for a competitor. This reduces their bargaining power, leading to lower wages.

19.12 Conclusion

As you have seen in this unit, income inequality among the world's households is falling fast, mostly because of the rapid increases in average income in two large and historically poor countries: China and India.

The most recent worldwide Gini coefficient for household income is 0.62. How unequal does that mean that people really are? We know that, for example, the average income of the top 1% in the world is 27 times the income of the poorest half of the people in the world.

But another way to see these differences, represented by a Gini coefficient of 0.62, is the following thought experiment. If you were to randomly pick pairs of households from all over the world and compare their income-you might get one family from Indonesia, one from Norway, one from Brazil, one from India, and two from China (that would not be a surprising outcome, likely even if you were randomly picking families)-you would find that the richer of the two families, on average, had 4.2 times the income of the poorer. The very rich are very few, so when we include them it would not change this average inequality between households.

But are we even that different? Do you think that the income earner (or earners) in the richer of the two families would on average be 4.2 times stronger, smarter, more hard-working or creative? This shows us that the economy produces inequalities, even among people who may not be very different. It rewards some with large incomes, and others with barely enough to survive.

Many of these income differences-seen as rewards for hard work, risk-taking, or creativity for example-are considered by most people to be entirely fair, or at least necessary to provide incentives for a well-working economy. Other income differences-the effects of discrimination, coercion, or accidents of birth for example, are regarded by many as unfair.

Economics can help to address the problem of unfair inequality by clarifying the causes of economic inequality and designing policies that can ensure more just outcomes, as has been done in many countries.

Concepts introduced in Unit 19

Before you move on, review these definitions:

19.13 References

Consult CORE's Fact checker for a detailed list of sources.

Acemoglu, Daron, and James A. Robinson. 2012. Why Nations Fail: The Origins of Power, Prosperity and Poverty, 1st ed. New York, NY: Crown Publishers.

Alvaredo, Facundo, Anthony B. Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. 2016. 'The World Wealth and Income Database (WID)'.

Atkinson, Anthony B., and Thomas Piketty, eds. 2007. Top Incomes over the Twentieth Century: A Contrast between Continental European and English-Speaking Countries. Oxford: Oxford University Press.

Bessen, James. 2015. Learning by Doing: The Real Connection between Innovation, Wages, and Wealth. New Haven, CT: Yale University Press.

Bowles, Samuel, and Arjun Jayadev. 2014. 'One Nation under Guard'. The New York Times. Updated 15 February 2014.

Bowles, Samuel, and Herbert Gintis. 2002. 'The Inheritance of Inequality'. Journal of Economic Perspectives 16 (3): pp. 3-30.

Clark, Gregory. 2015. The Son Also Rises: Surnames and the History of Social Mobility. Princeton, NJ: Princeton University Press.

Daly, Mary C., and Leila Bengali. 2014. 'Is It Still Worth Going to College?'. Federal Reserve Bank of San Francisco. Updated 5 May 2014.

Deaton, Angus. 2013. The Great Escape: Health, Wealth, and the Origins of Inequality. Princeton, NJ: Princeton University Press.

Diamond, Jared. 1999. Guns, Germs, and Steel: The Fates of Human Societies. New York, NY: Norton, W. W. & Company.

Dube, Arindrajit, T. William Lester, and Michael Reich. 2010. 'Minimum Wage Effects across State Borders: Estimates Using Contiguous Counties'. Review of Economics and Statistics 92 (4): pp. 945-64.

Flannery, Kent, and Joyce Marcus. 2014. The Creation of Inequality: How Our Prehistoric Ancestors Set the Stage for Monarchy, Slavery, and Empire. Cambridge, MA: Harvard University Press.

Heckman, James. 2013. Giving Kids a Fair Chance: A Strategy That Works. Cambridge, MA: MIT Press.

Jayadev, Arjun, and Samuel Bowles. 2006. 'Guard Labor'. Journal of Development Economics 79 (2): pp. 328-48.

Milanovic, Branko. 2007. Worlds Apart: Measuring International and Global Inequality. Princeton, NJ: Princeton University Press.

Milanovic, Branko. 2012. The Haves and the Have-Nots: A Brief and Idiosyncratic History of Global Inequality. New York, NY: Basic Books.

Norton, Michael I., and Dan Ariely. 2011. 'Building a Better America-One Wealth Quintile at a Time'. Perspectives on Psychological Science 6 (1): pp. 9-12.

Piketty, Thomas. 2014. Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press.

Rawls, John. (1971) 2009. A Theory of Justice. Cambridge, MA: Belknap Press of Harvard University Press.

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Economic disparities are mostly a matter of where you were born, who your parents are, and (in some countries) your gender. Well-designed policies and institutions can reduce inequalities without lowering average living standards Having declined for most of the twentieth century, inequality of income then increased in the US, the UK, India, and many other countries.

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Sustainability of Personal ICT devices 2022

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Sustainability of Personal ICT devices 2022

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Eurostat Sustainable Development Goals (SDG)

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Eurostat Sustainable Development Goals (SDG)

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The 17 Sustainable Development Goals (SDGs) and their related 169 targets, which are at the heart of the UN's 2030 Agenda for Sustainable Development, provide a new policy framework worldwide towards ending all forms of poverty, fighting inequalities and tackling climate change, while ensuring that no one is left behind.

Sustainable development objectives have been at the heart of European policy for a long time, firmly anchored in the European Treaties (Articles 3 (5) and 21 (2) of the Treaty on European Union) and mainstreamed in key cross-cutting projects, sectoral policies and initiatives. The 2030 Agenda for Sustainable Development and its 17 Sustainable Development Goals (SDGs), adopted by the United Nations (UN) in September 2015, have given a new impetus to global efforts for achieving sustainable development. The EU, in coordination with its Member States, is committed to support the implementation of the 2030 Agenda and to strive towards a sustainable future for all. The EU's answer to the 2030 Agenda is outlined in the 22 November 2016 European Commission's Communication Next steps for a sustainable European future - European action for sustainability".

Eurostat is called to regularly monitor progress towards the SDGs in an EU context. For this purpose it coordinated the development of the EU SDG indicator set and keeps it up to date. It also produces regular monitoring reports on progress towards the SDGs in an EU context.

To find out more about the SDGs in an EU context and the results of Eurostat's monitoring, please see the pages ' Key findings' and ' Indicators' in this section.

The Communication foresees regular monitoring of progress towards the SDGs in an EU context. The Eurostat publication ' Sustainable Development in the European Union - Monitoring report on progress towards the SDGs in an EU context - 2021 edition' is the most recent of these regular monitoring exercises. It looks at the aspects of the SDGs that are relevant from an EU perspective and therefore does not aim at exhaustively assessing EU progress towards the 169 targets of the 2030 Agenda. It provides a first statistical assessment of trends in relation to the SDGs in the EU during the past five years ('short-term') and, whenever data availability allows, during the past 15 years ('long-term').

The indicator trends are described on the basis of specific quantitative rules. For indicators for which quantitative EU targets exist, the progress is analysed in relation to those targets. This applies to 15 out of the 102 indicators, mainly in the areas of climate, energy consumption, education, poverty and employment. All other indicators are analysed according to the direction and speed of change. The indicator trends are presented visually in the form of arrows. The methodology applied is explained in detail in the monitoring report.

The monitoring report builds on the EU SDG indicator set. The 102 indicators (37 of which are multipurpose, i.e. are used to monitor more than one SDG) have strong links with the above-mentioned Communication and the EU policy initiatives mentioned in the accompanying Commission Staff Working Document 'Key European action supporting the 2030 Agenda and the Sustainable Development'.

The EU SDG indicator set is open to annual reviews to incorporate indicators from new data sources as well as to take into account new targets in line with the longer-term vision of the EU after 2020 and the priorities of the European Commission, such as the European Green Deal and other initiatives. In preparation of the EU SDG monitoring report 2021, the indicator set was reviewed between October 2020 and January 2021. This​ report describes the process and presents the outcome of the review. The new​​​ EU SDG indicator set 2021 is implemented on Eurostat's website together with the release of the 2021 edition of the EU SDG monitoring report. The previous versions of the indicator set are also available in Excel format: 2020, 2019, 2018 and ​​​​​​​ 2017.

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Overview - Sustainable development indicators

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The 17 Sustainable Development Goals (SDGs) and their related 169 targets, which are at the heart of the UN's 2030 Agenda for Sustainable Development, provide a new policy framework worldwide towards ending all forms of poverty, fighting inequalities and tackling climate change, while ensuring that no one is left behind.

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For more information on WID.world and its history, click here.

For more information on the network of researchers, click here.

For more information on methodology, click here.
How to read WID.world graphs?
Click here for help on how to navigate through WID.world menus and graphs.
I encounter technical problems on WID.world, what should I do?
First, accept our apologies. Second, you should delete the cache memory of your browser (generally under "settings/history/clear cache"), then close it, and try again. If this does not solve the problem, you may want to try with a different browser. And, finally, send us an email with the description of the issue, and the details of your operative system and browsers versions. Our contact mail is in the website footer, under the CONTACT US section.
What distinguishes WID.world's inequality data from the OECD, the World Bank, or other inequality data providers?
Only few institutions provide inequality estimates and those who do so (e.g. the the OECD or the World Bank data portals) rely for the most part on household surveys. One key problem with surveys, however, is that they are based upon self-reporting and are well known to underestimate top incomes and top wealth shares. In addition, surveys only cover a limited time span and make it impossible to offer a long-term perspective on inequality trends.

In contrast, WID.world combines national accounts and survey data with fiscal data sources. This allows us to release inequality estimates that are more reliable - from the bottom to the top of the distribution of income and wealth - and also that span over much longer periods.

The data series provided in WID.world should however not be seen as perfect and definitive: existing series are continuously updated and improved by WID.world fellows, following new raw data releases or conceptual and methodological improvements. All the methodological followed to construct our series can be found in country-specific papers in our methodology library or in the DINA guidelines.

Should you have further questions on the data, do not hesitate to contact us.
What distinguishes WID.world's national accounts data from the UN, the IMF, the World Bank, or other national accounts data providers?
Estimates for national accounts (such as national income and national wealth) found on WID.world and on international statistical institutions databases are generally consistent, buy can vary for several reasons.

First, we release detailed series for national wealth accounts, which usually cannot be found on other portals. Next, we include corrections for offshore wealth and offshore capital income, so that our series on foreign capital income inflows and outflows are consistent at the global level (e.g. they sum to zero), which is typically not the case in existing databases.

Finally, reliable series for the consumption of fixed capital (capital depreciation) estimates are not readily available for a large number of countries, so we combine various sources and develop new methods to derive consistent global series.

As a consequence, we are able to offer consistent global series on national income - i.e. GDP minus consumption of fixed capital, plus net foreign income - which do not exist elsewhere.

WID.world uses 2011 Purchasing Power Parity round for international comparisons. It should also be noted that default monetary values for Eurozone countries are displayed in PPP Euros and are thus different from Market exchange rate Euros. A Eurozone country with high relative prices will have a lower PPP Euro average income values. Market exchange rates values can be obtained in our custom menus.

All these methodological choices can explain slightly different values between WID.world and other data portals. They are described in the Metadata associated to each variable and in the associated methodological documents. See in particular the " World National Accounts Series Methodology " ( here) and the " Distributional National Accounts Guidelines " ( there).

In addition, it should be noted that there are specific countries such as China where there is substantial controversy about price deflators and aggregate real growth. In such cases we review all existing series and attempt to combine them in the most sensible manner. This is fully explained in the country-specific papers.

Should you have further questions on the data, do not hesitate to contact us.
There are already many on line economic data portals, why using WID.world?
Over the past decades, the increase in economic inequalities was largely driven by a rise in income and wealth accruing to the top of the distribution. However, household surveys, the data sources traditionally used to observe these dynamics, do not capture these evolution very well. They provide useful information and cover a lot of countries but do not inform adequately on income and wealth levels of the richest individuals.

WID.world overcomes this limitation by combining different data sources: national accounts, survey data, fiscal data, and wealth rankings. By doing so, it becomes possible to track very precisely the evolution of all income or wealth levels, from the bottom to the top. The key novelty of the WID.world project is to use such data in a systematic manner, allowing comparisons between countries and over long time periods.

For more information on what you will find (and will not find) on WID.world, click here.
What is the meaning of the economic concepts used on WID.world?
We try our best to use economic concepts which are consistent with national accounting (i.e. the system used for measuring the economic activity of a nation) and that can also make sense for the general public. On each graph, users can click on the "?" icon and will find the definition of the concepts at stake.

Users can also use our quick-search glossary to find the definition they want.
How is WID.world funded?
WID.world is entirely funded by public, non-profit actors and personal donations.

For more information on our funders, click here.

If you wish to support us, please click on the DONATE button at the bottom of the funding page.

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For more information on WID.world and its history, click here. For more information on the network of researchers, click here. For more information on methodology, click here. How to read WID.world graphs? Click here for help on how to navigate through WID.world menus and graphs. I encounter technical problems on WID.world, what should I do?

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Economic disparities are mostly a matter of where you were born, who your parents are, and (in some countries) your gender. Well-designed policies and institutions can reduce inequalities without lowering average living standards

Having declined for most of the twentieth century, inequality of income then increased in the US, the UK, India, and many other countries.

Nonetheless, because of the rapid economic growth of China and India, countries with very large populations, income inequality among all people in the world has declined since the end of the twentieth century.

Discrimination based on race, gender, or religion, and other forms of unequal opportunity mean that otherwise identical people will have different incomes and economic opportunities, contributing to inequality.

Income disparities among people are due to what they own (for example, a piece of land), are (male or female), or have (particular skills) that enable them to receive income.

The institutions and policies in force in a society and the technologies used in production influence these determinants of income.

Some inequalities provide incentives to study and work hard, and to take the risks associated with innovation and investment.

But inequalities also restrict economic opportunities of the less well off and may also result in a more conflict-ridden society and impose costs, impairing economic performance.

Well-designed and implemented government policies can limit unfair economic inequality while raising average living standards, as has been done in many countries.

It is 1975. Renfu is the child of a local Communist Party leader. In 10 years, he will attend Tsinghua University, an elite engineering university in Beijing, and will join the Communist Party himself. In 20 years, he will run a state-owned enterprise. In 30 years, he will be CEO of the company after it is privatized, and be highly ranked within the Party.

However, Yichen, whose parents have no party connections, will not go to university, but instead work the land alongside her parents until she is 16, and then work at a state-owned enterprise making car parts for export to the US and Europe. When she is 30 years old, she will take a job in the new Motorola factory opening in nearby Tianjin, paying double her current wage. She will not be able to migrate legally to Tianjin and leaves her daughter behind with her parents.

Yichen and Renfu are hypothetical people. We could have inserted a disclaimer: 'All characters appearing in this work are fictitious...' But that would not be entirely true-they illustrate the divergent histories of real people alive today.

Let's also consider two other hypothetical people living in the US, also in 1975. Mark and Stephanie, both 17, live in Gary, Indiana. Mark is about to finish high school and start working in the local unionized steel mill with his father, where the pay is good and he doesn't have to spend four years in further education before earning a wage.

In the 1981 recession, Mark will lose his job. He will try to use his mechanical ability to open a car parts business. With little wealth of his own to post as collateral, he will not be able to obtain a bank loan, so he will move south to another factory. This one is non-unionized, and he will make less money than he did in Gary. In 2008, during the recession, his factory will replace him with a KUKA Robotics Corporation Titan industrial robot.

Stephanie, both of whose parents are doctors, decides she will attend Indiana University Bloomington, majoring in psychology. Afterwards she will work for a large financial corporation in Chicago and, after a series of promotions, becomes a vice-president for human resources. She will invest her savings in the stock market, which yields an average return of more than 10% for many years, and will benefit from government tax cuts that favour high earners.

These four people had very different life outcomes. Is there anything wrong with that? Each of the four made good choices knowing what they could have known at the time, everybody worked hard, and yet they had very different lives. We might say that they simply drew different hands in the card game of life.

Their parents are an important difference in the hands that they drew. This starts with the fact that Yichen and Renfu were born in China, and Mark and Stephanie in the US. The parents of the two in China were likely to be equally poor, although Communist Party members enjoyed a higher level of social prestige and education. The gap in wealth between the two sets of American parents would probably have been larger. If Mark was black the gap would be greater than if he was white, but his family would still have been far better off in material terms than both the Chinese families.

In 2017, the children of Stephanie and Renfu, who have been relatively successful in each country, will have access to a variety of opportunities not available to the children of Yichen and Mark. In China, Renfu's children will attend better schools and have better job prospects because of their father's connections. With luck, they may attend a US university, gain valuable work experience in the university-trained, English-speaking global labour market, and return to China with salaries many times those of the average Chinese citizen.

Yichen's daughter will not obtain a high-quality primary or secondary education. This is because the hukou restrictions mean she must go to school in Yichen's rural home district and not in Tianjin, where her mother works. Nevertheless, most likely she will be better off over her lifetime than her parents, and will certainly be better off than her grandparents.

In the US, Stephanie's children will attend either a public school in her expensive neighbourhood, well funded by local property taxes, or an expensive private school. They will get early access to a much larger vocabulary, form lifelong friendships with other kids from their privileged background, and engage in a variety of interesting extracurricular experiences that help their educational performance and will help them get admission to elite universities. This will translate into average lifetime earnings of close to $800,000 greater than the earnings of those whose education finishes at high school level.

Mark's children will have to deal with poorly funded public schools, the absence of union jobs, a minimum wage that will be worth less in real terms than it was in their parents' generation, and changes in technology and trade that will amplify the effects of these problems. The life trajectories of these four people illustrate just a few of the global changes in the distribution of income that have occurred in the past 40 years.

Inequality exists across many dimensions, including income, wealth, education, health, and other opportunities. In this unit, we will focus primarily on inequalities in wealth and income, both because they have been studied extensively by economists and because they are strongly related to other forms of inequality. We begin with three sets of facts:

We then ask why inequality is widely seen as a problem, and provide a way to approach the question of whether there is too much (or too little) inequality. We present a model of the causes of economic inequality in order to understand how public policies and other changes can alter the degree of economic inequality. And we then use this model to explain both recent changes in the levels of economic inequality in a number of countries, and the effects of government policies on the degree of inequality.

Exercise 19.1 Income variation across and within countries

In Unit 1, Figure 1.2 showed the distribution of income across and within countries in 2014. The height of each bar in the chart varies along two axes. The first axis of variation, from left to right of the figure, is a ranking of countries according to gross domestic income per capita from the poorest on the left (Liberia), to the richest on the right (Singapore). The second axis, from the front to the back of the figure, shows the distribution of income from poor to rich within each country.

You can find an interactive version of this figure at https://tinyco.re/7434364.

Go back over the stories of Mark, Renfu, Stefanie, and Yichen and make your guess about which decile fits each of the fictional characters. Briefly justify your choice.

19.1 Inequality across the world and over time

As you know from Unit 5, we can use Lorenz curves to estimate Gini coefficients, which measure the degree of inequality in wealth, income, earnings (income from work in the form of salaries and wages), years of schooling, and other indicators of economic or social success.

Wealth, earnings, market income and disposable income

Figure 19.1 shows data on three dimensions of inequality (wealth, earnings, and disposable income) in three economies. Recall that wealth is the value of the assets owned by a household (net of their debts). Earnings are income from labour, including from wages, salaries, and self-employment. Market income is the sum of:

all income received as earnings

all income received from business owned by the household or from investments

Finally, disposable income is the income that a family can spend

after paying taxes

after receiving any monetary transfers from the government such as unemployment benefit and pensions

Two things stand out in Figure 19.1:

Income inequalities over time and among countries

Another way to measure inequality focuses on the very rich, providing an answer to the question: what fraction of total income or wealth belongs to the richest 1% or 10% of the population? This indicator has the advantage that it can be measured over hundreds of years, because the very rich have long been required to pay taxes, and hence we have reasonably good information on their incomes and wealth. Figure 19.2 shows the fraction of all wealth held by the richest 1%, for all countries on which long-run data is available.

There appear to be three distinct periods: the eighteenth and nineteenth centuries up to about 1910 show increasing wealth inequality (excepting Norway and Denmark), the twentieth century until 1980 shows decreasing wealth inequality, and the period since shows a modest increase in wealth inequality.

Figure 19.3 presents similar data for the share of income before taxes and transfers (rather than wealth) received by the top 1% of income earners. As in Figure 19.2 there are cross-country differences. For example, in recent years the US is much more unequal than China, India, or the UK. But there are also common trends, similar to the second and third periods in the distribution of wealth: a trend towards less inequality in much of the first three quarters of the twentieth century, followed by an increase in inequality since about 1980.

Explore the top incomes in countries that you are interested in the World Wealth and Income Database.

But this sharp U-turn towards greater inequality did not occur in all countries, including most of the major economies of the continent of Europe. These are shown in Figure 19.4.

Looking at Figures 19.2 to 19.4, one can see that:

We used data created by Thomas Piketty and his collaborators to create Figures 19.3 and 19.4. He is an economist and author of the bestselling economics book Capital in the Twenty-First Century. In our 'Economist in action' video, he examines economic inequality from the French Revolution to today, and explains why careful study of the facts is essential.

Inequalities between and within nations

At the beginning of Unit 1 you read that prior to the emergence of capitalism, the income a daughter or a son received depended on where their parents were on the economic ladder. It mattered much less in which part of the world the son or daughter was born.

The economic take-off of the first capitalist economies changed this.

The 'great divergence' in Unit 1 resulted because the kink in the hockey stick for per capita income came early for some countries (Britain, Italy, and Japan in Figure 1.1a), later for others (China and India), and has not yet occurred for others (Nigeria and Argentina) (see also Figure 1.11). The result of the uneven timing of the capitalist revolution around the world was a widening of inequalities among the people of the world, which occurred over the nineteenth and twentieth centuries until very recently. Even the poor in North America and Europe became richer than the rich elsewhere.

How do we measure global inequality? Think about the Lorenz curve constructed by lining up all the individuals in the world from lowest to highest income, irrespective of the country people live in. You know from Figure 1.2 that the poorest 20%-the part of the Lorenz curve extending from zero to 0.20 on the horizontal axis-would be very flat: this would represent most of the populations of Liberia and Nigeria, and middle and lower income people in Indonesia and India for example. If we construct the entire Lorenz curve, we can calculate the Gini coefficient for the whole world. This is shown for market income in Figure 19.5. For example, in 2003 the worldwide Gini coefficient was 0.69. We can see that inequality among the world's individuals is high but has fallen very recently.

The other series in Figure 19.5 (the red line) presents global inequality in a different way. It focuses on the income differences between countries. Imagine that everyone in each country earned the average income for that country. In this thought experiment, everyone in the UK would earn exactly the UK's average income, whereas everyone in China would earn exactly the Chinese average income. What would income inequality look like in this hypothetical example?

The red line shows the result of performing this calculation. In our thought experiment, the only source of inequality in the world would be inequality across countries. Inequality is reduced, but substantial inequalities still exist due to the vast differences in income between countries.

You can see that the Gini coefficient for all individuals in the world in 1950 (the beginning of the blue line) was 0.71, and this number would have been 0.64 had there been perfect equality within each country (the red line). As a result, we see that 90% of global inequality in income is accounted for by our measure of inequality between countries (that is because 0.64/0.71 = 0.9, or 90%).

The figure also shows that between-country inequality has been falling rapidly: by 2018, 74% of global inequality was between-country inequality (0.45/0.61 = 0.74).

The most recent Gini coefficient for the whole world is 0.62. You know that this is closer to 1 (one person has all the income in the world) than to 0 (no income differences in the world). But how much inequality does this really indicate? To see how to interpret the Gini coefficient, read the Einstein: 'The Gini Coefficient and worldwide income differences', which is at the end of this section.

Figure 19.5 has three main messages for us:

A glimpse into the future of the rich economies: The missing middle?

The increased inequality that has occurred within many developed countries has been associated with a changing distribution of jobs. Low-paying jobs and high-paying jobs have increased in number while middle-income jobs have become scarcer. The result-more jobs at the top and the bottom of the economic ladder, and fewer on the middle rungs-has been termed 'the missing middle'.

The data in Figure 19.6 illustrate both trends for the US economy. We have used the US economy as an illustration because of the quality of the available data, but similar trends are evident in other high-income countries.

Figure 19.6 arranges jobs from the highest paid (in hourly wages) at the top to the lowest paid jobs at the bottom, and estimates growth or contraction of employment on the horizontal axis.

Notice these things about the data:

The missing middle: Both high-wage and (especially) low-wage occupations are adding many jobs, but employment gains among the occupations with wages in between are more limited.

Jobs replace work once done by family members: The biggest increases are in human services, most of them in health-related professions. These growing occupations substitute for work once done primarily by family members, such as personal care aides and home health care aides.

Machines do routine work: Digitalization reduces the demand for jobs that involve routine tasks, such as postal mail sorters and machine operators. The tasks that machines are not replacing tend to be either well paid (personal financial advisors, nurse practitioners) or poorly paid, such as those taking care of the elderly at home.

High-wage job gainers work with information technologies: Growing occupations with high wages (outside human services) such as operations researchers, statisticians, and web developers are those in which digital information processing has greatly increased the productivity of workers with the right kinds of skills.

Workers with average wages are the losers: Occupations with job losses tend to have near-average wages or less.

Figure 19.6 only showed occupations for which gains or losses are projected to be at least 20% of their 2014 level and change by at least 10,000 employees. But as Figure 19.7 shows, this pattern holds when we look at all jobs in the US economy. The projected trends shown in Figures 19.6 and 19.7 have been underway in the US since at least the 1970s.

Exercise 19.2 Inequalities among your classmates

1. Using this Gini coefficient calculator, calculate the degree of inequality of height among your classmates.

2. Why is this Gini coefficient so much smaller than it was for wealth in Figure 19.1?

3. Now use the calculator to compute the Gini coefficient for another measure (for example, age, weight, commuting time to university, number of siblings, or grade in the last exam).

4. Explain any differences between this Gini coefficient and that for wealth.

Question 19.1 Choose the correct answer(s)

Figure 19.1 shows the inequality in wealth, earnings, and disposable income in the US, Sweden, and Japan using the Gini coefficient.

Based on this information, which of the following statements are correct?

Question 19.2 Choose the correct answer(s)

In Thomas Piketty's 'Economist in action' video, which of the following were NOT among the reasons that Piketty gave for the fall in the incomes of the very rich during the twentieth century?

Question 19.3 Choose the correct answer(s)

Figure 19.6 is a scatterplot of occupations for the US economy, with the 2015 mean hourly wages on the vertical axis and the 2014-24 projected job growth on the horizontal axis:

Based on this information, which of the following statements is correct?

Einstein The Gini coefficient and worldwide income differences

In Unit 5 you learned that the Gini coefficient is a measure of inequality that is defined as half of the relative mean differences in incomes between all pairs of people in a population.

Recall that the mean difference in incomes among all pairs in the population which we denote as Δ can be expressed as the income of the richer of the pair ( y r) minus the income of the poorer of the pair ( y p) summed over all of the pairs in the population, and then divided by the number of pairs in the population ( n). The relative mean difference is this quantity divided by mean income, y.

So half of the relative mean difference is:

By rearranging this equation, you can see that the average difference between the two paired people will be the mean income times twice the Gini coefficient:

But there is a more interesting interpretation of the Gini coefficient. If we have drawn all possible pairs from the world's population, the mean income in the world () will be:

where we defined and are the average incomes of the richer and the poorer of each of the pairs, respectively. So we can now rewrite the expression for the Gini coefficient in terms of and :

By rearranging and dividing through by , we have:

Using this final expression, if the Gini coefficient for the world is 0.62, then:

This says that if the Gini coefficient is 0.62, then across all of the pairs in the population or across a large random sample of the population, the better off of the two is on average 4.26 times richer than the less well off.

Exercise 19.3 Another way to interpret Gini coefficients

Use Figure 5.16 to estimate the Gini coefficient for disposable income in Denmark and South Africa. In explaining the difference in income inequality between these two countries, you could use the information in the Gini as follows: if two people are chosen at random from the population of the country, what is the average ratio of the richer person's income to that of the poorer person's? To allow you to translate data on the Gini coefficient into this ratio, use the formula in the Einstein to construct a table of the richer/poorer ratio for Gini coefficients ranging from 0.0 to 0.9 (in increments of 0.1). Graph your results. Explain the difference in inequality between Denmark and South Africa using your results. What does the formula imply if the Gini coefficient is equal to 1?

19.2. Accidents of birth: Another lens to study inequality

Much of the inequality in the world today can be traced to differences among people in things over which they have virtually no control, such as their race, sex, nation, or parents. We call these differences 'accidents of birth'.

To see how important accidents of birth can be, try the following thought experiment. Go back to Figure 1.2. Suppose that all you care about is income, and you can choose either:

the income decile you are in, but the country you are born in will be decided by chance

the country you are born in, but the decile you are in within the country will be decided by chance

Did you choose option 1 (the decile) or option 2 (the country)?

If you chose option 1, you would of course choose to be in the top decile, so you would be somewhere at the back of Figure 1.2. But where? You would have an equal chance of being born in Nigeria on the left-hand side or in the UK on the right-hand side.

If you chose option 2, you could select one of countries at the right-hand end with the highest average income. You are as likely to be in the lowest decile, at the front of the figure, as in the highest decile, at the back.

One's citizenship is one of the great accidents of birth affecting income. Passports and borders limit the economic opportunities people from different countries face. People with the same education, capacities, and ambition but born on different sides of a national border face very different life chances, whether that is the border between Mexico and the US, The People's Democratic Republic of Korea (North Korea) and South Korea, or the Mediterranean Sea that divides North Africa from Europe. Even where migration is allowed, migrants are often denied access to political and labour rights, as in the Gulf States and some East Asian countries.

Gender and other forms of categorical inequality

Inequalities based on accidents of birth also exist within countries:

categorical inequality

Inequality between particular social groups (identified, for instance, by a category such as race, nation, caste, gender or religion). Also known as: group inequality.

Inequalities based on one's ethnic identity or caste are examples of categorical inequality (also known as group inequality), meaning economic differences among people who are treated as being in different social categories as defined by more powerful social classes. The Indian castes are categories, as are those of 'African', 'White', 'Coloured' and 'Asian' in South Africa. Categorical inequalities are for the most part based on accidents of birth, because one is born into membership in one of the categories, and switching category is typically difficult if not impossible.

To understand how easily segregation by race or some other categorical characteristic arises, take two minutes to play the online game The Parable of the Polygons.

The most common form of categorical inequality is that between men and women. There are many economic differences between men and women on average. This is a bit puzzling because other than differing biological roles in reproduction, men and women are so similar: similar parents, similar schools (in most countries), similar genetic inheritance on matters affecting intellectual skills and so on. But it is clear that the economy treats men and women differently. This is much more true in some countries than in others, but it is true for all countries.

Income disparities between men and women among otherwise similar individuals are one measure of this inequality. Figure 19.8 shows the expected lifetime earnings (labour income) of men and women in the US, who work full time from the time they leave school until retirement. As a result, any differences in the figure are not due to women having more time out of the labour force (on average) because of child rearing.

Because the quality of schooling does not differ between males and females on average (and girls tend to do as well on most tests), the gender differences in pay are not due to differences in cognitive ability or quality of schooling. Yet for every level of schooling, women can expect to earn much less than men.

The figure also shows, however, that additional schooling contributes to higher lifetime incomes, and that those women who complete university (a bachelor's degree) can expect to earn much more than men who ended their schooling after secondary school.

In many parts of the world girls receive considerably less schooling than boys, but as Figure 19.9 shows, girls go to school for the same number of years on average as boys in both the US and France, and longer in Brazil. Countries in which women have historically suffered extraordinary social and economic disadvantages, such as China and Indonesia, have virtually eliminated the gender gap in years of schooling, and India, though far behind, is rapidly closing it.

Intergenerational inequality

In addition to categorical differences such as nation, gender, race, or ethnic group, a second source of economic inequality within a nation is inherited. You may be rich or poor simply because your parents were rich or poor.

Two hundred years ago, in most countries it was taken for granted that somebody would expect a life of poverty simply because her parents had been poor, or that someone else would inherit the ownership of his father's company and social status, without having to prove that he was the best person for the job. The inheritance of inequality from one generation to the next seemed to be part of the natural order of things.

But this has changed with the spread of public education and, in many countries, with the decline in discrimination against poor people due to their race, religion, or simply their humble origins. In some countries, the economic status of one's parents matters a great deal for the economic success of their children; in other countries, differences among parents are only weakly transmitted to their offspring.

The expression intergenerational transmission of economic differences refers to the processes by which the economic status of the adult sons and daughters comes to resemble the economic status of the parents. The transmission process takes many forms:

Children inherit the wealth of their parents.

The genetic makeup of the children is similar to the parents.

Through parental influence in child rearing, parents and children tend to share similar preferences, social norms, and knowledge, skills and social connections acquired outside formal schooling.

intergenerational inequality

The extent to which differences in parental generations are passed on to the next generation, as measured by the intergenerational elasticity or the intergenerational correlation. See also: intergenerational elasticity, intergenerational mobility, intergenerational transmission of economic differences.

Intergenerational inequality occurs where these processes result in similarity between the economic status of parents and their children: the children of the well off become rich themselves, while the children of the less well off stay poor.

Economists and sociologists measure intergenerational inequality by ranking parents by their incomes or wealth, and then looking at what income or wealth their kids end up with when they become adults. They confirm that there is substantial intergenerational inequality. Kids whose parents had a high income are likely to grow up to have high incomes themselves, and kids from low-income families are likely to have low incomes as adults.

This is what we see in Figure 19.10, which gives measures of the intergenerational inequality of men in the US (left panel) and Denmark (the right panel), based on their labour earnings (wages or salaries). The tall bar on the left in the US panel means that among those whose fathers were in the bottom fifth of the earnings distribution, 40% were themselves in the poorest fifth, while 7% ended up in the top fifth of the earnings distribution. By contrast, 36% of those born to the richest fifth were themselves in the richest fifth-the tall purple bar on the right.

One of the reasons that children of the rich tend to be richer than the children of the poor is the financial support that rich parents give to their children, both during the parents' lifetimes and at death in the form of inheritances. The data in Figure 19.10, however, is based on labour earnings, not inherited wealth. The earnings of parents and their children appear to be similar in the US, partly because children of well off parents receive more, higher-quality, schooling. They also benefit from the networks and connections of their parents, which improve access to the labour market.

The data from Denmark in the right panel suggests a more level playing field. Only 25% of those born to parents in the poorest fifth of the population end up in the poorest fifth themselves, compared to 40% in the US. This suggests that those born to relatively poor parents are less disadvantaged in Denmark. Similarly, 33% of those born to parents in the richest fifth end up in the richest fifth themselves, compared to 36% in the US. Based on this data, we would conclude that intergenerational inequality is lower in Denmark than in the US, though it still does not appear to be a completely level playing field.

intergenerational elasticity

When comparing parents and grown offspring, the percentage difference in the second generation's status that is associated with a 1% difference in the adult generation's status. See also: intergenerational inequality, intergenerational mobility, intergenerational transmission of economic differences.

A measure that can summarize the overall rate of intergenerational inequality in a society is the intergenerational elasticity of income or wealth. To see what this measures, consider two pairs of fathers and children. The father in the first pair is richer than the father in the second. The intergenerational elasticity measures how much richer the child of the well off father will be than the child of the poorer father. An elasticity of 0.5, for example, means that if one father is 10% richer, then his child, when grown up, will be on average 5% richer than the other child. The higher the intergenerational elasticity, the greater the degree of intergenerational transmission of economic status and the greater the level of intergenerational inequality. In a society with a high intergenerational elasticity, intergenerational mobility is low.

The term intergenerational elasticity has nothing to do with the usual meaning of the word elastic. But, like the price elasticity of demand for a good, it concerns the percentage change in something that is associated with a percentage change in something else.

What is the relationship between a measure of intergenerational inequality such as the intergenerational elasticity and the extent of inequality among the members of a population at a given point in time? You can think of many reasons why the two would go together.

Figure 19.11 presents evidence on the relationship between intergenerational elasticity for earnings and earnings inequality at a particular time. We refer to earnings inequality at a particular time, which we measure using the Gini coefficient for income, as cross-sectional inequality. Note that we do not include the effects of taxes and government transfers in Figure 19.11 when we measure both income inequality and intergenerational transmission of earnings, because we are interested in the movements of these two dimensions of inequality that are independent of government policy.

The figure shows that for the countries considered, inequality in earnings at any particular point in time tends to be higher when intergenerational inequality is high. The US, UK, and Italy are examples of countries that have both high cross-sectional inequality and high intergenerational inequality. In other countries (Norway, Denmark, Finland) both intergenerational inequality and cross-sectional inequality are quite limited. But some countries differ according to which type of inequality is most pronounced. Compare, for example, Canada and Switzerland.

Does cross-sectional inequality cause intergenerational inequality, or the other way around, or both, or neither? We know that societies with a strong culture of fairness and equal treatment, such as Denmark, adopt policies to reduce inequality between people at a given moment, including offering generous benefits to unemployed and retired individuals through the welfare state. At the same time, they also attempt to limit intergenerational inequality by providing equal opportunities for high-quality education, and through other policies that would reduce intergenerational transmission of economic status. This is part of the explanation of the contrast between Denmark and the US in Figure 19.10.

Another likely source of the correlation in Figure 19.11 is that in any period (a generation for example), some individuals experience good luck-for example, living in a region that experienced an economic boom, while others experience bad luck-serious illness (their own or a family member), unplanned pregnancy, business failure, or because technological change or shifts in demand make their skills less valuable. These 'shocks' create more inequality in any given generation.

But if having high-income parents gives their sons and daughters economic advantages when they grow up, then these shocks live on even after the parents pass away. A person's father may have been rich just by good fortune, but his son and daughter will also be rich (or at least richer than they would have been) by inheritance.

Thus, in countries where intergenerational inequality is substantial, for example in the US, Italy, and the UK, high or low incomes resulting from good luck or bad luck are passed on to the next generation, and added to whatever shocks of good or bad fortune that the next generation experiences. As a result, intergenerational inequality contributes to cross-sectional inequality.

You now know some basic facts about inequalities around the world. Knowing these facts, we ask what, if anything, is wrong with economic inequality?

Exercise 19.4 How inequalities of birth persist between generations

1. Go back to the stories of Yichen, Renfu, Stephanie, and Mark and indicate all of the accidents of birth that affected their economic successes or failures.

2. Give some reasons why the intergenerational inequality and inequality between members of a population at a given moment in time are positively correlated.

Question 19.4 Choose the correct answer(s)

Figure 19.10 shows the proportion of children in earnings quantile conditional on their father's earnings quantile in the US and Denmark, respectively.

Based on this information, which of the following statements is correct?

The data provides support for the 'American Dream', a term coined in 1931 by James Truslow Adams that refers to 'a dream of social order in which each man and woman shall be able to attain to the fullest stature of which they are innately capable ... regardless of the fortuitous circumstances of birth or position' (in The Epic of America, 1931).

In the US, 7.4% of those from the poorest 20% of families managed to move up to become part of the richest 20%.

In Denmark, it is far more difficult for the richest families to preserve their status for the next generation than in the US.

The figure suggests that there is very little governments can do to reduce intergenerational transmission of economic status.

19.3 What (if anything) is wrong with inequality?

In November 2016, we asked students beginning economics at Humboldt University in Berlin, 'What is the most pressing issue that economists today should address?' Their replies are shown in the word cloud in Figure 19.12, in which the size of the word or phrase indicates the frequency with which that term was mentioned. Students in other universities around the world gave similar answers.

Perceived, ideal and actual inequalities

One of the reasons why inequality is seen as a problem is that many people think there is too much of it.

Michael Norton, a professor of business administration, and Dan Ariely, a psychologist and behavioural economist, asked a large sample of Americans how they thought the wealth of the US should be distributed: what fraction of it, for example, should go to the wealthiest 20%? They also asked them to estimate what they thought the distribution of wealth actually was.

Figure 19.13 gives the results, with the top three bars showing the distribution that different groups of respondents considered would be ideal, and the fourth bar the wealth distribution that they thought actually existed in the US. The top bar shows that Americans thought that, ideally, the richest 20% should own a little more than 30% of total wealth-some inequality was desirable, but not a lot. Now contrast this with the fourth bar ('Estimated'), which shows that they thought that the richest 20% owned about 60% of the wealth. The bottom bar shows the actual distribution. In reality, the richest fifth owns 85% of the wealth. The actual distribution is much more unequal than the public's estimate-and contrasts sharply with the lower inequality that people would like to see.

Different groups largely agree on the ideal distribution of wealth. Americans with an annual income greater than $100,000 thought that the share going to the top 20% should be slightly larger than those who earned less than $50,000 thought it should be. Not shown in the figure: Democratic Party voters wished for a more equal distribution than Republican Party voters, and women preferred more equality than did men. The differences between these groups, however, were small.

When is inequality unfair?

Although there seems to be a consensus on the ideal outcome in the US, policies that would redistribute income and wealth are controversial and debated passionately-as they are in most countries. Differences in self-interest contribute to the arguments. Richer Americans, for example, tend to oppose redistribution that favours the poor, while poorer Americans support it.

But, as the experiments in Unit 4 would lead us to expect, self-interest is just part of the explanation. People differ also because they hold different beliefs about why the poor are poor and how the rich became rich. In laboratory settings, people often express strong feelings of fairness, and give up considerable sums of money to ensure that outcomes are consistent with ideas of economic justice.

For example, Responders in the ultimatum game reject what they consider an unfair offer, preferring to receive nothing and to impose the same fate on the Proposer than to agree to being treated unfairly. Both rich and poor may think that high levels of inequality are unfair and that the government should reduce economic disparities, even if it means voting for policies that would reduce the disposable income of the voter.

In Unit 5, you read about contrasting ideas about fairness, not based on how people play in experimental games, but instead on moral principles. Procedural theories, which are ideas of fairness based on how the inequality came to be, focus not on how poor or rich someone is, but instead on why the person is poor or rich.

Christina Fong, an economist, wanted to know if people in the US think this way when it comes to their political support or opposition to policies to raise the incomes of the poor, financed by general taxation. She found that a person who thinks that hard work and risk-taking are essential to economic success is much less likely to support redistribution to the poor than one who thinks that the key to success is inheritance, being white, your connections, or who your parents are.

The results of her study are in Figure 19.14. Notice that white people who think that being white is important to getting ahead strongly support redistribution to the poor-evidently because they think that the process that determines economic success is unfair.

This suggests that for many people, the question 'how much inequality is too much?' cannot be answered unless we know why a family or person is rich or poor. Many people think it is unfair if income depends substantially on what we call an 'accident of birth' (categorical inequality)-your race, your sex, or your country. Inequalities based on hard work or taking risks are less likely to be seen as a problem.

Exercise 19.5 Estimated, ideal, and actual distributions of wealth

Use this Gini coefficient calculator to determine the Gini coefficients for wealth ownership given by the estimated, ideal, and actual distributions in Figure 19.13. Note: You will have to estimate the data visually from the chart.

Exercise 19.6 A level playing field

When people think about 'too much inequality', some think about the Gini coefficient measuring inequality at a point in time, while others are more interested in intergenerational inequality.

Use an example of two fictional families in each country to explain the combination of cross-sectional and intergenerational income inequality in Canada and Switzerland shown in Figure 19.11.

Now think about the indifference curves that you could draw in this figure that would indicate the combinations of inequality and intergenerational inequality that would be equally fair in your judgement.

1. If you cared only about the Gini coefficient and you disliked inequality, what would they look like?

2. If you cared only about the intergenerational elasticity and you disliked inequality, what would your indifference curves look like?

3. On Figure 19.11, draw indifference curves according to your personal preferences for cross-sectional and intergenerational inequality. Use your indifference curves to rank the countries from the fairest to the least fair.

19.4 How much inequality is too much (or too little)?

We know that accidents of birth matter. But even if the playing field were level (that is, accidents of birth did not matter), we would still face a question: how rich should the winners be compared to the losers?

A lens for looking at unfairness: The veil of ignorance.

To think about this question, transport yourself to a hypothetical world in which you (perhaps along with other fellow citizens) are asked to design your model society. There will be two groups or classes of equal size, one called 'richer' and the other 'poorer'. You will get to live in the society you design after you have answered the question 'how rich should the richer class be and how poor should the poorer class be?'

But there is a hitch: which class you get to be in will be determined by the flip of a coin after you have decided how unequal the society will be.

This thought experiment is what the American philosopher John Rawls, whom we encountered in Unit 5, termed choosing a social contract from behind a veil of ignorance. The 'veil of ignorance' ensures that we do not know which position we would occupy in the society we were designing.

Behind the curious device of the veil is an important concept. Rawls' fundamental idea is that justice should be impartial. It should not favour one group over another, and the veil of ignorance invites you to think this way (because you do not yet know which group you are going to be in). Rawls asked us to think about justice as if:

[N]o one knows his place in society, his class position or social status; nor does he know his fortune in the distribution of natural assets and abilities, his intelligence and strength, and the like. ( A Theory of Justice, 1971)

This does not tell us the answer to how much inequality there should be, but it does suggest a way to look at it.

Feasible inequality

Economics gives us tools for studying what combinations of the income of the rich and the poor are feasible, and how we might reason about which ones are preferable to others.

Let's try one way to answer the question of 'how rich should the richer class be and how poor should the poorer class be'. Let's say there should be no difference between the incomes of the rich and the poor. Suppose that, in this case, both classes would receive $100,000 annually (per adult). This is shown by point E (for Equality) in Figure 19.15, where the 45-degree line gives all of the points of equal income between the two classes (so there is really no meaning to 'rich' and 'poor'). The figure shows the annual income per adult of the poor and the rich on separate axes.

Would this be your choice? In this version of an ideal society, you would not run the risk of ending up poorer than others after the coin flip. But as an economist you might think that complete equality in the society would mean that there were insufficient incentives for people to work, study, and take risks innovating and investing, so that at least some inequality could actually be better for everyone.

In the figure, points between E and R show possible combinations in which the rich are richer than the poor, but where the poor also are richer than they would be under complete equality. To put it another way, from any one of these points, including point E, there is a win-win possibility: giving more income to the rich allows the poor to have more income as well.

Comparing the two points, you can see that E is Pareto inefficient because both the rich and poor are better off at R than at E. The income distribution at R is also the one at which the poor are as rich as they can possibly be in this economy, as indicated by the feasible frontier. This is the point that Rawls favoured (and why we called it point R).

Would you choose R? Notice that, above R, the frontier is very steep. This means that it's possible to make the rich much richer by making a small reduction in the income of the poor.

The red curved line passing through R and E (and the other points above R) is the frontier of the feasible set of income distributions for the economy in question. We assume that a government can adopt policies to bring about any one of these economically feasible points, but in Unit 22 we will introduce limits on the government's ability to do so, which would have the effect of shrinking the feasible set. As with all feasible frontiers, the slope is a marginal rate of transformation. In this case, the transformation is of income losses of the poor into income gains for the rich.

If the point R had been proposed, would you want to consider other points higher up on the feasible frontier? Remember, after the coin flip, you will get either the income of the rich or that of the poor with equal probability (one half), so you know that:

As long as income gains for the rich come at little expense of income losses for the poor, you would definitely do better to move above point R. If you were interested in maximizing your expected income and did not care about the degree of inequality, then you would choose point A, where the income gains of the rich are exactly offset by income losses by the poor, so the marginal rate of transformation is equal to one.

But after point A, the inequalities would become so severe that the average income would fall, and the rich would be getting a larger slice of a smaller pie. This might occur if the poor were not fed enough to work hard, or were angry enough about their condition to motivate the rich to divert some economic resources from goods and services production into protecting their wealth, which reduces total output. By looking ahead to Figure 19.30c, you will see data showing that more unequal societies (such as the US, UK, and Italy) devote more resources to workers employed in private and public security activities than do other more equal countries with similar GDP per capita.

Like the feasible set when Angela and Bruno were bargaining in Unit 5, there is a minimum level of income that the poor can get. This minimum could be set by their biological survival needs, or perhaps by the fact that if income fell below this level they would revolt. Notice that if the poor were to be even poorer than at point F, the rich would also suffer. So like point E (maximal equality), point D (minimal income of the poor) is not Pareto efficient.

In the figure we have considered the following income distributions:

E: complete equality

R: the distribution with the highest income for the poor

A: the highest average income of rich and poor

F: the maximum income of the rich

D: the distribution in which the poor are at their minimum feasible living standard

A preference for fairness

Which would you choose? Points between D and F are easy to eliminate from the running, as they are all inferior to point F for both classes. And the same goes for points between E and R. Eliminating all Pareto-inefficient distributions from consideration means that no points in the interior (inside) of the feasible set would be considered.

That leaves points between F and R. How will you choose among them? To answer this, you need to consult your indifference curves. In this case, an indifference curve gives combinations of the incomes of the two classes that you value equally.

Curves further away from the origin are preferred (more income for both groups is always better). The slope of these indifference curves is the marginal rate of substitution between income for the rich and income for the poor.

You would then maximize your utility by finding the point on the feasible frontier at which the marginal rate of transformation is equal to the marginal rate of substitution. If you wished to maximize your own expected income, then you would place an equal value on the income of the rich and the poor because you are equally likely to be one or the other.

inequality aversion

A dislike of outcomes in which some individuals receive more than others.

But you might care about the condition of the poorer class even if you were lucky enough to be assigned to the richer class in the coin flip (remember, you have to make your choice before you know your assignment). That is, you might be inequality averse, caring about your own payoffs but also disliking inequality across groups. In this case, you would have an indifference curve like the blue one shown in the figure. You would choose point B, somewhere between Rawls' ideal (the highest feasible income of the poor) and point A, the highest average income.

The familiar graph of the feasible set and a family of indifference curves helps to clarify the choices about inequality and fairness that a citizen or group of citizens may wish to make. But it does not tell us how any of the points on the feasible frontier might actually be implemented. Changing the level of inequality in a society requires altering one or more of the causes of the current state of inequality. To understand income inequality, we first have to understand the factors that determine an individual's income.

Question 19.5 Choose the correct answer(s)

Figure 19.15 shows the feasible frontier of the incomes of the rich and the poor.

Which of the following statements is correct?

19.5 Endowments, technology, and institutions

Income and endowments

In this section, we provide a framework that helps explain why different individuals receive different incomes.

endowment

The facts about an individual that may affect his or her income, such as the physical wealth a person has, either land, housing, or a portfolio of shares (stocks). Also includes level and quality of schooling, special training, the computer languages in which the individual can work, work experience in internships, citizenship, whether the individual has a visa (or green card) allowing employment in a particular labour market, the nationality and gender of the individual, and even the person's race or social class background. See also: human capital.

An individual's income depends on things that they own, or are, or have that allow them to receive income. These things affecting a person's income are called endowments and include:

human capital

The stock of knowledge, skills, behavioural attributes, and personal characteristics that determine the labour productivity or labour earnings of an individual. Investment in this through education, training, and socialization can increase the stock, and such investment is one of the sources of economic growth. Part of an individual's endowments. See also: endowment.

Their financial wealth: Their savings or stocks or bonds that they own, on which they receive interest or dividends.

The physical assets they own: For example, land or the buildings and machinery of a company on which they may receive profits or rents, and which they can use as collateral.

Their schooling and work experience, which affects their value to an employer and therefore their earnings on the labour market (sometimes termed their human capital).

Their race, gender, age, and other aspects that may affect wages, access to credit, or other exchanges.

Their citizenship and whether the individual has a visa, which determine whether they can legally work in a particular country and therefore their earnings on the labour market.

Any other attribute, or possession, or capacity that affects the income an individual will receive.

As a result, we can think of an individual's income as depending on:

their endowments

the income resulting from each item in the set of their endowments

So, for example, consider a person, Ella, whose endowment is the ability to work full time (1,750 hours) at a wage based on her skill as a medical technician (€30 per hour). She also receives a child benefit of €2,000 as an entitlement from the government for her child. Her endowment would be the following list:

ability to work 1,750 hours of labour per annum as a medical technician

the right to a child benefit to assist in caring for her child

She has been able to secure only half-time work (875 hours) so the annual income she derived from all sources is: (875 hours × €30) + (1 child grant × €2,000) = €26,250.

Now consider Kamal, who recently inherited a sum from his late father sufficient to start a small business. He was previously working as the manager of a similar small firm for €120,000 per year. Kamal's endowment is:

ability to work full time using skills and experience as a manager

ownership of the buildings, equipment, and other assets of his firm, worth €8 million

If he did not manage the firm himself, he would have to hire a full time manager with similar skills and experience, costing him €120,000. Last year, his firm's (accounting) profit was €600,000 without counting Kamal's own efforts as a manager, worth €120,000 a year. So his income is the €600,000 in profit, which we divide into the returns to his managerial efforts (€120,000) and the returns to the ownership of assets (€480,000).

By studying why people have differing endowments, and what determines the income associated with each of the endowments, we can understand income inequality.

The factors influencing individual income can be understood using the model of cause-and-effect relationships in Figure 19.16. The arrows point from a cause to an effect.

Both institutions and technologies are part of the explanation of differing endowments among individuals. Inherited wealth gave Kamal a valuable asset, while subsidized higher education helped Ella qualify as a medical technician. Both are examples of the effect of institutions on endowments.

We have seen that intergenerational inequality will be greater where inheritances are not heavily taxed and where educational policies allow the wealthy to acquire more and better education for their children. If marriage customs result in spouses having similar levels of wealth-called 'positive assortment'-this will contribute to inequalities in endowments. Elite private universities, for example, contribute to positive assortment because like exclusive social clubs, they provide meeting and matching opportunities for the sons and daughters of the wealthy. These are also examples of institutions influencing differences in endowments.

Technology matters, too. Where there are strong economies of scale such as in the technology of digital platforms, these will support the winner-take-all forms of competition that we explain in Unit 21. In this setting, a few people-the winners-will end up with substantial endowments in the form of valuable financial or real assets, while the rest end up with little.

The value of a particular endowment, say a programming skill or ownership of a 3D printer, depends on both technology and institutions, as well as on other factors, including supply and demand. The demand for Ella's skill was limited, perhaps due to cuts in health care spending, so she was unable to work full time. Next year Kamal's firm may face competition from a new competitor, making the 7.5% rate of return ($600,000/$8,000,000) that he made this year impossible. Both are examples of how institutions affect the income provided by an asset.

Technology matters, too. Being physically strong was a valuable endowment in agriculture-at least until mechanization made it less important in determining earnings. In that case a change in technology (mechanization) reduced the demand for a particular kind of skill, and so its value (relative to other skills) fell. The value of land, for example, will depend on how productive it is in growing marketable crops (technology) and whether it is zoned for commercial or residential uses (institutions).

Using the model to review inequality from previous units

In previous units, we studied how differences in endowments determined economic outcomes, including inequality. Figure 19.17 summarizes these situations, starting with the interaction in Unit 5 between Bruno, the landlord, and Angela, the farmer he employed.

Recall that how much Bruno got and the inequality between them depended on:

The endowments of the pairs of individuals in Figure 19.17 appear in the second column of the figure. In the first example, Bruno owns the land and Angela only owns her time and capacity to work. This inequality in land ownership matters because it determines who has to work for whom, and who can earn income from allowing others to work with their capital goods or their land.

Endowments matter in another way, because they change Angela's reservation option. If Angela owned land that she could work herself, then Bruno would need to pay her at least enough to ensure that she would rather work for him than work on her own land.

Recall that a change in institutions and policies can change Angela's reservation option. Before the rule of law, the institutions were such that Bruno could simply coerce her to work, and the only thing that constrained the size of the surplus he could get was the need to keep Angela healthy enough to work the next day.

The institutional change, which gave her the right to say no, improved this reservation option. Bruno had to offer Angela a deal that would make her better off working for him than not working. Angela's new 'right to say no' raised the value of her labour endowment.

In the last column of Figure 19.17 we consider the way that changes in technology affect the degree of inequality. In the row concerning the firm's owners and employees, a labour-saving technology, as we saw in Unit 16, can-at least initially-reduce the number of workers a firm needs, making employees more vulnerable to job loss and reducing the likelihood of getting another job at the same wage for those who have been fired.

Like technology, institutions and policies affect the value of endowments. In the example of Ella, the medical technician, her specialized skills are part of her endowment but their paid value (€30 per hour in the example) will depend on institutions. If gender discrimination is a common practice of employers, then her skills might be worth less. If a license is required to do this work, then the value of her skills will be greater if she is licensed. These are examples of institutions and policies affecting the value of endowments.

The credit market in Unit 10 is another example. Recall that Julia's endowment is $100 next year. What she can consume now depends on her wealth (what is in the bathtub), and that depends on the institutions and policies determining whether she can borrow, and the interest rate at which she can borrow.

If her only option is the village moneylender in Chambar or a payday lender in New York, she faces a high interest rate and her wealth (now) is much lower than $100. If she can borrow at a low interest rate, her wealth is quite close to $100. If she can't borrow at all, then there is nothing in the bathtub and her wealth now is zero.

How endowments, technology, institutions, and inequality interact over time

Endowments and the income that they provide are constantly changing as people acquire more skills or as the value of some endowment-such as a piece of land or a rental apartment-falls. Figure 19.16 illustrated the causes of economic inequality. In Figure 19.18, we illustrate inequality as a cause of changes in institutions, technology, and differences in endowments.

The arrow from economic inequality to differences in endowments in the next period captures the fact that the children of richer parents may end up with more and higher quality education, or with greater inherited wealth.

Economic inequality may also influence institutions and policies. An example we shall see in Unit 22 is that in most countries-even democracies-a wealthy person typically has more influence on what the government does than does a poor person. A greater gap between the rich and the poor could increase the political advantage of the wealthy, resulting in policies favouring those with higher incomes.

Exercise 19.7 Yichen, Renfu, Mark, and Stephanie

Consider the economic situation of Yichen, Renfu, Mark, and Stephanie, discussed at the start of this unit. Give examples of how technology, institutions, and differences in endowments explain economic inequality between these actors, and how inequality between them could change over time.

19.6 Inequality, endowments, and principal-agent relationships

Recall that the labour and credit market models in Units 9 and 10 provided the background for our macroeconomic models of the functioning of the whole economy and for the study of how shocks and policies affect economy-wide employment, incomes, and inflation. We used the Lorenz curve to summarize the effects on inequality. And in explaining the model of inequality in Figure 19.16, we used examples from the labour and credit markets.

principal-agent relationship

This relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract. Also known as: principal-agent problem.

The principal-agent models also give us a new way to study an important dimension of inequality: differences in power affect the type of choices that a person may feasibly make. Principals are in a position to exercise power over agents, but agents rarely can exercise power over principals. Here is why.

The employer (the owner or the manager who is the principal in the labour market) has the power to determine what the firm will produce, using what technology, and in which country to locate production. They also have the power to set the wage and the tasks that a worker is directed to perform, and can also fire the worker. The worker chooses how to go about her work within limits that the employer sets.

Recall that in order to motivate the worker to work hard and well, the employer sets a wage so that the employee is better off with the job than she would be without it, receiving an economic rent. The employer can fire the worker and deprive her of the employment rent she would otherwise receive. The fear of losing this rent is an important reason for the worker to carry out the employer's wishes. It is also the reason why the employer has power over the employee.

The worker could, of course, quit. But this does not make the relationship equal when it comes to power. If she is receiving an economic rent she would penalize herself by quitting, and her employer would just replace her with someone currently unemployed.

We can contrast this with the relationships among price-taking buyers and sellers at the equilibrium of a competitive market. None of these traders is in a position to demand that any other trader act in one way or another. Think about the buyer, for example, who orders the seller to make the good available at a lower price, threatening not to buy otherwise. What would the seller do? Nothing. The seller can sell as much as she wishes at the going price (remember, the demand curve facing an individual firm is flat).

A second contrast is with the interactions we studied in Unit 4 where the actions open to all parties were identical-for example, either use integrated pest management or chemical fertilizers, either learn C++ or Java.

Like the relationship between the employer and employee, the other principal-agent models we have seen reflect the unequal relationships between groups of people with differing endowments, such as landlords and tenant farmers, and borrowers and lenders.

Figure 19.19 illustrates how the credit and labour markets influence the relationships among the groups of lenders and borrowers, and employers and employees.

Starting at the upper left of the figure, wealthy individuals can use their wealth to purchase the capital goods to become employers and they can also lend to others. Among the less wealthy, there will be some successful borrowers who can as a result also become employers. Those with even less wealth cannot borrow (they are the credit market excluded that you studied in Unit 10, or can only borrow where the house provides the collateral for the mortgage), and must seek work as employees. Employers then hire employees from among the less wealthy, with some remaining unemployed (due to the workings of the labour market that you studied in Units 6, 9, and 15).

Horizontal arrows indicate a principal-agent relationship. Lenders and employers are the principals in the figure; their common red colour indicates this similarity. Agents-successful borrowers, and employees-are coloured green to distinguish them from would-be agents (credit market excluded and unemployed) who are coloured purple. You definitely do not want to be in the purple boxes. But even if you are an agent lucky enough to be in one of the green boxes, the principal can put you back in the purple box just by refusing to deal with you. This is why lenders and employers have power over borrowers and employees.

Figure 19.19 helps us understand why some people end up as principals (employers, for example) while others end up as agents (employees). If one is wealthy, one can be both a lender and an employer. There is some truth to the saying that 'people are born into their position in the economic order'. This was literally true in some economies of the past. For example, the position of the slave was perpetuated by the enslavement of their children as a matter of law.

Something similar can occur in places where wealth is inherited from parent to child. The children of employees (who inherit little wealth) are also more likely to become the next generation's workers than are the children of employers. You already saw that the children of well off parents in the US also tend to have high incomes when they become adults (Figure 19.10).

But look again at that figure: there is some mobility among the income groups even in the US and there is very little intergenerational inequality in Denmark. Becoming an employer requires that one has sufficient wealth. But inheriting wealth from a parent is not the only way, and in some countries not even the most important way to acquire wealth. The wealth necessary to become an employer may be acquired by saving. It may also be acquired by developing a great project and persuading investors called 'venture capitalists' to fund it.

We have also seen in Units 13 and 16 that there are transitions by individuals between boxes over their life-time. A younger person may initially be a borrower and then be a lender later in life; a spell of unemployment can be followed by one of employment.

Question 19.6 Choose the correct answer(s)

Which of the following statements are correct?

19.7 Putting the model to work: Explaining changes in inequality

The model presented in the previous section helps us to understand why individuals have different incomes. To understand inequality, however, we need to consider the changes across the entire income distribution. In this section, we will apply the labour market model from Unit 9, in combination with our understanding of the determinants of individuals' income, to look at the effect on inequality of:

an increase in the educational level of the workforce

a reduction in discrimination against a segment of the workforce

automation of production reducing the demand for some skills and increasing others

You may wish to review the workings of the labour market model described in Unit 9 before proceeding.

A more educated and more productive workforce

What will be the consequences if workers have acquired more schooling? We expect additional schooling to increase productivity, meaning that a unit of effort by a more educated worker produces more goods per hour using the same technology. The direct effect of additional schooling on an individual is therefore to improve their endowment of labour. Holding everything else equal, the increased productivity means that any individual can get paid a higher wage for their labour.

However, what if the entire workforce becomes more educated? This could be the result, for instance, of an increase in the compulsory schooling age. At the pre-existing real wage, the result of higher productivity will be a higher profit for the firms. This shifts the price-setting curve upwards, as shown in the left panel of Figure 19.20. With higher profits, new firms enter and existing firms hire additional workers, which reduces the unemployment rate. Lower unemployment in turn makes it easier for a dismissed worker to find a new job. It therefore increases the workers' reservation position, raising the wage. Workers both possess a better, higher-productivity endowment of labour time and enjoy better prices for their endowment.

The effects on inequality are shown in the right panel of Figure 19.20. There are now fewer unemployed workers. The segment of the Lorenz curve representing employed workers is now flatter because even though the real wage has risen, a larger fraction of the work force (85% instead of 80%) receives the same 60% of the (now increased) total output.

The line segment for the owners is unaffected because the same 10% of the population continue to receive 40% of the output; like the wages of workers, their profits are up because more is being produced. In this example, the effect of the increased education and productivity of the workforce on inequality is to reduce the Gini coefficient from 0.36 to 0.33.

A reduction in labour market segmentation

Until now we have assumed that all workers receive the same wage in a single labour market, but in reality there are many distinct labour markets. In what is termed the primary labour market, workers may be represented by trade unions, and enjoy high wages and job security. 'Job ladders' allow promotion to better paying and more secure jobs. Primary labour market jobs are frequently referred to as 'good jobs'.

Workers in the secondary labour market are on short-term contracts with limited wages and job security, and tend to be young or from populations discriminated against by race or ethnic group. In many European countries, these are called 'zero-hours contracts' because the employer does not commit to providing work for any particular number of hours. The secondary labour market is also referred to as the 'gig economy' in which freelance work or very short-term contracts are the norm, rather than permanent jobs. For any given endowment of skills, these workers will usually receive a lower income than the workers in the primary labour market. Institutions therefore benefit the workers in the primary labour market and disadvantage workers in the secondary market, increasing income inequality.

Figure 19.21 shows a Lorenz curve for an economy with labour market segmentation, with a low-wage segment and an equal number of high-wage primary segment workers. The owners are not segmented because they can easily invest their wealth in firms in either or both sectors and, as a consequence, the rate of return will be the same in both sectors. The elimination of labour market segmentation means that all workers receive the same wage, but unless this affects the relative bargaining power of workers and owners, it does not alter the share of the output going to workers as a whole. This demonstrates how institutional change can reduce inequality by aligning the wages individuals receive for their endowments.

The figure illustrates the fact that much of the inequality in modern economies is among employees (from secondary labour market workers to very highly paid professionals), and that reducing these inequalities can significantly reduce the Gini coefficient. Where trade unions have reduced labour market segmentation and narrowed the wage differentials among workers, inequality is lower. An example is the so-called solidarity wage policy introduced in Sweden, which we will discuss in Unit 22.

Automation

automation

The use of machines that are substitutes for labour.

Automation is a term used to describe new technologies that allow machines to do the work that people used to do. Technological innovations that replace labour have been an essential part of the capitalist economy since the introduction of the spinning jenny in the eighteenth century, which we described in Unit 2. As we saw in Unit 16, new technologies typically put some people out of work, while increasing the demand for the skills of other workers. We can study these effects using the Lorenz curve and the Gini coefficient derived from it.

To see how, consider a hypothetical economy in Figure 19.22, before and after it introduces machines that perform routine operations that had always been done by humans. We'll call these machines 'robots'. The solid blue Lorenz curve depicts the distribution of income between five employers and 95 workers before the introduction of the robots. Five of the workers are unemployed, and among the 90 who are employed, all receive the same wage, whether they do routine or non-routine work.

The slope of the flatter of the two upward-sloping lines is an indication of how much workers are paid relative to their productivity. We see that the 90 employed workers receive 60% of the income of the economy. So each receives 0.60/90 or two-thirds of a per cent of what the economy produces. The slope of the steeper solid line shows that five owners receive 40% of the income, so that each receives 8% (= 0.40/5) of the output of the entire economy.

To understand the short-run impact of the plan to introduce robots, think about the skill endowments of the workers. Sixty of them are doing routine jobs that were once relatively well paid, such as machine tending or mail sorting, that can now be done by robots. Others have the training to not just operate machinery, but to design, repair, and calibrate machinery, and manage its deployment.

The short-run effects depend on the kinds of work a worker does:

These two effects are shown in the new (dashed) Lorenz curve depicting the short-run effects of the new technology on workers who previously earned two-thirds of a per cent of output each. At least some of the 60 workers for whom the robots are labour-replacing lose their job. Five of them have now joined the unemployed; the machines have replaced their labour. Those who remain employed have suffered a fall in their bargaining power (because they too can be replaced). These 55 workers now receive 10% of the output of the economy, and their earnings fall to 0.18% of the total output each.

On the other hand, the 30 workers with skills that are complementary to the robots have gained. They now receive 50% of the output of the economy, or a little more than 1.67% each.

The effect of automation thus can be similar to the effect of labour market segmentation, but in the case of robots, the segregation of workers depends on whether their skills are easily substituted by machines (the losers) or instead are complementary to the machines (the gainers).

The result is that the Gini coefficient increases from 0.38 to 0.66, shown by the new Lorenz curve falling further below the perfect equality line.

An example of the effect of automation is the introduction of automatic teller machines (ATMs) by banks. Surely this would have increased unemployment among human bank tellers?

James Bessen, an economist, looked at the employment levels in the US and found that the number of bank tellers continued to rise even after the machines were installed. Rather than doing mechanical tasks, they were now providing other services such as advice to customers.

Bessen also found employment increased among bookkeepers and retail sales staff despite automation of some of their tasks, but on the other hand, technology did displace the jobs of travel agents. Automation was complementary to the skills of some bookkeepers and bank tellers, but it was a substitute for the skills of travel agents.

Listen to James Bessen talk about his book in a May 2016 episode of the EconTalk podcast.

What determines whether automation increases or decreases wages and employment? We can use an analysis similar to the one we did in Unit 16. There are two contradictory effects.

On one hand:

On the other hand:

As we saw in Unit 16, adjustment of local labour markets to labour-saving technology and competition from imports may take a very long time.

The model cannot determine whether the new Nash equilibrium in the labour market will result in a more equal distribution of income or a less equal one. Inequality among workers will be greater due to the fact that the robots created winners and losers among employees, by raising the value of some labour endowments (the engineers) and lowering the value of the labour endowments of others (the routine workers). If the level of unemployment goes back down to its pre-automation level, and if the firm's markup on costs is unaffected, then the only durable effect will be greater inequality among workers, resulting in an increase in the Gini coefficient.

A government observing the process of automation might respond with levying taxes on the enhanced profits of the owners and on the incomes of the workers with increased wages. In designing the taxes, it would need to take into account their effect on the behaviour of workers and employers. The revenue from these taxes can be used to finance:

Exercise 19.8 How automation affects employment

Return to Figures 19.6 and 19.7. Use what you have learned in this section about robots as substitutes or complements to employees' endowments to explain some of the patterns in job growth shown in these figures.

Question 19.7 Choose the correct answer(s)

Which of the following statements regarding segmented labour markets are correct?

19.8 Predistribution

redistribution policy

Taxes, monetary, and in-kind transfers of the government that result in a distribution of final income that differs from the distribution of market income. See also: predistribution policy.

predistribution policy

Government actions that affect the endowments people have and their value, including the distribution of market income and the distribution of privately held wealth. Examples include education, minimum wage, and anti-discrimination policies. See also: redistribution policy.

statutory minimum wage

A minimum level of pay laid down by law, for workers in general or of some specified type. The intention of a minimum wage is to guarantee living standards for the low-paid. Many countries, including the UK and the US, enforce this with legislation. Also known as: minimum wage.

Governments influence the degree of inequality in the economy. They do this in two ways:

Redistribution: By taxes and transfers that result in a distribution of disposable income that differs from the distribution of market income (as we saw in Figure 19.1) and by expenditure that provides public services to households.

Predistribution: By affecting the endowments that people have and the value of those endowments, leading to a change in the inequality in market income (going back to Figure 19.1 again, here governments affect the distribution of earnings before taxes and transfers or the distribution of privately held wealth).

Examples of predistribution that you have already seen include:

Other aspects of predistribution affect the basic institutional structure of the economy. By defining and enforcing the legal framework in which the employers, banks, employees, unions, borrowers, and other key economic actors interact, governments affect the distribution of market income. Using the legal system, governments can also alter which property rights are protected, for example banning slavery, legalizing unions (Units 9 and 16), establishing trading rights in emissions (Unit 18), or setting the duration of intellectual property rights and patents (Unit 21). All of these measures can change the relative bargaining power between groups as well as their reservation options, which in turn will change the distribution of income.

Finally, governments can change the set of contracts that are allowed, which alters the distribution of income. We discussed one example in Unit 5, when we saw the effect of legislation that limited the maximum hours that employees could work.

Another important example of predistribution by limiting the kinds of contracts that are allowed is a statutory minimum wage, which prohibits contracts with wages below a certain level. This affects the value of a worker's endowment of labour, but it may also affect the likelihood that the worker will be able to find a job. The costs of the minimum wage could be fewer jobs.

Arin Dube, an economist, studied differential changes in minimum wages in bordering local areas in the US. In our 'Economist in action' video he explains that he found that raising the minimum wage had a little negative impact on employment but increased the income of poor workers on average.

Ensuring high-quality early childhood education is another predistribution policy. In our 'Economist in action' video, James Heckman, a Nobel-prize-winning economist from the University of Chicago, shows how economists can learn from experiments and other data about how to level the playing field for children growing up poor.

Figure 19.23 lists a set of policies that can reduce inequality in market incomes, drawn from this and other units.

non-compete contract

A contract of employment containing a provision or agreement by which the worker cannot leave to work for a competitor. This may reduce the reservation option of the worker, lowering the wage that the employer needs to pay.

Exercise 19.9 Non-compete contracts in the labour market model

Legislation can rule out particular kinds of contracts, such as those that prohibit employees from leaving their firm to work for a competitor. The justification offered for these non-compete contracts is that workers leaving a firm may take with them industrial or trade secrets that would benefit the competition. But in the US, non-compete clauses are even included in contracts of fast-food workers. Use the labour market model to explain why employers would introduce non-compete contracts in sectors where industrial secrets are not an issue.

19.9 Explaining recent trends in inequality in market income

Can these policies or other changes help explain the trends in market income inequality? Figure 19.24 indicates three of these trends and suggests possible explanations based on the models you have learned.

To explain the reduction in between-country inequality (and the associated reduction in between-household inequality) in the world, think of the world as a single capitalist economy with a labour market that is segmented along national lines. To do this, we propose a very simple economy of the 'world' with just two 'countries': China and Europe-and-North-America. So instead of two labour market segments in the same country, there are two countries, a low-wage country and a high-wage country, a little like China and the US in Unit 18.

Just as it is not easy for workers to move up from the secondary to the primary labour market within a country, the global economy has nationally segmented labour markets because of the barriers facing workers who would like to relocate from one country to the other. And, just as in the national economy, owners are not segmented. They invest their wealth wherever it will get the highest return. As we saw in Unit 18, globalization is only partial: the world labour market is far from integrated while capital mobility is high, because money does not need a green card or a work visa to be allowed to 'work' in a country.

The process of globalization has been associated with a reduction in global labour market inequality, as the once-low wages in successful exporter countries like China begin to catch up with wages in the higher-wage economies like France. A second effect has been a vast increase in the amount of labour that is now available for employment in the global capitalist economy, and this has been associated with an increase in the share of income going to owners of firms rather than employees.

19.10 Redistribution: Taxes and transfers

Differences among economies in the extent and nature of redistribution

Our models of wages and profits try to explain market income. But that is not the amount of income that people have to spend, nor does it include things essential to our livelihoods that we do not purchase, but instead acquire as a matter of citizenship.

Disposable income, as you know, is the income a person has after paying any income taxes and social security contributions, and after receiving any government transfers. But this is not an adequate measure of a household's living standard because it does not include the effects of indirect taxes, such as value added tax, and the extent to which free or subsidized public services such as public education and health are available to households.

in-kind transfers

Public expenditure in the form of free or subsidized services for households rather than in the form of cash transfers.

These public expenditures are called in-kind transfers because they are a transfer to households in the form of free or subsidized services, rather than in the form of cash. When we take into account both indirect taxes and in-kind transfers, we arrive at a third income concept, called final income. Final income is the most complete measure of the living standard of a household. It tells us the value of all the goods and services that the household is able to consume. Figure 19.26 summarizes the relationship between these three income concepts.

Figure 19.27 shows the Gini coefficients for market income, disposable income, and final income for three large middle-income countries. In South Africa, direct taxes and transfers reduce the Gini by 0.08, from 0.77 to 0.69. Indirect taxes and public services reduce the Gini by a further 0.09 to 0.60 for final income, but it remains exceptionally unequal. Brazil had much higher inequality than Mexico in both market income and disposable income, but the Gini coefficient for final income falls to almost the same level as Mexico's, at 0.44 compared to 0.43.

The welfare state

welfare state

A set of government policies designed to provide improvements in the welfare of citizens by assisting with income smoothing (for example, unemployment benefits and pensions).

The policies that turn market income into final income are often referred to as the welfare state. These policies can be broken down into the taxation side and the expenditure side. The taxation side is any policy that collects revenue for the government, while the expenditure side is any policy that either gives money to households, or spends money on their behalf. We will see more about the composition of government expenditures in Unit 22.

In countries where redistribution reduces inequality by a lot, most of this work is done by expenditures, rather than taxation.

In the 28 countries in the European Union, the average Gini in 2015 for market income is 0.46, which taxes and transfers reduce to 0.27 for disposable income. But taxes only achieve 0.04 of that redistribution, with the remaining 0.15 driven by transfers to households. This doesn't mean that they have low tax rates, but instead it means that rich and poor pay similar shares of their incomes in taxes. On the other hand, poorer households benefit proportionally much more from expenditures.

Data on the Gini coefficient for the EU was taken from 'Effects of tax-benefit components on inequality (Gini index), 2011-2015 policies', which you can access on the Euromod statistics website.

Transfers, both in cash and in kind, have a large impact on inequality. But in most cases this is not their purpose. Most transfers are justified for other reasons, and reducing inequality is just a desirable side effect. Public education, for instance, has many justifications, including as an investment in human capital that makes the country more productive. Public health subsidies are often justified on the basis of a basic human right to life and to good health.

The welfare state is often represented and debated as a system of redistribution from the rich to the poor. But it is equally seen, and often defended, as redistribution from the lucky to the unlucky. Parts of the welfare state also redistribute from the young to the old.

social insurance

Expenditure by the government, financed by taxation, which provides protection against various economic risks (for example, loss of income due to sickness, or unemployment) and enables people to smooth incomes throughout their lifetime. See also: co-insurance.

In countries with large welfare states, much of the expenditure is on forms of social insurance, which includes assistance to poor households, but also includes public pensions, unemployment benefits, social housing, child benefits, and other expenditures that are targeted at groups that are not defined by low income. Public pensions transfer income to the old. Child benefits, like expenditures on public education, transfer income to the young (or those who care for them). Since they are paid for by taxes contributed by working adults, they are a way for society to enable people to smooth incomes throughout their lifetimes. We receive income from the government when we are very young and very old, when our incomes are low or zero, and we pay some of it back to the government when we are of working age and receiving a salary.

Similarly, public unemployment insurance is a way for people of working age to smooth their incomes in the face of the risk of unemployment. We pay while we are working, and we receive payments if we are out of work.

These forms of social insurance are not targeted specifically at poor people. But they have a large impact on inequality because most retired people and unemployed people would be very poor if they did not receive social insurance payments. In fact, in the European Union, public pensions are the policy with the greatest impact on inequality. They reduce the average Gini coefficient by 0.11, more than all other transfers combined.

Figure 19.28 shows the average household market income and disposable income in the UK in a single year, by age of the household's primary earner. Households whose primary earner is less than 25 years old have an average household market income of £24,108 and an average household disposable income of £24,735. The richest group of households is those whose primary earner is aged 40-44 years old, and incomes decline rapidly after 60-64 years, as primary earners tend to retire. Disposable income is higher than market income for the under-25s and the over-65s, when market income is at its lowest, and conversely for those aged 25-64, when household income is at its highest.

If we hypothetically imagine that there is one household at each age group, the Gini coefficient for market income would be 0.249 while for disposable income it would be 0.139-the tax and benefit system as a whole reduces inequality because it effectively redistributes from richer households to poorer households. But the figure demonstrates that much of this result could be due to redistribution from those of working age to the retired.

How economists learn from facts What is the best way to give money to the poor? Randomize and find out.

Most countries adopt some policies to raise the living standards of the poor. But what is the best way to do this? If governments would like to transfer funds to individuals or families, should it go to the very poor, or only those who are working, or only those attempting to find work? Should the transfer be given to just the poor, or everyone?

The questions are controversial, and the answers will depend on more than economics. But economists have been using experiments to illuminate at least the costs and benefits of different mechanisms.

Economists have explored the effects of simply giving away cash to the poor, without requiring that they work or make any repayment. In theory, cash payments that one receives whether or not one is employed should have little impact on labour supply. Experiments have found that cash grants are a remarkably cost-effective way of reducing poverty on many dimensions, from increasing consumption to decreasing stress levels. These results have led policymakers to rethink their programs, for example, by comparing the anti-poverty effect of a dollar spent on, say, job training programs, with the effect of simply giving that dollar away.

Some have proposed to expand the cash payment to everyone, not just the poor, in what has been called Unconditional Basic Income Grants (UBI or BIG). Some Silicon Valley groups are funding initial experiments in these more universal cash grants in Oakland, California, randomizing access to cash. Some of them believe that technology is accelerating at such a rate, reducing labour demand to such an extent that universal income grants are going to be needed to keep the vast bulk of humanity from destitute unemployment.

Another proposal in Finland randomly selects betwen 2,000 and 3,000 people to receive monthly lump-sum payments of $600 to see if basic income grants can lower poverty as well as simplify the administration of programs to help the poor. Experimenting with a policy before adopting it wholesale is allowing economists to study some of the effects of particular policies, as well as letting policymakers use evidence to decide whether or not to adopt a policy.

Progressive and regressive redistribution

progressive (policy)

An expenditure or transfer that increases the incomes of poorer households by more than richer households, in percentage terms. See also: regressive (policy).

regressive (policy)

An expenditure or transfer that increases the incomes of richer households by more than poorer households, in percentage terms. See also: progressive (policy).

distributionally neutral

When the direct effect of a tax or transfer policy (compared to what would happen in the absence of the policy) is a reduction in inequality, it is called progressive. We have just seen that expenditures are more progressive than taxes. If a policy's direct effect is a rise in inequality it is called regressive. Policies that are neither progressive nor regressive are called distributionally neutral.

For an expenditure or transfer to be progressive, it has to increase the incomes of poorer households by more than richer households, in percentage terms. This guarantees that it will reduce the Gini coefficient, and lead to a shift upwards in the Lorenz curve. Note that this policy might mean that in absolute terms (in units of currency), the richer households are receiving more.

Consider Bruno, the landlord, and Angela, the farmer. Suppose that the outcome of their bargaining is that Bruno's income is three times as large as Angela's, with Bruno receiving 3,000 pesos per year and Angela receiving 1,000. Suppose also that Angela has two children and Bruno three, all of whom go to publicly funded schools, and that the government spends 200 pesos per year per child. This means that Angela receives in-kind transfers worth 400 pesos per year and Bruno 600. For Angela this implies an increase in her final income of 40%. For Bruno, it is an increase of only 20%. So the transfer is progressive, and the Gini coefficient for final income will decline.

If it seems odd that the Gini will decline even if Bruno receives more than Angela, the explanation is that the Gini coefficient depends on relative incomes, or the ratios of incomes between households. Bruno's market income is three times Angela's market income. A policy that reduces that ratio will reduce the Gini coefficient. In the second case above, Bruno's final income was 3,600 pesos while Angela's was 1,400, which gives a ratio of 2.57 compared to 3 for market income. Even though Bruno received more in absolute terms, relative inequality between them declined, so the Gini coefficient declined.

Primary schooling is usually very progressive. A case of education expenditure that can be regressive is publicly funded university education. This is because children from richer families are much more likely to go to university. So if Bruno's and Angela's children were all of university age, but Bruno's children were attending university while Angela's were working, then public university spending would be regressive: Angela's family would receive nothing, while Bruno's would receive something.

When it comes to taxes, an analogous principle applies. A tax is progressive if richer households pay a larger share of their incomes than poorer households, and regressive if poorer households pay a larger share of their incomes than richer households. So if Bruno paid 300 pesos in tax and Angela paid 150 pesos, then the tax would be regressive, even though Bruno is paying more in absolute terms: Bruno's tax is 10% of his income while Angela's is 15% of hers. Again, this is explained by the effect on the ratio of their incomes. Their after-tax incomes of 2,700 and 850 have a ratio of 3.18, which is higher (more unequal) than the ratio of their market incomes.

Taxes and expenditures can be analysed separately, but it is important to remember that expenditures are only possible because taxes pay for them. When a government spends money on public schools that benefit some households, they are financed by taxes that are paid by all households. This is why fiscal policy is redistributive: all households both give and receive, but some give more than they receive, and vice versa for others. The net effect is to transfer income from some households to other households.

Figures 19.29a and b show the distribution of taxes and public spending in Mexico. Figure 19.29a gives the figures in absolute terms while Figure 19.29b gives them as a percentage of market income. People in the bottom decile each received total benefits worth Mex$6,682 (Mexican pesos) on average per year, compared with Mex$5,557 received by those in the top decile. As Figure 19.29b shows, when represented as a share of market income, these transfers increase the lower the decile, with the bottom decile receiving benefits worth 135% of their market income and the top decile receiving only 13%. Therefore the transfers are progressive, reducing inequality.

For taxes, on average those in the bottom decile paid Mex$594 each, compared with Mex$25,902 for those in the top decile. But since the market incomes of the top decile were 40 times as high as those of the bottom decile, for both groups these taxes represented 12% of income, indicating that taxes are neither regressive nor progressive.

Figure 19.29a shows that the net effect of taxes and transfers is that the lower the decile, the more they receive-with deciles 9 and 10 being net contributors, rather than beneficiaries. This implies that the overall fiscal system is progressive, reducing the Gini coefficient. It also means that fiscal policy effectively redistributes income from the top two deciles (mainly the top decile) to the bottom eight deciles. However, the benefits to deciles 1 through 8 are larger than the cost to deciles 9 and 10. This is partly because the Mexican government also receives revenues from the production of oil. These oil revenues are distributed, but are not re distributed-they represent income the government receives without taxing households and businesses.

Figure 19.29b shows clearly that expenditures are more progressive than taxes: while richer households tend to pay a slightly larger share of income in taxes than poorer households, public expenditures are a much larger share of income for poorer households than richer households.

Exercise 19.10 Regressive and progressive taxes

1. A poll tax is a tax where everyone pays the same absolute amount to the government. Is it progressive, regressive, or distributionally neutral?

2. A basic income is a benefit where everyone receives the same absolute amount from the government. Is it progressive, regressive, or distributionally neutral?

3. Suppose you learn that the richest 10% of people pay 30% of income tax. Does it mean that the tax system is progressive?

4. Some governments of developing countries give scholarships for some of their best students to go to graduate school abroad. If there are no eligibility restrictions, is this policy likely to be progressive or regressive? What might justify this policy?

19.11 Equality and economic performance

The success of Operation Barga in raising productivity in farming (Unit 5), of Oportunidades in Mexico, and of pensions in South Africa in raising school achievement and child health may help explain the fact that more equal countries do as well as (or better than) unequal countries, in terms of standard economic performance.

We saw in Figure 17.15 that the low levels of inequality, the enhanced power of trade unions, and the growth of pro-poor tax and transfer policies during the golden age of capitalism were associated with the most rapid growth of income per capita in modern history. Investment, too, occurred at levels not seen before, raising the capital stock at an unprecedented rate of growth.

Earlier in this unit (Figure 19.3) we showed the centuries-long U-turn of top incomes in many countries including the US and the UK. By this measure, late twentieth-century inequality had risen to levels not experienced since before the Great Depression. But this U-turn pattern is far from universal, as Figure 19.4 showed.

Most of the countries in Figure 19.4-where the U-turn towards greater inequality did not occur or was far less pronounced-are high performers. These countries achieved both rapid growth in income per capita and modest levels of inequality of disposable income, as you can see in Figure 19.30a. In this case, we measure inequality in income after taxes and transfers (disposable income) because this is the best available measure of inequality available across all countries. The conclusion from Figure 19.30a is that countries differ a lot in how equal their living standards are, and that the growth in productivity (GDP per capita) seems unrelated to the level of equality.

There have also been high and low performers among the catch-up economies. Figure 19.30b shows that South Korea and Taiwan were able to achieve high growth with relatively low inequality over the past 30 years, whereas the performance of Latin American economies along both of these dimensions was typically much worse.

Figures 19.30a and 19.30b are initially surprising because economists have often claimed that high taxes and transfers depress incentives for people to work hard and take the kinds of risk necessary for innovation to occur. Explanations of why egalitarian economies such as Japan, South Korea, and Taiwan in Asia, and Nordic and other northern European countries have done so well economically include:

High levels of cooperation and trust: An economy based on services such as the production of knowledge and care of others cannot perform well if people are entirely self-interested. Cooperation and trust are essential for much of the modern economy, but they are difficult to sustain among people paid vastly different sums of money. Societies that are more equal create more trust among citizens and therefore enjoy better economic performance.

Policies that enhance the endowments of the poor: High-quality health services and education contribute to the more productive use of an economy's resources. This is also true of policies that raise the value of the endowments of the poor, as illustrated by the land reform (Operation Barga) in West Bengal.

Less use of guard labour: The construction of secure environments for the rich, such as gated communities, and other guarding activities that protect the assets of and provide security to the wealthy divert resources that could be used for productive investment.

Figure 19.30c illustrates this last point: the US, Italy, and the UK are countries with highly unequal disposable incomes that hire three times as many guards (public and private security personnel, excluding armed forces) than do the more equal nations of Finland, Denmark, and Sweden. An unequal society may expend a lot of resources on protecting property rights and enforcing the rule of law.

Exercise 19.11 The U-turn countries

Look again at the difference between the U-turn countries in Figure 19.3, which showed a trend towards greater equality in the first three quarters of the twentieth century followed by an increase in inequality since about 1980, and the countries in Figure 19.4, in which inequality did not increase significantly, or at all.

Make a list of possible explanations as to why countries in the two groups took such different courses since 1980, making sure to check (using the Internet or other sources) that any technological or institutional changes you refer to are historically accurate.

Exercise 19.12 High and low performers

Above, we have arbitrarily drawn a line on Figure 19.30a to distinguish high from low performers. But what counts as 'high' performance depends on your preferences.

1. Sketch your indifference curves in the space given by Figure 19.30a, according to your preferences for inequality and growth. (Hint: is the slope of the indifference curve positive or negative?)

2. Use your indifference curves to rank the countries in Figure 19.30a, from the most to the least preferable.

Question 19.10 Choose the correct answer(s)

Which of the following statements is correct regarding policies on inequality?

Japan is a more equal society than the US in terms of wealth or earnings even before taxes and transfers.

Giving everyone access to education, regardless of wealth, is one way to make the human capital endowments of the rich and poor more equal.

The evidence so far suggests otherwise; the benefit of a wage increase more than offsets the cost of a possible (if any) decrease in employment by a wide margin (see the 'Economist in action' video of Arin Dube).

'Non-compete contracts' prohibit workers from leaving their firm for a competitor. This reduces their bargaining power, leading to lower wages.

19.12 Conclusion

As you have seen in this unit, income inequality among the world's households is falling fast, mostly because of the rapid increases in average income in two large and historically poor countries: China and India.

The most recent worldwide Gini coefficient for household income is 0.62. How unequal does that mean that people really are? We know that, for example, the average income of the top 1% in the world is 27 times the income of the poorest half of the people in the world.

But another way to see these differences, represented by a Gini coefficient of 0.62, is the following thought experiment. If you were to randomly pick pairs of households from all over the world and compare their income-you might get one family from Indonesia, one from Norway, one from Brazil, one from India, and two from China (that would not be a surprising outcome, likely even if you were randomly picking families)-you would find that the richer of the two families, on average, had 4.2 times the income of the poorer. The very rich are very few, so when we include them it would not change this average inequality between households.

But are we even that different? Do you think that the income earner (or earners) in the richer of the two families would on average be 4.2 times stronger, smarter, more hard-working or creative? This shows us that the economy produces inequalities, even among people who may not be very different. It rewards some with large incomes, and others with barely enough to survive.

Many of these income differences-seen as rewards for hard work, risk-taking, or creativity for example-are considered by most people to be entirely fair, or at least necessary to provide incentives for a well-working economy. Other income differences-the effects of discrimination, coercion, or accidents of birth for example, are regarded by many as unfair.

Economics can help to address the problem of unfair inequality by clarifying the causes of economic inequality and designing policies that can ensure more just outcomes, as has been done in many countries.

Concepts introduced in Unit 19

Before you move on, review these definitions:

19.13 References

Consult CORE's Fact checker for a detailed list of sources.

Acemoglu, Daron, and James A. Robinson. 2012. Why Nations Fail: The Origins of Power, Prosperity and Poverty, 1st ed. New York, NY: Crown Publishers.

Alvaredo, Facundo, Anthony B. Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. 2016. 'The World Wealth and Income Database (WID)'.

Atkinson, Anthony B., and Thomas Piketty, eds. 2007. Top Incomes over the Twentieth Century: A Contrast between Continental European and English-Speaking Countries. Oxford: Oxford University Press.

Bessen, James. 2015. Learning by Doing: The Real Connection between Innovation, Wages, and Wealth. New Haven, CT: Yale University Press.

Bowles, Samuel, and Arjun Jayadev. 2014. 'One Nation under Guard'. The New York Times. Updated 15 February 2014.

Bowles, Samuel, and Herbert Gintis. 2002. 'The Inheritance of Inequality'. Journal of Economic Perspectives 16 (3): pp. 3-30.

Clark, Gregory. 2015. The Son Also Rises: Surnames and the History of Social Mobility. Princeton, NJ: Princeton University Press.

Daly, Mary C., and Leila Bengali. 2014. 'Is It Still Worth Going to College?'. Federal Reserve Bank of San Francisco. Updated 5 May 2014.

Deaton, Angus. 2013. The Great Escape: Health, Wealth, and the Origins of Inequality. Princeton, NJ: Princeton University Press.

Diamond, Jared. 1999. Guns, Germs, and Steel: The Fates of Human Societies. New York, NY: Norton, W. W. & Company.

Dube, Arindrajit, T. William Lester, and Michael Reich. 2010. 'Minimum Wage Effects across State Borders: Estimates Using Contiguous Counties'. Review of Economics and Statistics 92 (4): pp. 945-64.

Flannery, Kent, and Joyce Marcus. 2014. The Creation of Inequality: How Our Prehistoric Ancestors Set the Stage for Monarchy, Slavery, and Empire. Cambridge, MA: Harvard University Press.

Heckman, James. 2013. Giving Kids a Fair Chance: A Strategy That Works. Cambridge, MA: MIT Press.

Jayadev, Arjun, and Samuel Bowles. 2006. 'Guard Labor'. Journal of Development Economics 79 (2): pp. 328-48.

Milanovic, Branko. 2007. Worlds Apart: Measuring International and Global Inequality. Princeton, NJ: Princeton University Press.

Milanovic, Branko. 2012. The Haves and the Have-Nots: A Brief and Idiosyncratic History of Global Inequality. New York, NY: Basic Books.

Norton, Michael I., and Dan Ariely. 2011. 'Building a Better America-One Wealth Quintile at a Time'. Perspectives on Psychological Science 6 (1): pp. 9-12.

Piketty, Thomas. 2014. Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press.

Rawls, John. (1971) 2009. A Theory of Justice. Cambridge, MA: Belknap Press of Harvard University Press.

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Economic disparities are mostly a matter of where you were born, who your parents are, and (in some countries) your gender. Well-designed policies and institutions can reduce inequalities without lowering average living standards Having declined for most of the twentieth century, inequality of income then increased in the US, the UK, India, and many other countries.

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Core Economics - Economics of the Environment

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Core Economics - Economics of the Environment

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How economic activity affects the fragile biosphere of our planet, and how the resulting environmental problems can be addressed

Production and distribution of goods and services unavoidably alter the biosphere.

Climate change resulting from economic activity is a major threat to future human wellbeing, and it illustrates many of the challenges of designing and implementing appropriate environmental policies.

Well-designed environmental policies implement the least-cost ways of reducing environmental damages and balance the cost of reducing environmental damage against the benefits.

Some policies use taxes or subsidies to alter prices so that people internalize the external environmental effects of their production and consumption decisions; other policies directly prohibit or limit the use of environmentally damaging materials and practices.

Some environmental systems exhibit processes of degradation, in which substantial and hard to reverse environmental damage occurs abruptly. Prudent policies avoid triggering such processes.

Evaluating environmental policies raises challenging questions about how to value our natural surroundings and the wellbeing of future generations.

In 1980, one of the most famous bets in science history took place. Paul Ehrlich, a biologist, predicted that rapidly increasing population would make mineral resources scarcer. Julian Simon, an economist, thought that humanity would never run out of minerals because higher prices would stimulate the search for new reserves, and ways of economizing on the use of resources. Ehrlich bet Simon that the price of a basket of five commodities-copper, chromium, nickel, tin, and tungsten-would increase in real terms over the decade, reflecting increased scarcity.

inflation-adjusted price

Price that takes into account the change in the overall price level.

On 29 September 1980, they bought $200 of each of the five commodities (a total wager of $1,000). If prices of these resources went up faster than inflation over the next 10 years, Simon would pay Ehrlich the difference between the inflation-adjusted prices and $1,000. If real prices fell, Ehrlich would pay Simon the difference. During that time, the global population increased by 846 million (19%). Also during that time, income per person increased by $753 (15%, adjusted for inflation in 2005 dollars). Yet, in those 10 years, the inflation-adjusted prices of the commodities fell from $1,000 to $423.93. Ehrlich lost the bet and sent Simon a cheque for $576.07.

The Ehrlich-Simon bet was motivated by the question of whether the world was 'running out' of natural resources, but an interval of 10 years is unlikely to tell us much about the long-run scarcity of raw materials. The basic framework of supply and demand (see Units 8 and 11) tells us why. Commodities such as copper or chromium generally have inelastic (steep) short-run demand and supply curves because there are few substitutes for these resources. This means that relatively small demand or supply shocks generate large and sudden changes in the market-clearing price, similar to the market for crude oil that you encountered in Unit 11.

But what should happen to the price and availability of copper or chromium in the long run?

As the price of copper rises, producers have an incentive to invest in new technologies that will make its extraction cheaper. Consumers will substitute away from copper to other raw materials. Both of these forces push prices down.

As prices of copper begin to fall, firms cut down on new extraction investments and consumers demand more copper. This pushes the prices back up. The presence of market prices for raw materials therefore ensures that despite increases in population and affluence, we do not 'run out of resources'. The ratio of known reserves to production does not fall far.

Over the last 200 years, prices for many mineral resources have not changed much, although extraction has increased dramatically. Although prices fluctuate from year to year, the overall trend is flat. This indicates that the supply of many raw materials in the earth's crust- natural resources -is quite vast.

The transformation of living standards since the Industrial Revolution has been possible because of the combination of human ingenuity and available resources in the form of air, water, soil, metals, hydrocarbons like coal and oil, fish stocks, and so on. These were all once abundant and free, apart from the costs of extraction. Some, like hydrocarbons and mineral resources, are still abundant. Others, like unpolluted air, biodiversity (including coral reefs and many land and marine species), forests (due to deforestation and desertification), and clean water, are becoming scarce.

But the absence of prices is not the only reason why managing renewable natural resources is so hard. In some cases, the fragility of our environment under pressure from the growth of economic activity can lead not only to progressive degradation, but also to accelerating, self-reinforcing collapse. An example is the Grand Banks cod fishery, in the north of the Atlantic Ocean. In the eighteenth and nineteenth centuries, legendary schooners such as the Bluenose (Figure 20.2) raced back to port to sell their catch to be the first on the market, and to offer fresh fish. By the late twentieth century, the Grand Banks had sustained the livelihoods of the US and Canadian fishing communities for 300 years.

Then suddenly, the fishing industry in the Grand Banks died and, along with it, many of the old fishing towns. Figure 20.3 gives the quantity of cod caught over 163 years, showing a gradual upward trend and a pronounced spike coinciding with the introduction of industrial fishing less than 50 years before the eventual disappearance of cod from the Grand Banks. You learned some reasons why an open-access resource is likely to be overexploited in Units 4 Unit 12, and it appears that in this case the cod was greatly overfished. North Atlantic fisheries are now recovering after governments imposed restrictions, but we still do not know if the cod will come back in their previous numbers.

Rapid changes like the Grand Banks cod disappearance are referred to as ecosystem collapse, and result from environmental vicious circles. In the Amazon, for example, change may become self-reinforcing due to the positive feedback processes illustrated in Figure 20.4. Past a certain level of deforestation, the process becomes self-sustaining even without further expansion of farming.

Similarly, the process of global warming can be self-reinforcing due, for example, to its impact on Arctic ice cover, as we will see later in Section 20.8.

The depletion of commodities and global warming are two aspects of environmental degradation. But we will see that there is also an important difference between the two: commodities are priced and traded, and so over-use of some resources may self-correct as prices of scarce commodites rise. Negative external environmental effects are usually only corrected through coordinated policy or political action, which is harder to achieve. This action has often been too little or too late, as we will see.

In the rest of this unit, we will show that environmental problems are as diverse as nature itself, and that understanding the economics of the environment will require you to employ not only the tools you have learned already, but also to study the interaction of physical and biological processes with human economic activity.

20.1 Recap: External effects, incomplete contracts, and missing markets

The study of environmental economics began in Unit 1 of this course, where we saw that economic activity (the production and distribution of goods and services) takes place within the biological and physical system. As we saw in Figure 1.5 and Figure 1.12, the economy is embedded within society, but also within the ecosystem. Resources flow from nature into the human economy. Waste, such as carbon dioxide (CO ₂) emissions, or toxic sewage produced by firms and households, flows back into nature-mainly into the atmosphere and the ocean. Scientific evidence suggests that the planet has a limited capacity to absorb the pollutants that the human economy generates. In this unit, we investigate the nature of the global ecosystem, which provides the resources that feed economic processes and the sinks where we dispose of our wastes.

In Unit 4, we introduced environmental problems at a local level, among people who were similar in most respects. Anil and Bala were neighbouring landowners with a pest management problem. They could choose between an environmentally damaging pesticide and benign pest management systems. The outcome was inefficient and environmentally destructive because they could not make a binding agreement (a complete and enforceable contract) in advance about how they would act. In Unit 4, we also discovered that contributing to sustaining the quality of the environment is, to some extent, a public good, and that there are strong self-interested motives to free ride on the activities of others. So, while everyone would benefit if we all contributed to protecting the environment, we often do not do our part.

When small numbers of individuals interact, however, we saw that informal agreements and social norms (a concern for the others' wellbeing, for example) might be sufficient to address environmental problems. Examples found in real life include irrigation systems and the management of common land.

In Unit 12, we expanded the scope of environmental problems to include two groups of people pursuing different livelihoods. We considered a hypothetical pesticide called Weevokil (based, again, on real-world cases) and its effects on fishing and the jobs of workers who produce bananas. In this case, there was a missing market-the plantation owners did not need to buy the right to pollute the fisheries, because they could do it for free. This is another case of an incomplete contract.

In cases like this, taxes can increase the polluter's marginal private cost of production so that it equals the marginal social cost, resulting in the socially optimal level of production (and pollution). We canvassed a variety of solutions to the environmental problem (the external effects of the pesticide on the downstream fisheries), including bargaining between the organizations of fishermen and the plantation owners, and legislation (in the real-world case that inspired our Weevokil model, the government eventually banned the chemical).

Figure 20.5 reproduces a segment of Figure 12.8 that summarizes the nature of market failures in interactions between economic actors and the environment, and lists some possible remedies.

In this unit, we also consider the problem of climate change. Like the market failures above, climate change arises due to missing markets. However, unlike local environmental issues, climate change is global in scope. It involves people with vastly differing interests, ranging from those whose entire nation may be submerged by rising sea levels to those who profit from the production and use of the carbon-based energy that contributes to global climate change. We will see that many of the concepts developed already, such as feasible sets and indifference curves, apply in these cases as well.

The problem of climate change combines missing markets, uncertainty about its effect on the economy, the possibility of positive feedbacks and environmental tipping points, the need for international cooperation, and intergenerational issues. It is the greatest challenge of our time, and we need to use our entire toolkit (and more) to see how we can address it.

20.2 Climate change

Many scientists now see climate change as the greatest threat to future human wellbeing. We focus on climate change because of its importance as an environmental problem, and because it illustrates the difficulties of designing and implementing adequate environmental policies. This problem tests our framework of efficiency and fairness to the limit, because of five features that climate change shares with other environmental problems:

greenhouse gas

Gases-mainly water vapour, carbon dioxide, methane and ozone-released in the earth's atmosphere that lead to increases in atmospheric temperature and changes in climate.

Stabilizing yearly emissions is not sufficient: Climate is affected by the total amount of greenhouse gases in the atmosphere. This is increasing due to the annual flow of emissions. But merely stabilizing emissions at current levels will not be enough, because the stock of greenhouse gases would then continue to increase.

Irreversibility of climate change: Increases in the amount of CO₂ in the atmosphere are partially irreversible, which means that our current actions have long-lasting effects on future generations.

The worst-case scenario: Experts are uncertain about the scale, timing, and global pattern of the effects of climate change, but most agree that climate change could be catastrophic. Therefore, the most likely scenario should not be the only guide to policy. We need to take into account a range of possible scenarios, including some very unlikely but disastrous ones.

A global problem requiring international cooperation: The contributions to climate change come from all parts of the world, and its effects will be felt by all of nearly 200 autonomous nations. It will be solved only by a high level of cooperation between the largest and most powerful nations, at a minimum, on a scale without historical precedent.

Conflicts of interest: The impacts of climate change differ among people according to their economic circumstances, both across the globe and within countries. Future generations will experience the effects of today's emissions, but also the actions we take to reduce them. It is unclear how to balance the competing interests of individuals in different economic circumstances, and the interests of current and future generations.

Climate change and economic activity

Figure 20.6 shows the data on the stock of CO ₂ (in parts per million) using the right-hand scale, and global temperature (as the deviation from the average over the period 1961-1990) using the left-hand scale, for the period since 1750.

Burning fossil fuels for power generation and industrial use leads to emissions of CO ₂ into the atmosphere. These activities, together with CO ₂ emissions from land-use changes, generate greenhouse gases equivalent to around 36 billion tonnes of CO ₂ each year. Concentrations of CO ₂ in the atmosphere have increased from 280 parts per million in 1800 to 400 parts per million, currently rising at 2-3 parts per million each year. CO ₂ allows incoming sunlight to pass through it, but traps reflected heat on the earth, leading to increases in atmospheric temperatures and changes in climate. Some CO ₂ also gets absorbed into the oceans. This increases the acidity of the oceans, killing marine life.

Figure 20.6 illustrates a key fact of climate science: that global warming is an effect of the amount of CO ₂ and other greenhouse gases in the atmosphere. To use the language of Unit 10, where we discussed income (a flow) and wealth (a stock), climate change is caused by the stock of atmospheric greenhouse gases, not by the flow of our annual emissions. It's what's in the tub that matters. Figure 20.7 presents this new use of the bathtub model to illustrate the problem.

The increase in CO ₂ in the atmosphere is occurring because the processes reducing the stock (natural decay of the CO ₂ and absorption of CO ₂ by forests) are far less than the new emissions that we add annually. Moreover, deforestation in the Amazon, Indonesia and elsewhere is reducing the CO ₂ 'outflows' while also adding to CO ₂ emissions. These forests are often replaced by agricultural activities that produce further greenhouse gas emissions in the form of methane releases from livestock and nitrous oxide releases from fertilizer overuse.

Martin Weitzman argues there is a non-trivial risk of a catastrophe from climate change in an EconTalk podcast.

The natural decay of CO ₂ is extraordinarily slow. Of the carbon dioxide that humans have put in the atmosphere since the mass burning of coal that started in the Industrial Revolution, two-thirds will still be there a hundred years from now. More than a third of it will still be 'in the tub' a thousand years from now. The natural processes that stabilized greenhouse gases in the atmosphere in pre-industrial times have been entirely overwhelmed by human economic activity. And the imbalance is accelerating.

It is estimated that we can emit only a further 1 to 1.5 trillion tonnes of CO ₂ into the atmosphere to give reasonable odds of limiting the increase in temperature to 2°C above pre-industrial levels. Should we manage to achieve this limit on emissions, there is still a probability of around 1% that temperature increases would be more than 6°C, causing a global economic catastrophe. If we exceed the limit and temperature rises to 3.4°C above pre-industrial levels, the probability of a climate-induced economic catastrophe would rise to 10%.

To support the objective, the IPCC published a special report in 2018, according to which global warming in excess of 1.5°C above pre-industrial levels would mean a significant increase in temporary and permanent damage to people, species and ecosystems.

Figure 20.8 shows the relationship between estimated temperature increases and CO ₂ emitted. It also shows the amount of CO ₂ that would be emitted if we:

burnt the fossil fuels that can be economically extracted at current prices and technology (reserves)

burnt all fossil fuels in the earth's crust (resources)

Figure 20.8 indicates that keeping the warming to 2°C implies that the majority of fossil fuel reserves and resources should remain in the ground.

Exercise 20.1 Assessing the economic impacts of global warming

In 1896, Swedish scientist Svante Arrhenius estimated the impact of doubling CO ₂ concentrations in the atmosphere, and later suggested that 'the colder regions of the earth' might want to burn more coal so as to enjoy a 'better climate'.

In the next century, entire countries may disappear as the level of the oceans rise in response to the melting of the West Antarctic and Greenland ice sheets.

1. Find out what you can about which regions, industries, occupations, firms, or cities are likely to be:

1. most positively affected by climate change

2. most negatively affected by climate change

2. What are the main reasons why the effects of climate change differ across these groups?

Exercise 20.2 Climate change causes and evidence

Use information from the National Aeronautics and Space Administration web page on climate change, and the latest report of the Intergovernmental Panel on Climate Change to answer the following questions:

1. Explain what climate scientists believe to be the main causes of climate change.

2. What evidence is there to indicate that climate change is already occurring?

3. Name and explain three potential consequences of climate change in the future.

4. Discuss why the three consequences you have listed may lead to disagreements and conflicts of interest about climate policy. (Hint: You may find it useful to draw on your answers to Exercise 20.1 about the winners and losers from climate change.)

Question 20.3 Choose the correct answer(s)

Figure 20.8 shows the temperature increase arising from the CO ₂ emitted, generated at different levels of use of fossil fuel reserves (which can be technically and economically extracted) and resources (estimated total amounts) in the earth's crust. For example, it states that a further 1 to 1.5 trillion tonnes of CO ₂ emissions would be likely to lead to a 2°C increase in temperature, compared to the pre-industrial average.

You are also given that 36 billion tonnes of CO ₂ are generated each year currently. Based on this information, which of the following statements is correct?

The figure suggests that the world should stop using coal immediately.

Using up all the reserves but none of the resources should keep the temperature from rising more than 2°C.

Limiting further CO₂ emissions to 1 to 1.5 trillion tonnes will ensure that the temperature will not rise more than 2°C.

Stabilizing the emission rate at the current level will not be enough to prevent the possibility of a climate-induced economic catastrophe.

False. Whether we should stop using coal depends on the costs of further temperature increases relative to the benefits of coal use.

False. Temperatures would increase by 3°C if we used all fossil fuel reserves.

False. 1 to 1.5 trillion tonnes of CO₂ emission would be likely to lead to a 2°C increase in temperature. However, larger increases in temperature are possible due to uncertainty concerning the link between emissions and temperature.

True. Stabilizing emissions will cause a constant increase in the stock of CO₂ in the atmosphere, leading to further temperature increases.

20.3 The abatement of environmental damages: Cost-benefit analysis

Like other environmental problems, climate change can be addressed by environmental damage abatement policies such as:

discovering and adopting technologies that are less polluting

choosing to consume fewer or less environmentally damaging goods

banning or limiting the use of environmentally harmful substances or activities

However, the economic costs of immediately eliminating all CO ₂ emissions would surely exceed the environmental benefits. But what level of environmental abatement should be adopted instead?

This is in part a question about the facts: What is the trade-off between the benefits of producing and consuming more, and the enjoyment of a less-degraded environment? It is also an ethical question: how should we value environmental quality? How should we trade off consumption now, with environmental quality enjoyed both by current and future generations?

If we ask citizens about their views of proposed environmental policies, we expect their responses will differ, partly because a deteriorating environment affects different people in different ways. Your point of view may depend on whether you work outdoors (you will benefit more from a less polluted local environment) or in fossil fuel production (you may lose your job if the higher abatement costs levied on your firm causes it to shut down). It may depend on whether you have no choice but to live near a source of air pollution, or are wealthy enough to have a second home in the countryside.

Your opinion about how much we should spend today to protect future environments would no doubt differ from the values of those who make up the distant future generations that would be affected by our choices, if we could ask them. People's views are strongly influenced by their self-interest but, as you would expect from the behavioural experiments in Unit 4, not totally so. We worry about the effect on others, even complete strangers.

For simplicity, we begin by setting aside these differences and consider a population composed of identical individuals. We ignore future generations, or optimistically assume that we will all live forever. We will begin by also assuming that everyone enjoys (or suffers from) the same level of environmental quality. Later in this unit we will look at what changes when we do not make these assumptions.

We will also start off with what we call the 'ideal policymaker' who seeks to serve the citizens' interests.

How can economics help the policymaker determine the level of environmental quality that we would like to enjoy, knowing that people may have to consume less so they can enjoy a better environment? The first thing to think about is the actions that we can take and their consequences: the feasible set of outcomes.

To do this, we need to consider the ways that the resources of the society could be diverted from their current uses to reduce the environmentally degrading effects of economic activity. The nation may adopt policies to limit environmental damage. We refer to such policies as abatement policies, since they abate (reduce) pollution and environmental damage. The amount of reduction in emissions caused by these policies is referred to as the quantity of abatement. Abatement policies include taxes on emissions of pollutants, and incentives to use fuel-efficient cars.

In the rest of this section, we use a specific example to illustrate the general approach to environmental cost-benefit analysis. The specific case is the choice of global policies that reduce greenhouse gas emissions. Keep in mind that we are assuming that the policymakers throughout the world are able to implement these policies.

Abatement costs and the feasible set

To get some idea of how economists assess abatement policy options, we look at the estimated cost of reduction of global greenhouse gas emissions in Figure 20.9, which shows the relationship between potential abatement and the cost of abatement per tonne. It is the marginal cost curve for the good, which we refer to as the global greenhouse gas abatement cost curve. These estimates were made by the consultancy firm McKinsey.

The measure of potential abatement, gigatonnes (10⁹ tonnes) of carbon dioxide equivalent (GtCO ₂e), is a unit used by the UN climate change scientific panel, the IPCC, to measure the effect of a technology or process on global warming. It expresses how much warming a given type of greenhouse gas would cause by using the equivalent amount of CO ₂ emissions that would have the same effect.

Each bar represents a change that could reduce carbon emissions. The height shows the cost of using the technology to reduce carbon emissions, in terms of euros per tonne of reduced CO ₂ emissions. The width shows the reduction of CO ₂ emissions, compared to the level without policy intervention. Therefore, for each method, a short bar means that there is a lot of abatement per euro spent. A wider bar means that this method has a higher potential to abate emissions.

Note that in this figure we have only included policies which have a cost. There are many other policies that are win-win, because they both reduce carbon emissions and save money, such as fitting insulation in older houses. The full range of policies can be seen in Figure 20.26; the costly ones are in Figure 20.9. We discuss the implications of win-win policies in Section 20.10. You may wish to read that section now before working through the rest of the unit.

In Figure 20.9, we order the policies from those with the least cost per tonne of CO ₂ abated on the left to the highest cost per tonne abated on the right. By this measure, abating carbon emissions through changes in agriculture is the most efficient method, if we disregard the win-win policies. Nuclear, wind, and solar photovoltaics are all moderately efficient. At the time these estimates were produced, retrofitting gas-fired power plants for carbon capture and storage is the highest-cost policy per tonne of CO ₂ abated. Together, the bars form a marginal cost curve, showing the cost of an additional tonne of abatement at any given level of abatement, assuming that we adopt the most efficient technologies first.

The science in this field is young, and technologies are continuously developing. As knowledge advances, the estimated abatement cost curve will change-indeed, it is likely to have changed already from the data shown here, which was published in 2013. For instance, rapid reductions in costs of solar power are likely to increase the efficiency of solar abatement, and therefore reduce the height of the bars associated with solar energy (see Figure 20.19a).

But even focusing on only the most efficient bars, implementing any of these abatement policies would divert resources from the production of other goods and services: the opportunity cost of an improved environment would be reduced consumption.

We can use data from the marginal cost curve for abatement (as in Figure 20.9) to estimate how much abatement we get for any level of expenditure, assuming we implement the most efficient methods first. These calculations are given in Figure 20.10. We would start by implementing the cheap and effective measures, such as land management and conversion policies. Having exhausted these policies, the curve becomes flatter at higher levels of expenditure, where we would be devoting more resources to less efficient methods such as carbon capture and storage (CCS) modifications to power stations. For more detail on the calculations of marginal abatement costs, see the Einstein at the end of this section.

The curve in the figure, called the least-cost abatement curve, gives all the combinations of expenditures and resulting abatement when the lowest-cost changes are introduced first and the higher-cost ones are introduced later.

Using figures like 20.10, we can establish all of the possible combinations of consumption and abatement that are feasible. The available abatement technology is shown by the shaded set of points in Figure 20.11. In this figure, the horizontal axis measures the expenditure on abatement. The vertical axis measures environmental quality by the amount of abatement achieved. The zero point on the vertical axis is a situation in which no abatement occurs.

dominated

We describe an outcome in this way if more of something that is positively valued can be attained without less of anything else that is positively valued. In short: an outcome is dominated if there is a win-win alternative.

The shaded area is the feasible set of abatement expenditures and environmental outcomes. Points like A in the interior of the set are inefficient abatement policies. At A, we can see that there are alternative measures that would achieve the same level of abatement (25 gigatonnes) at lower cost (€400 billion rather than €600 billion). Similarly, for an expenditure of €600 billion, the choice of the most cost-effective abatement techniques would deliver 30 tonnes of CO ₂ abatement and therefore higher environmental quality than at point A. Economists say that a point like A is dominated by points A′ and A″ and all the points in between. This means that at any of these other points there could be lower abatement costs and the same level of abatement (A′), or greater abatement at the same cost (A″).

How would an inefficient point like A in Figure 20.11 occur? In Figure 20.10, the policies were ordered so that the first expenditures on abatement are devoted to the most effective abatement policy. After exhausting the potential of each policy we moved to the next most effective policy.

To highlight the difference between an efficient and an inefficient abatement policy, Figure 20.12 shows the abatement options based on the data in Figure 20.9, but with more costly policies adopted first. If a society has committed to spend €8.37 billion on abatement, and spends it all on coal carbon capture, nuclear, and other less effective options, then the least-cost abatement curve would be as shown in Figure 20.12.

We can see that if €8.37 billion were spent on abatement, the level of abatement would be 4.94 gigatonnes of CO ₂, rather than the abatement of 11.2 gigatonnes that would have occurred if the society implemented least-cost policies, as shown in Figure 20.10.

Figures 20.10 and 20.12 send a clear message about priorities. If we have a limited amount to spend on abatement, and abatement technology does not change, focus on reducing pastureland conversion. According to Figure 20.10, we should also adopt nuclear power (assuming that waste storage and other security issues can be addressed), solar, and wind power before building new coal plants with carbon capture and storage (CCS), or retrofitting old coal plants for CCS.

To study environment-consumption trade-offs, we invert the least-cost abatement curve, just as we did with the grain production function in Unit 3. Suppose that, after a given level of government expenditure on other policies and also a given level of investment, the maximum amount that people could consume in the economy if no abatement is implemented is €500 billion of goods and services. Then the feasible choices are the shaded portion of Figure 20.13.

In Figure 20.13, the vertical axis still measures the quality of the environment, but the horizontal axis now measures the goods available for consumption after abatement costs (from left to right). So, abatement expenditures are now measured from right to left.

The abatement choice problem now looks familiar. The policymaker wishes to select a point among the alternatives on the feasible frontier. Recall from the earlier units that the slope of the feasible frontier, also known as the marginal rate of transformation (MRT), is how much of the quantity on the vertical axis you would get by giving up one unit of the quantity on the horizontal axis. In the consumption-environment feasible frontier, this is the marginal rate of transformation of foregone consumption into environmental quality:

The steeper the feasible frontier (the greater the slope), the smaller the opportunity cost, in terms of foregone consumption, of further environmental improvements.

Environment-consumption indifference curves

Which point on the feasible set will the policymaker choose? The answer can be found by studying the policymaker's environment-consumption indifference curves in Figure 20.14, which show how much consumption citizens are willing to trade in exchange for better environmental quality.

We can write the slope of the indifference curve, the marginal rate of substitution (MRS) as:

The policymaker's MRS will be high (a steep indifference curve) if consumption is valued highly by the citizens (a large marginal utility of consumption), and if citizens do not place a high value on additional abatement to improve environmental quality (marginal utility of abatement is low). Conversely, if the citizens value additional environmental quality highly relative to consumption, the MRS will be less steep.

In Figure 20.14, the indifference curves are straight lines because we have assumed for simplicity that the marginal utility of consumption and the marginal utility of environmental quality are both constant. That means they do not depend on the quantity of consumption or on the amount of abatement.

To think about how citizens' preferences affect the optimal policy chosen, we suppose that the policymaker takes account of the preferences of all of the citizens, counting them equally. This means that if citizens decide to value environmental quality more, then the indifference curves of the policymaker will be flatter to reflect this.

Cost-benefit analysis: The ideal policymaker chooses an abatement level

Our policymaker uses two principles to make a decision about the level of abatement:

She considers only abatement policies on the frontier of the feasible set: This eliminates higher-cost abatement policies that are inside the shaded area.

She chooses the combination of environmental quality and consumption that puts her on the highest possible indifference curve.

To satisfy both conditions, she finds the point on the feasible frontier that equates the MRT (the slope of the feasible frontier) with the MRS (the slope of her highest possible indifference curve).

We can see from Figure 20.14 that point X is the level of environmental protection that the policymaker will wish to implement. The benefit indicated by the environmental quality index of 62 is achieved at a cost of reducing consumption by €50 billion and allocating it to abatement.

What would produce a different choice of abatement level?

Different values: If the citizens cared less about the environment, then the indifference curves would be steeper than those in Figure 20.14, and the policymaker would choose a point like B, with higher consumption and lower abatement.

Different costs of abatement: If abatement became cheaper than shown in Figure 20.14, then the feasible set would be steeper at each level of abatement. This would expand the production frontier upwards, implying that the policymaker would choose a higher level of abatement and lower consumption.

Exercise 20.3 Choosing abatement strategies

Look at the high-cost abatement strategies that we use to illustrate an inefficient abatement policy in Figure 20.12. Can you think of reasons why these policies might be introduced instead of the more cost-effective ones?

Exercise 20.4 Optimistic and pessimistic policies

In Figure 20.14, we described how a policymaker representing a uniform group of identical citizens chooses the optimal amount of abatement.

1. Draw the indifference curves of the policymaker if she were to represent two different groups of citizens (again, we assume that all citizens in each group are identical, and the marginal utility of consumption and environmental quality are both constant). In the first group, citizens care more about environmental quality than consumption, and in the other group, citizens care more about consumption of goods and services. Explain why the optimal level of abatement costs will differ across groups.

2. Now consider the example in the text of the abatement of global greenhouse gases. What are the main simplifications in the model that might lead the policy maker who uses this model to ignore important aspects of the problem of global greenhouse gas abatement?

In reality, there is uncertainty about the effectiveness of abatement expenditure and hence how costly abatement of environmental damage will be.

1. On a new diagram, draw the feasible consumption frontier based on an optimistic assessment of the costs of abatement.

2. Now draw the feasible consumption frontier based on a pessimistic assessment of the costs of abatement on the same diagram.

3. By adding the policymaker's indifference curves to your diagram in each case (assuming all citizens are identical), show how actual environmental quality chosen by the policymaker will differ, even if preferences are the same, depending on whether costs of abatement are assessed optimistically or pessimistically.

Question 20.4 Choose the correct answer(s)

Figure 20.9 shows a global greenhouse gas abatement curve, defined as the abatement in 2030 compared with 'business as usual', produced by McKinsey in 2015. The width of each bar indicates potential abatement measured in gigatonnes of CO ₂, while the height indicates the cost of abatement per tonne.

Based on this information, which of the following statements is correct?

Einstein Marginal abatement costs and the total productivity of abatement expenditures

How do we construct the line segments that define the boundary of the feasible set in Figure 20.10 from the data in Figure 20.9?

Let the height of the first bar (the most cost-effective abatement expenditure) in Figure 20.8 be y and the width of that bar be x. Then, in Figure 20.10:

the initial slope of the curve is 1/y

the horizontal axis value of the first point is xy

this point's vertical axis value is x

The other line segments making up the curve in Figure 20.9 are constructed in the same way.

20.4 Conflicts of interest: Bargaining over wages, pollution, and jobs

Conflicts of interest arise because environmental quality is never the same for everyone. Some people benefit or suffer more than others, depending on their location and income, as we saw in the banana pesticide case studied in Unit 12.

Here are two examples of how costs and benefits are not equally shared. In 2008 and 2009, two oil spills in the Niger River delta destroyed fisheries. The spills resulted from the oil extraction activities of the Anglo-Dutch company, Royal Dutch Shell. Lawyers for the Ogoni people, who suffered these external effects, brought a lawsuit against the Nigerian subsidiary of Shell in the British courts. In 2015, Shell settled out of court and paid £3,525 per person, of which £2,200 was paid to each individual, and the rest to support community public goods. This award amounted to more than most Ogoni people would earn in a year. Lawyers representing the community helped to set up bank accounts for the 15,600 beneficiaries.

The transfers may have compensated the Ogoni in part for the loss of a healthy environment, restoration of which the UN Environment Programme has estimated will cost $1 billion and take 30 years. For Royal Dutch Shell, the settlement at least partially internalizes the negative external effects of their activities, and might lead the company's owners (and others extracting oil in the delta) to consider a change in their behaviour.

In 1974 a giant lead, silver, and zinc smelter owned by the Bunker Hill Company was the only major employer in the town of Kellogg, in the American state of Idaho, employing 2,300 people. Many children in the town developed flu-like symptoms. Doctors discovered that they were the result of high lead levels in their blood-high enough to impair cognitive and social development of children.

Three of the children of Bill Yoss, a welder at the smelter, had been found to have dangerously high levels of lead poisoning. 'I don't know where we'll end up,' he told a People reporter, 'We may pull out of the state.'

The company refused to release its own tests of the smelter's lead emission levels. Unless the state's emissions regulations were relaxed, it said, the smelter would shut down, which it did, in 1981. Former employees looked for work elsewhere. The value of the homes and businesses in the town fell to a third of its earlier level. The local schools, which were supported by property taxes, did not have the funding to cope with those who remained.

We model this problem by considering a hypothetical town, Brownsville, with a single business that employs the entire labour force but whose toxic emissions are a threat to the health of the citizens. The firm can vary the level of emissions that it imposes on the town, but the costs of implementing emissions capture and storage means lost profits. The single owner of the firm (who bears the costs of reducing the level of emissions) lives far enough away that the level of emissions he selects does not affect the quality of his environment. Therefore citizens and the business will have a conflict of interest over the level of emissions in the town, and also over the wages paid. You can think of the citizens as valuing 'environmental quality', which decreases when emissions increase and can be measured by an air quality index.

The citizens of the town have some bargaining power because each is free to leave Brownsville and seek employment elsewhere. So the business must offer them a package of environmental quality and wages that is at least as desirable as their reservation option, which is what they might expect to receive if they left Brownsville. We call this limit on what the business must offer the citizens the 'leave town condition'.

The business owner has bargaining power, too, because the wage and environment package that he offers must result in profits high enough that the firm does not simply shut down or relocate (we call this the firm's 'shutdown condition'). The citizens cannot demand more than this wage, or they would be unemployed (remember there are no other firms in Brownsville). Thus the firm's reservation option places limits on the bargain that the citizens can strike with the firm.

We represent the relationship between the business and the citizens in Figure 20.15. The wage paid to the employees of the firm is on the horizontal axis. The level of environmental quality experienced by the citizens is on the vertical axis. We make the following assumptions:

Citizens are identical and so experience the same environmental quality.

The owner is unaffected by the level of pollution: For him, the environmental external effects resulting from his decision about emissions are borne by others. Pollution for him is a private 'good', and he does not consume any of it.

Work through the analysis in Figure 20.15 to see how the choices of the citizens and businesses are modelled.

You may recall that this figure is very similar to Figure 5.8, in which Angela the farmer and Bruno the landowner were bargaining over the amount of grain Angela would transfer to Bruno. As in that problem, the study of a bargaining problem is easier if the slope of the indifference curves remains unchanged at a given wage as utility increases.

Here, the conflict is about the amount of emissions that the townspeople will suffer. The firm's profits depend on the emissions, and profits are greater if it can dispose of more toxic materials freely.

The position of the citizens' reservation indifference curve depends on what they would expect to get in some other location. If they could find a high-paying job in a non-toxic community, the curve would be higher and to the right of the one that is shown. Its slope, the marginal rate of substitution, is the citizens' marginal utility of higher wages, divided by the marginal utility of environmental quality.

We assume that the citizens' marginal valuation of improvements in the environment is constant, but (in contrast to the model in Section 20.3) they have diminishing marginal utility of receiving higher wages. At high wages (and very poor environmental quality) on the far right of the reservation indifference curve, the MRS is small (the curve is almost flat) because citizens would not care much about wages (as they are already getting paid a high wage) but they are very concerned about the poor environment. At low wages the curve is steep, because they place a high value on wage increases.

The firm's shutdown condition shows the combinations of wages and environmental quality offered by the firm that would barely keep the firm in Brownsville. All of the points on this line have the same cost of producing a unit of output and, as a result, the same profit rate. The firm's profits are increasing as you move towards the origin. It is like the isocost curve in Unit 2, and the isocost lines for effort in Unit 6.

The cost of raising the wage by $1 is $1. Assume the cost incurred by the owner if he reduces emissions is p per unit of abatement, so the owner's MRS = 1/ p. A steep line indicates that p is small-avoiding emissions and thereby allowing a healthier environment is cheap.

The firm faces a trade-off. If it is at point B in the figure, it pays wages and produces emissions at a level that makes it barely profitable enough to stay in business. Therefore, if it offers a higher-quality environment to the citizens, it can only do this by offering a lower wage. The opportunity cost of one unit of a better environment is p in reduced wages.

Any combination of wages and environmental quality in the shaded portion of the figure is a feasible outcome of this conflict. Any combination on the vertical line between A and B is a Pareto-efficient outcome. We cannot say which feasible outcome will occur, though, unless we know more about the bargaining power of the citizens and the firm.

The firm has all the bargaining power

If the firm could simply announce a take-it-or-leave-it ultimatum, then it would choose point A in Figure 20.15. The firm's costs will then be well below the shutdown level of costs because they will be freely emitting toxic materials, which reduce the citizen's environmental quality from E max, the least emissions (and highest quality environment) consistent with the firm staying in business, to E min. This difference ( E max − E min) shows up as cost reductions, and hence as additional profits, in the firm's accounts. It also shows up as exposure to health hazards in the medical records of the people who live in the town.

The firm's chosen point, A, is on the citizens' reservation indifference curve where the vertical distance between the firm's shutdown condition and the citizens' leave town condition is the greatest. This will occur when:

Citizens have all the bargaining power

If the bargaining power had been reversed, then the citizens would choose to impose E max and wages w*. This ensures that the citizens are on their highest possible indifference curve, while also satisfying the firm's shutdown condition. Again, at this point the MRS of the business is equal to the MRS of the citizens.

Dividing the mutual gains

The difference between E max and E min measures the extent of mutual gains the townspeople and the business may enjoy. Any outcome between A and B on the figure is preferable to the next best alternative for the business (shut down) and the citizens (leave town). You can think of the mutual gains as a pie that the citizens and the business owner will divide. How the pie is divided up between the two parties depends, as we have seen in Units 4 and 5, on their relative bargaining power.

A point such as C in Figure 20.15 might be possible if the citizens, acting jointly through their town council, imposed a legal minimal level of environmental quality and wages for the business to continue to operate. Acting together, the citizens would have more bargaining power than if they used the threat to leave town as individuals: they could require that the business at least meet the citizens' 'shut-it-down condition' shown in Figure 20.15.

Bargaining power in this case would be affected not only by the two parties' reservation options but also by:

Enforcement capacity: The town government may not have enforcement capacities to impose an emissions limit on the firm.

Verifiable information: The citizens may not have sufficient information about the levels and dangers of emissions to win a case in court. If so, the firm would not comply with an agreed-upon emissions level such as at C in Figure 20.15.

Citizen consensus: If the town's citizens were not in agreement about the dangers of the emissions, the elected officials of the town who legislate an emissions limit might not be re-elected.

Lobbying: The firm may be able to convince the citizens that their health concerns were misplaced, or had little to do with the firm's emissions.

Legal recourse: The firm may be legally entitled to emit any level of emissions that it finds profitable (perhaps subject to having purchased permits allowing it to do this).

So far we have focused on the question of how much abatement there should be. Now we consider a second question: How should the desired level of abatement be accomplished?

20.5 Cap and trade environmental policies

price-based environmental policy

A policy that uses a tax or subsidy to affect prices, with the goal of internalizing the external effects on the environment of an individual's choices.

quantity-based environmental policy

Policies that implement environmental objectives by using bans, caps, and regulations.

In Unit 12, we saw possible remedies for the market failure that arose from the negative external effects of pesticide use. The range of remedies included private bargaining between the pesticide users and the fishing community whose livelihoods were threatened, taxes to make the pesticides (or the bananas produced using them) more expensive, ownership of all affected assets by a single business or other decision-making entity, and quotas or outright bans on the use of the pesticide. Some of these policies would have made it more expensive to harm the environment so as to provide incentives for greener economic decision making ( price-based policies). Others would have made it illegal ( quantity-based policies).

cap and trade

A policy through which a limited number of permits to pollute are issued, and can be bought and sold on a market. It combines a quantity-based limit on emissions, and a price-based approach that places a cost on environmentally damaging decisions.

A policy called cap and trade is a policy that combines a legal limit on the amount of emissions with an incentive-based approach to assigning the abatement required to meet this legal limit among firms and other actors.

Here is the idea:

The government or governments set the total level of abatement required: This is called the 'cap' and it constitutes the 'quantity' side of the policy.

The government creates permits: The number of permits issued limits total emissions to the size of the cap.

The government allocates permits: They can be given to the firms operating in industries emitting the pollutant, or they can be auctioned to polluting firms by the government.

The permits are traded: For some firms, polluting is very profitable and abatement costly. They will buy permits from other firms. Firms that produce little pollution or have low costs of abatement may have excess permits, which they can sell. Trade occurs until the gains from trade are eliminated.

The firms submit permits to government to cover their emissions: For each tonne of emissions produced, firms are required to provide one permit to the government. Ideally, government monitoring ensures that firms cannot cheat, and any firms caught violating the law are penalized with large fines.

Cap and trade policies are a way of implementing some desired level of emissions (or, equivalently, the total level of abatement required, E*) as the ideal policymaker did in Figure 20.13.

The desired level, however decided, is shown by the length of the horizontal axis in Figure 20.16. The question addressed by cap and trade is: given that firms vary in their production technologies, how will the total amount of required abatement be divided among them? The objective of a scheme for trading permits is that the abatement should be done by the firms for which this is least costly because this saves scarce resources that can be used elsewhere.

To see how this works, go through the analysis in Figure 20.16, which shows the case where the number of permits is initially divided equally between two firms with different costs of abatement.

There are many ways in which the permits might be traded once they are issued. One is the auction-type market studied in Unit 11, in which we saw (from an experiment) that the traders quickly converged to trading at a price like P*, which is the market-clearing price. The trading of permits achieves the desired level of abatement at the lowest resource cost to the economy. P* is the permit price and is equal to the marginal cost of abatement in the economy.

Cap and trade: Examples of emissions trading

One of the earliest cases of successful emissions trading was the sulphur dioxide (SO ₂) cap and trade scheme in the US, implemented in the 1990s and intended to reduce acid rain. By 2007, annual SO ₂ emissions had declined by 43% from 1990 levels, despite electricity generation from coal-fired power plants increasing more than 26% during the same period.

The European Union Emissions Trading Scheme (EU ETS), launched in 2005, is the largest CO ₂ cap and trade scheme in the world, and now covers 11,000 polluting installations across the EU. National governments auction 57% of permits in the EU ETS, and the overall emission cap (that is, the amount E* in Figure 20.16) is tightened every year. Some of the auction proceeds are used to fund low-carbon energy innovation. Similar carbon trading schemes exist in other countries and regions.

The EU ETS has been less successful than the US SO ₂ scheme. Some analysts think this is due largely to the fact that the permitted level of emissions was too high (too large a cap). After the financial crisis in Europe, lower aggregate demand caused the demand for electric power to shrink and with it, firms' profit-maximizing emissions levels. With supply exceeding demand, the price of permits fell dramatically, providing little incentive for firms to undertake abatement expenditures. These effects are shown in Figure 20.17.

This highlights a drawback of cap and trade. The price signal is not necessarily a reliable guide for future abatement investment decisions. In Germany, for example, the fall in permit prices led to several high-emitting coal power plants reopening, because dirty technology was profitable again.

But emissions trading schemes do not need to leave the market entirely free. The UK, for example, uses a carbon price floor, which sets a minimum price for British participants in the Emissions Trading Scheme. They do this to avoid the 'virtually free pollution' outcome that occurs when the permit price crashes.

The estimated total external cost of a tonne of carbon dioxide emissions differs depending on how we value future generations, as we shall see in Section 20.9. A low-end estimate in 2017 dollars is about $40 per tonne of CO ₂ emissions, and it is rising fast because the greater the amount of CO ₂ in the atmosphere, the higher the marginal effect on climate of adding more. The recent price of a permit on the European Union Emissions Trading Scheme (shown in Figure 20.17) is less than a fifth of this cost, so the permit plan is inducing decision-makers to internalize only a small fraction of the negative external effects.

Ideally, a tax on fossil fuels could entirely offset these external effects, with the added advantage that businesses and others would then face less uncertainty about the cost of burning carbon. A tax on carbon would raise the cost of emitting carbon in exactly the same way as having to pay for an emissions permit would do. In fact, the effect on costs would be identical if the market-determined cost of the permit were to be the same as the tax rate per tonne of emissions set by the government. The effect of the increase in costs would be higher prices of emissions-intensive goods and hence, ceteris paribus, demand for such goods would fall. Both the cap and trade and a carbon tax are said to be a way to 'put a price on' the external effects of carbon emissions.

How high should the price of carbon emissions be?

Given that producers and users of fossil fuels are usually heavily subsidized (at very different rates from country to country) the tax or the cost of a permit would have to exceed $40. On average around the world, fossil fuel subsidies are about $15 per tonne, so an optimal tax would be $55 per tonne (to internalize the external costs and to offset the subsidy). A simpler policy would be to eliminate the subsidies and set the carbon tax at our best estimate of the external cost of burning carbon.

The pros and cons of these two policies:

a cap and trade permit based system with a sufficiently low cap

a carbon tax at a sufficiently high rate to offset the external costs (and subsidies, if these remain)

These have been actively debated among environmental economists, with no clear consensus other than that either is preferable to the policies being pursued in most countries. Cap and trade, however, has been more popular, perhaps because it has the advantage of flexiblity. The ability to set the carbon price, but then to control the way in which permits are allocated and traded, gives the policymaker two 'levers'. In contrast, a single tax may be politically unpopular for a policymaker to implement.

Exercise 20.5 Assessing cap and trade policies

1. Explain why the green area in Figure 20.16 represents the total gains from trade. Hint: think about the first permit that Firm B buys from Firm A. How much is the most that Firm B would have been willing to pay? How much was the least that Firm A would have been willing to accept in order to part with the permit?

2. How would you explain the way a cap and trade policy works to someone who has not studied economics? How would you respond to their concerns that the policy is likely to be ineffective or unfair? Many newspapers and blogs publish 'op-eds', that is, opinion editorials from the public. A common length limit is 600 words. Find some op-eds on climate policy, and having looked at how they are written, draft your answer to this question in the form of an op-ed.

Exercise 20.6 A successful tradable emissions permit program

The cap and trade sulphur dioxide permit program in the US successfully reduced emissions. The program costs were approximately one-fiftieth of the estimated benefits.

Read Robert Stavins and colleagues' views on the US sulphur dioxide cap and trade program at VOXeu.org.

In the view of the authors, why are cap and trade systems such powerful tools to achieve reductions in emissions?

Also read 'The SO₂ Allowance Trading System' by Richard Schmalensee and Robert Stavins of the MIT Center for Energy and Environmental Policy Research.

1. Summarize the evolution of permit prices using Figure 2 in the article.

2. How well can the price movements in permit prices be explained by the analysis in Figure 20.16?

Look again at Hayek's explanation of prices as messages (Unit 11), and the analyses of asset price bubbles (Unit 11) and housing bubbles (Unit 17).

Could we use similar reasoning to explain price movements in Figure 2 of the paper by Schmalensee and Stavins?

Exercise 20.7 Would a carbon tax reduce emissions more than regulation?

In 2017, economists Martin Feldstein and Greg Mankiw (respectively economic advisors to US Presidents Ronald Reagan and George W. Bush), together with Ted Halstead, a climate campaigner, suggested in the op-ed 'A Conservative Case for Climate Action' that an ideal climate policy in the US should consist of three parts:

A single carbon tax should replace all regulations that are aimed at reducing carbon emissions.

Revenues collected from the tax should be refunded to American taxpayers in quarterly paychecks ('carbon dividend').

American firms that export to countries without carbon taxes should not pay a carbon tax, while importers should face an import tax on the carbon contents of their products (a 'carbon border adjustment').

1. Explain the economic reasoning behind each part of the proposal.

2. Why do the economists think replacing regulations with a single carbon tax would be more efficient?

3. Some environmental groups oppose the carbon dividend. They argue that the money could be better spent. Do you agree? What should carbon revenues be spent on? Do you think citizens are more likely to support a carbon tax if there is a carbon dividend?

4. Why do the economists think a border carbon adjustment is necessary? What would be the effect of a domestic carbon tax without a border carbon adjustment? What incentives does it create for American companies and for foreign companies? Is it fair on firms from developing countries (who often generate a lot of electricity from high emissions coal) who export their products to the US?

5. Do you support the proposal by Feldstein, Mankiw, and Halstead. Explain why or why not. What changes would you make?

20.6 The measurement challenges of environmental policy

To implement environmental policies using the framework we have provided, we need to measure the value of abatement.

Placing a value on the benefits of abatement is challenging because we are dealing with missing markets for environmental quality and uncertain long-term impacts. What is the value of preserving a rainforest, saving a threatened species, creating better air, or less noise? To answer these questions, different methods are used depending on whether the environmental issue in question is affecting environmental wellbeing, health, consumption, or future assets.

hedonic pricing

A method used to infer the economic value of unpriced environmental or perceptual qualities that affect the price of a marketed good. It allows a researcher to put a price on hard-to-quantify characteristics. Estimations are based on people's revealed preferences, that is, the price they pay for one thing compared to another.

contingent valuation

A survey-based technique used to assess the value of non-market resources. Also known as: stated-preference model.

We examine two methods of measuring the benefits of abatement: hedonic pricing and contingent valuation.

Contingent valuation

Among the easiest and most widely used methods of valuing the benefits of abatement is simply to ask people. For example, after the 1989 Exxon Valdez oil spill in Alaska, which released 11 million gallons (42 million litres) of crude oil into beautiful Prince William Sound, the court used contingent valuation to assess the value of the losses (such as the value of natural beauty) caused by the spill. They did this in a survey by asking respondents how much they would be willing to pay to prevent a new spill. The study estimated the lost value in 1990 to be at least $2.8 billion. Exxon eventually paid $1 billion in damages in a settlement with the governments of Alaska and the US.

Researchers used contingent valuation techniques to get a quantitative estimate of the value of elephant conservation in Sri Lanka. Farmers were killing elephants to protect crops and homes. The researchers wanted to know how much Sri Lankans would be willing to pay to the farmers as compensation for the damages caused by the elephants, if the farmers stopped killing them.

Contingent evaluation is called a stated preference approach because it is survey-based and accepts the respondents' statements of their values as indicative of their true preferences. This is not the case for hedonic pricing.

Hedonic pricing

Hedonic pricing is called a revealed preference approach because it uses people's economic behaviour (not their statements) to reveal what their preferences are. Laboratory experiments are a similar method of studying revealed preferences, as we saw in Unit 4. But lab experiments are not very useful in valuing the environment.

For example, how much do you value having your residence being free of the sound of aircraft flying overhead? Economists observe that houses under aircraft flight paths are sold for less than equivalent houses in quieter locations. By comparing data on house prices, we can calculate the amount people are prepared to pay to avoid the noise pollution.

This technique was used in the UK to set the tax for landfill waste. The marginal benefits of abatement were estimated in a study that used data on more than half a million housing transactions over the period 1991-2000. By controlling for a large number of factors that can account for the variation in house prices, the researchers then tested whether any of the variation left unexplained could be accounted for by the proximity of the house to a landfill site. The researchers found that being within a quarter of a mile (400 metres) of a working landfill site reduced house prices by 7%. They calculated that the marginal benefit from reducing the proximity to a landfill site was £2.86 per tonne of waste (in 2003 prices).

Hedonic pricing and contingent valuation give us a way to measure the way people value a particular change in the environment given their experience of this change. Green growth accounting gives us a way to estimate the value of conserving environmental resources for society as a whole, today and in the future. Below, you will learn about how some economists are placing a monetary value on society's use of natural assets.

How economists learn from facts Natural capital and green growth

depreciation

The loss in value of a form of wealth that occurs either through use (wear and tear) or the passage of time (obsolescence).

Recall that depreciation refers to the wearing out or using up of the physical capital goods used in production. In the green growth accounting framework, the environment is similarly considered as an asset that can be used up. The environment is part of what society needs to produce goods and services. Thus, environmental degradation reduces the assets of the society in much the same way as the wear and tear or obsolescence of machines used in production.

Remember that income is the most a person, or a nation, could consume without reducing its capacity to produce in the future. This was the message of the bathtub in Unit 10. Income is the flow of water into the tub minus the amount of evaporation that is reducing the total amount of water in the tub. Income according to this definition is gross income minus depreciation.

Although environmental degradation is not measured in conventional national accounts, it should be, because using up our natural capital is no different from the wear and tear on the machines and other equipment we use.

The World Bank estimates that in low-income countries, natural capital comprises 47% of wealth, so using some of this up and not counting the loss overstates how fast income is really growing. By how much though? In order to take natural capital loss into account, we must figure out how much it will cost (per year) to replace the lost natural capital and then subtract it from the annual GDP figure (remember that the most common measure of income, GDP, does not even take account of the depreciation of capital goods because of difficulties with measurement).

green adjustment

Accounting adjustment made to conventional measures of national income to include the value of natural capital.

If you make this accounting adjustment (also known as a green adjustment), 'success stories' of economic growth look less impressive. When Indonesian government policy generated a timber boom between 1979 and 1982, Robert Repetto and his colleagues from the World Resources Institute estimated that the country used up more than $2 billion of potential forest revenues. They showed that, after considering deforestation, oil depletion, and soil erosion, Indonesia's true average annual rate of growth of income (net of used up natural capital)-originally reported as 7.1% from 1971 to 1984-was in reality only 4%. A similar exercise was carried out for Sweden between 1993 and 1997, where the loss of natural assets was estimated to be around 1% of GDP per year.

When economists disagree Willingness to pay versus the right to a livable environment

The Constitution of the Republic South Africa asserts the citizen's 'right to an environment which is not detrimental to his or her health or wellbeing'. The Supreme Court of India ruled that the 'right to life' guaranteed by the Constitution of India 'includes the right to enjoyment of pollution-free water and air ...' Similar rights are granted in at least 13 other constitutions, including those of Portugal, Turkey, Chile, and South Korea. Use the Constitute Project website to check the constitution of your country, or any other in which you are interested, to see if you can find these guarantees.

Political movements opposing the privatization of water supply have used similar language. Access to clean water, they argue, is a human right. When a feature of the environment such as proximity to a landfill, noise pollution, or toxic emissions from a smelter is valued in monetary terms using the methods described above, this ignores the principle advanced by many that people have a right to an environment free of these hazards.

But in response, others ask: why should the quality of the environment that you experience be any different from the quality of the car that you drive or the food that you eat? You get what you pay for, and if you are unwilling to pay, then why should the policymaker worry about your values? If you believe this, the benefits of abatement policies can be measured by the citizens' willingness to pay (WTP) for the improved environment that the abatement will allow.

The WTP measure is criticized by some economists and citizens because it implies that people with hardly any money place a limited value on the environment, just as they have a limited willingness to pay for anything else. They do not lack the will, but they lack the way. Therefore using WTP as the method of estimating the benefits of abatement-for example, when either contingent valuation or hedonic pricing is used-means that policies that improve environmental hazards that mostly affect the poor, like ensuring safe drinking water in urban areas, will be valued less than policies that raise the environmental quality experienced by rich people, like pristine rivers, lakes, and oceans to enjoy while boating.

Also, this value may depend on how the question that determines the stated preference is asked. If, instead of our WTP for preservation of the environment, we are asked what compensation we are willing to accept (WTA) for the same proposed reduction in the quality of the same environment, empirical evidence is that the result would be a higher number.

merit goods

Goods and services that should be available to everyone, independently of their ability to pay.

If a safe environment is a right, an economist would term it a merit good, which you may recall from Unit 12. It is like the right to vote, or legal representation in court, or an adequate education: a good that should be available to all citizens irrespective of their ability to pay.

The advantage of the approach based on willingness to pay is that it makes use of information on how people value the environment. This should be relevant to how much we invest in environmental quality. Defining the environment as a right has the advantage that it does not give priority to the preferences of those with higher incomes in shaping environmental policy.

Exercise 20.8 Wealth and natural capital

Download the World Bank data in 'The Changing Wealth of Nations' dataset.

Using the total wealth data, calculate the change in natural capital between 1995 and 2000 and between 2000 and 2005 in absolute terms for three high income, middle income, and low income countries. Summarize and interpret your results.

Go to the World Bank's open data website. Find and download GDP (in constant prices) for your chosen countries for 1995, 2000, and 2005.

Calculate the change in GDP between these periods in absolute terms. Draw a scatter plot with the percentage change in GDP on the vertical axis and the percentage change in natural capital on the horizontal axis. Does it look like there is a relationship between these two variables? Suggest explanations for any relationship you find.

Question 20.7 Choose the correct answer(s)

Which of the following statements is correct regarding valuation of the benefits of abatement?

20.7 Dynamic environmental policies: Future technologies and lifestyles

The trade-offs given by the feasible sets and indifference curves we have used in our analysis will change as people adopt new values and lifestyles and develop new technologies, and as our impact on the environment intensifies.

Prices, quantities and green innovation

marginal productivity of abatement expenditures

The marginal rate of transformation (MRT) of abatement costs into improved environment. It is the slope of the feasible frontier. See also: marginal rate of transformation, feasible frontier.

Improvements in technology can enlarge the feasible set. Some improvements may make abatement more efficient, lowering the opportunity cost of an improved environment. Others may improve methods of producing goods, reducing the environmental costs of consumption as a result. Figure 20.18 illustrates the effect of a technological improvement, which improves the marginal rate of transformation of foregone consumption into abatement (otherwise known as the marginal productivity of abatement expenditure), and hence into an improvement in environmental quality. By increasing the marginal productivity of abatement expenditure, it makes the feasible frontier steeper.

In Unit 2, you learned how the rents from innovation drive progress and the improvement of productivity. If the right incentives exist to create innovation rents, we would expect technological breakthroughs that can deliver substitutes for some resources that would otherwise be used up, or that need to stay in the ground if climate change is to be safely limited. One such case is the technological progress achieved in solar energy.

learning by doing

This occurs when the output per unit of inputs increases with greater experience in producing a good or service.

Subsidies to firms producing the panels and other equipment has helped fund research and development in these new sources of electricity. Subsidies to those installing solar panels have increased demand. The growth of demand has in turn led to a sharp decrease in the price of solar panels thanks to learning by doing in the production process, which makes production cheaper and cheaper.

The idea that environmental regulation can create greater efficiency and be an incentive to innovation is known as the 'Porter Hypothesis', because it was first argued by Michael Porter, an economist, in 1995. He argued that the costs of regulation led firms to look for cleaner, more efficient technologies. The benefits of these technologies compensate both the costs of regulation, and the costs of innovation.

Figures 20.19a and b show the dramatic improvement in photovoltaic cell efficiency over the last few decades, which has led to a reduction in the cost of producing solar electricity.

In the US, many renewable energy technologies can already compete with fossil fuel generation without the need for subsidies, in terms of the total cost per unit of electricity generated, as shown in Figure 20.19b. However, since we can only generate wind power when the wind blows and solar power when the sun shines, renewable energy generation can be less reliable than fossil fuel generation. Fossil fuel generation may therefore be preferred in the absence of subsidies, even though the unit costs for solar power are lower.

To illustrate how a tax can create innovation rents by changing relative prices and promote innovation by the private sector, we apply a model introduced in Unit 2. Imagine a textile producer called Olympiad Industries (a hypothetical business), located in a country where the supply of electricity is intermittent, and so like most firms in the country it owns a coal-fired power generator. Burning fossil fuel generates greenhouse gases but the alternative (solar power) is more expensive. While the firm has installed some solar panels, it relies primarily on coal for electricity generation.

Figure 20.20 illustrates the cost comparison. You will be familiar with the model: it is the one in Unit 2 in which we explained how relatively high wages in England made the introduction of a labour-saving innovation (the spinning jenny) profitable. The difference is that we are not considering an innovation that saves labour but instead saves environmental resources, many of which (unlike labour in England in the eighteenth century) have no price.

In this figure, we study the effects of a tax on carbon-based energy sources on a firm's choice of technology. Prior to the tax, the coal-intensive technology was the cost-minimizing way to produce. Hence there was no incentive for a firm to develop and use renewable energy sources, and as a result, there were no profits to gain from developing the alternative to coal. After the tax, the firm would save the equivalent of a tonne of coal per unit of output by developing and using the solar technology.

The comparison of costs gives the owner of Olympiad a reason to adopt solar technology. Here the tax has changed the message sent by prices. It now says that you can make a profit by using renewable sources of energy. It also says that sticking with coal may mean being undercut by your competitors, if they switch to the lower-cost technology.

Environmental policy and long-term changes in lifestyles

In the long run, in addition to the role of policy in green innovation, how much we value the goods that contribute to our wellbeing can also change. Recall our discussion of social preferences from Unit 4. We saw that individual behaviours can be motivated by a desire to contribute to the common good. Below, you see how economists apply this general idea of pro-social preferences to evaluate the potential contribution of such preferences to environmental conservation.

How economists learn from facts Social preferences and environmental sustainability

social preferences

Preferences that place a value on what happens to other people, even if it results in lower payoffs for the individual.

Do the kinds of altruistic and reciprocal social preferences that we studied in Unit 4 motivate people to act in ways that will sustain the environment? This is not an easy question to answer because people are naturally happy to attribute their environmentally friendly actions to their green values, even if the latter were not really the reason for the action.

But two experimental studies suggest that social preferences do support green actions.

In the northeastern region of Brazil, shrimp are caught in large plastic bucket-like contraptions; the fishermen cut holes in the bottoms of the traps to allow the immature shrimp to escape, thereby preserving the stock for future catches. The fishermen thus face a real-world social dilemma like the ones we studied in Unit 4: the expected income of each would be greater if he were to cut smaller holes in his traps (increasing his own catch) while others cut larger holes in theirs (preserving future stocks).

In prisoners' dilemma terms, small trap holes are a form of defection that maximizes the individual's material payoff irrespective of what others do (it is the dominant strategy). But a shrimper might resist the temptation to defect if he were both public spirited toward the other fishermen and sufficiently patient to value the future opportunities that they all would lose if he were to use traps with smaller holes.

Experimental economists Ernst Fehr and Andreas Leibbrandt implemented both a public good experimental game and an experimental measure of impatience with the shrimpers. Like the experiments in Unit 4, both were played anonymously and the payoffs were real. Those who did not contribute in the public goods game went home with more money than the cooperative types who contributed.

The researchers found that the shrimpers with both greater patience and greater cooperativeness in the experimental game punched significantly larger holes in their traps, thereby protecting future stocks for the entire community. The effects, controlling for a large number of other possible influences on hole size, were substantial.

Additional evidence that social preferences can support green outcomes comes from a set of experiments and field studies with 49 groups of herders of the Bale Oromo people in Ethiopia, who were engaged in forest-commons management. Devesh Rustagi and his co-authors implemented public-goods experiments with a total of 679 herders, and also studied the success of the herders' cooperative forest projects.

The most common behavioural type in the experiments, constituting just over a third of the subjects, were 'conditional cooperators', who reciprocated higher contributions by others by contributing more to the public good themselves. Controlling for a large number of other influences on the success of the forest projects, the authors found that groups with a larger number of conditional cooperators were more successful (planted more new trees) than those with fewer conditional cooperators.

This was in part because members of groups with more conditional cooperators spent significantly more time monitoring others' use of the forest. As with the Brazilian shrimpers, differences in the fraction of conditional cooperators in a group were associated with substantial increases in trees planted or time spent monitoring others.

This does not mean that generous, cooperative, and reciprocal preferences are sufficient to address problems of environmental sustainability. But it does show that these social preferences can help.

We saw above that environmental behaviours can arise because of pro-social preferences. But they can also arise because of changes in lifestyles. The example of the Netherlands will illustrate this point.

In Figure 3.1, you saw that production workers in the Netherlands worked fewer than half as many hours in the year 2000 as they had in 1900. In 2000 they enjoyed a lot more free time and consumed less than half as many goods and services as they would have done had they continued working more than 3,000 hours a year, as they did in 1900. If they still worked long hours and used all these earnings for consumption, their adverse impact on the environment would be larger.

Look ahead to Figure 20.25a, which shows the CO ₂ emissions and GDP per capita for a wide range of countries. As a thought experiment, imagine that the Netherlands were twice as rich as it is in that graph. What would be the environmental impact in terms of CO ₂ emissions? In that figure the Netherlands is slightly below the 'predicted' line so if we assume that this was also true of our hypothetical workaholic Dutch nation, we can determine the level of CO ₂ emissions using the line of best fit. Instead of emitting 9 tonnes of CO ₂ per capita per year, they would be emitting around 20 tonnes. This would make the Netherlands among the top polluters in the world.

The Netherlands experienced an unusually large fall in its work hours (Figure 3.1 shows that work hours in France and the US fell, but not on the same scale as the Dutch). But even for these and other countries, if free time had not expanded at the opportunity cost of less consumption, the impact on global climate change would have been worse.

A lifestyle that is rich in free time, and less rich than it could be in goods and services produced in the economy, is a 'greener' lifestyle. Environmental policies can contribute to people adopting this lifestyle.

To see how, imagine that Omar is considering how far to travel by air for his holiday. Omar has enough income to fly anywhere, but he knows that burning aviation fuel is a major source of greenhouse gases. He would also like to have more free time, but realizes that a shorter working week would mean he has less money for his next holiday.

We represent the trade-offs affecting his choice in Figure 20.21. On the horizontal axis we measure hours of free time per year. On the vertical axis we indicate his kilometres of air travel during the year. The red line gives the total amount of air travel that he can afford for each choice of free time. The red line is therefore his feasible air travel/free time frontier.

The feasible frontier is constructed as follows. Suppose Omar makes $50 an hour after taxes and that he is free to set his own hours of work. He spends $90,000 on things other than air travel and to earn this amount, he must work 1,800 hours during the year. So, from the 8,760 hours in the year that he could give to work (as in Unit 3), he chooses to work 1,800 hours. Thus he has 6,960 hours of free time if he takes no air travel at all: this is the horizontal axis intercept of the frontier. How much air travel will he choose if $1 buys 4 km of air travel?

Omar's preferences for free time and air travel are given by the indifference curves shown. The slope of the indifference curve indicates how much he values free time relative to air travel, that is, his MRS of free time for air travel.

Work through the analysis in Figure 20.21 to follow Omar's decision making.

income effect

The effect that the additional income would have if there were no change in the price or opportunity cost.

substitution effect

The effect that is only due to changes in the price or opportunity cost, given the new level of utility.

Omar flies less. There are two reasons for the change:

The income effect: Omar's choices are now more limited than before because the price of something that he consumes has gone up. His real income has fallen.

The substitution effect: The tax has increased the relative price of air travel, leading Omar to substitute to other ways of having a good life, by consuming other goods (not shown in the figure), working less, or both.

Exercise 20.9 Improvements in technology

1. Redraw Figure 20.18 to show an improvement in the technology for producing consumption goods, instead of an improvement in abatement technology.

2. Based on your diagram, explain what happens to the feasible frontier and the optimal choice of environmental quality and consumption, assuming nothing else changes.

Exercise 20.10 The price elasticity of demand

A study of vehicle use and gasoline prices in California estimated that the short-run price elasticity of demand for the number of miles a car is driven is -0.22. Suppose the price of gas is now $3 per gallon and a proposed tax would raise the price to $4 per gallon.

For someone who drives 200 miles per week, what is the predicted reduction in the miles driven if the tax is implemented?

The same study found that people with higher incomes responded more to gas price changes than people with lower incomes.

1. Can you think of reasons why this may be the case?

2. Sketch two demand curves reflecting the difference in price responsiveness among different income groups: one for high-income people and one for low-income people. Show why the tax will impose a larger cost on the low-income group.

Question 20.8 Choose the correct answer(s)

In Figure 20.20, points A and B are the two technologies available to a firm in its production. Specifically, technology A uses 4 tonnes of coal and 2 m ² of solar panel to produce 100 metres of textiles, while technology B uses 1 tonne of coal and 6 m ² of solar panel for the same output.

Initially, the price of 1 tonne of coal is half that of the price of using 1 m ² of solar panel. In its latest budget statement, the government proposes a tax on the use of coal such that the price ratio increases from 1/2 to 2. Based on this information, which of the following statements is correct?

Question 20.9 Choose the correct answer(s)

The following diagram shows a consumer's choice of the amount of air travel per year, using indifference curves between hours of free time per year and kilometres of air travel. The consumer cannot afford air travel when he chooses 6,960 hours of free time. The consumer's after-tax hourly wage is $50.

Initially, the cost of a 1 km of air travel is $0.25. In its latest budget statement, the government proposes a fuel tax such that the cost of 1 km of air travel doubles to $0.50. Based on this information, which of the following statements is correct?

20.8 Environmental dynamics

Long before human economic and other activity began to have a substantial effect, the natural environment was constantly changing as a result of the chemical and physical processes that make up the biosphere. Over tens of thousands of years, an ice age would give way to a period of warming in which glaciers and sea ice covers retreated towards the poles, to be followed by a new period of cold temperatures with the advance of the ice sheets into what are now temperate climates. On shorter time scales, clouds of dust sent up by massive volcanic eruptions blocked out the sun, as occurred during the 'little ice age' 500 years ago (you can see the drop in average temperature around the middle of the fifteenth century in Figure 1.6b).

Climate today is also heavily influenced by human economic activity, but it is a process with its own dynamics of change. A challenge to environmental policymaking is that changes to environmental systems can set in motion self-reinforcing feedback processes so that small initial changes lead to much larger effects, resulting in faster and greater deterioration than anticipated. Like the Grand Banks fisheries and the Amazon rainforest, many freshwater systems, such as lakes and rivers, are subject to vicious circles of deterioration and collapse. In this section, we will examine the dynamics of Arctic sea ice in order to understand these processes and the relevant policy implications.

Multiple equilibria and tipping points

equilibrium

A model outcome that is self-perpetuating. In this case, something of interest does not change unless an outside or external force is introduced that alters the model's description of the situation.

Equilibrium is a fundamental concept of economics. It is essential to the way we predict the prices of goods using the model of supply and demand, or the level of unemployment using the model of the labour market. As the examples of the cod fisheries collapse or the threats to the Amazon rainforest described at the beginning of the unit showed, there may be more than one equilibrium. A healthy sustainable environment could be an equilibrium-think of Grand Banks cod fishing in the 100 years prior to 1950. And another could be the same geographical location devoid of cod, an example of environmental collapse.

The case of Arctic sea ice is an example of an environmental system that due to global climate change may already have shifted irreversibly away from the sustainable equilibrium. Figure 20.22 shows that for the past 50 years, the extent of the sea ice at the end of summer has been declining at an increasing rate. The insert in the figure illustrates the change in the last few decades.

Here we use a model to examine the passage away from the sustainable equilibrium and the process of environmental collapse, just as we did in Unit 17 to study a house price bubble and subsequent crash. You will note the similarity between Figure 20.23 and Figure 17.18 of boom and bust in a housing market. But now, instead of the house price this year and next on the axes in the figure, the horizontal axis is the extent of sea ice today (called E t to refer to the environment this year). The vertical axis is sea ice next year. This figure shows how the extent of sea ice today maps to the extent of sea ice tomorrow.

Environmental tipping point

On one side of an environmental tipping point, processes of environmental degradation are self-limiting.

On the other side, positive feedbacks lead to self-reinforcing, runaway environmental degradation.

The 45-degree line depicts an unchanging environment, since along that line any value of sea ice this period on the horizontal axis is the same next period (on the vertical axis). The S-shaped curve is the 'environmental dynamics curve' or EDC for short. Just as in Unit 17 for the PDC (price dynamics curve), points at which the EDC crosses the 45-degree line are equilibria. This is because the amount of sea ice this year is the same as next year (remember an equilibrium is something stationary, that is, unchanging from year to year).

In Figure 20.23 'Extensive summer sea ice' (point B) and 'No summer sea ice' (point C) are the stable equilibria of the Arctic sea ice ecology. Each of these equilibria is stabilized by feedback processes as shown in Figure 20.23. First, consider the high equilibrium. Ice is a lighter colour than open sea surface area so more ice leads the earth's surface to reflect more radiation rather than absorbing radiation, so that temperatures stay low. These low temperatures maintain the ice which reflects the radiation, keeping temperatures low, and so on. This process can be described as a virtuous cycle, shown at the top left of Figure 20.23.

But there is another equilibrium without summer sea ice. This is shown at the top right in the figure. You can call it a vicious cycle, just the opposite of the virtuous cycle with extensive ice. The darker open sea surface area absorbs more radiation and warms up. The resulting higher winter and spring surface temperatures in turn cause less ice in the summer. Thus if either stable equilibria exists it will be maintained by the circle of causes indicated by the arrows shown in Figure 20.23.

At any point in between the two stable equilibria at B and C, from year to year the sea ice cover will either be increasing towards the virtuous equilibrium at B or disappearing towards the no-sea-ice vicious equilibrium at C. Suppose there is extensive sea ice so the ecology is near point B, but for some reason - perhaps an unusually hot year for example - the extent of sea ice is equal to E ₀, that is, less than the equilibrium level at B. The EDC shows the extent of ice will be greater than E ₀ the following year and the arrow indicates the adjustment back to the equilibrium at point B.

This occurs since the EDC is above the 45-degree line. When there is a lot of ice, the feedback in the direction of maintaining the ice cover is strong, and we tend to stay there even when variations in temperatures (due to seasons or decadal variation in ocean currents) cause temporary warming and temporary reductions in sea ice. The extent of the ice means that the system 'rebounds' towards the high equilibrium.

This is an example of a negative feedback process in which an initial shock which moves the system away from the equilibrium point is dampened so that the subsequent changes are in the opposite direction, counteracting the initial shock. If there is a small negative shock away from point B - a slight reduction in the amount of ice - then in later periods if there are no further shocks, the initial extent of the ice will be restored.

In addition to the two stable equilibria, there is also an unstable equilibrium at point A. You can refer back to Figures 11.18 and 11.19 for the adjustment processes around a stable and an unstable equilibrium. The unstable equilibrium at Point A is also known as a tipping point.

If for some reason - a succession of unusually hot years, for example - the extent of sea ice is reduced below E A the process works in the opposite direction. The process amplifies the initial shock (reduced sea ice) rather than dampening it. These are called positive feedback effects. At that point, the feedback reduces the ice cover, bringing the system to the no-Arctic-summer-ice state. The capacity of the system to recover would have been pushed beyond its limits. Environmental scientists are increasingly pointing to the existence and importance of tipping points in environmental systems, which represent a point which, if passed, sets in motion a process leading to abrupt and hard-to-reverse destruction of an environmental resource.

Climate change and environmental collapse

What is the role of climate change in all this? We shall see that to analyse this we need to explain why the S-shaped environmental dynamics curve can shift down. If it shifts, the system will not stabilize around the high-summer-ice equilibrium at B.

To understand these effects, take a look at Figure 20.24. A warmer climate means that for any amount of sea ice this year, the amount that will be there next year is less. This is not a movement along the EDC but instead a downward shift of the whole curve. As a result, less ice forms in the winter and the whole system is more vulnerable to the increase in temperature and open surface area in the summer.

A warming climate therefore does two things. First, starting from the high equilibrium, the downward shift in the EDC caused by a warming climate brings the virtuous equilibrium B and the tipping points A closer together. In Figure 20.24, the shift down in the EDC has moved the 'high' equilibrium downwards to B', so there will be less sea ice from year to year. Notice too that the warmer climate has also shifted the tipping point upwards to A' from its initial position at A, which widens the 'danger zone' of environmental collapse.

As a result, it will take a smaller shock - just one unusually hot year perhaps - to push the system past the tipping point into the region where positive feedbacks of the vicious cycle take over, driving the system to the no sea ice equilibrium.

Second, as you can also see from the figure, if the downward shift in the EDC is large enough it will change the system such that the equilibrium with extensive summer sea ice disappears.

Is this what has been happening over the last century? From Figure 20.22, it appears that until the late 1960s, the Arctic sea ice was at high equilibrium (like B). Thereafter, the extent of sea ice declined at first gradually, illustrated in Figure 20.24 by the movement from B downwards towards Z. But then Figure 20.22 shows that from the mid-1980s, the reduction in sea ice was much more rapid, as would occur if the last tipping point had been passed and the system was in freefall towards no summer sea ice at all (point K).

Combining the model and the available evidence, the change from the Arctic with extensive summer ice to the Arctic with no-summer-ice equilibria appears to be underway. Scientists are unsure how reversible this loss of the Arctic summer ice is even if we reverse global warming. We may have crossed a point of no return. The lack of Arctic sea ice - if that is what is in store - will add to the already powerful forces creating a warmer climate.

Prudential policies to address tipping points

prudential policy

A policy that places a very high value on reducing the likelihood of a disastrous outcome, even if this is costly in terms of other objectives foregone. Such an approach is often advocated where there is great uncertainty about the conditions under which a disastrous outcome would occur.

When it is likely that a system displays multiple equilibria and a tipping point, environmental policy must go beyond balancing the costs and benefits of the abatement of environmental damage in the neighborhood of some sustainable equilibrium. Instead, policymakers must devise measures to ensure that a tipping point - especially if it is uncertain - for a critical resource is not passed. In this context, a prudential policy would seek to avoid the risk that the given situation may itself be radically and irreversibly degraded.

The aim of policies to slow global warming would be to keep the EDC within the set of feasible environmental equilibria shown by the green dashed line between B and Z.

The need to be prudent arises not just because there is a tipping point but also because of the uncertainty about how close we are to the tipping point. There is also uncertainty about the magnitude of shocks that might push the system beyond the tipping point, even if the virtuous equilibrium B remained above the tipping point. Prudent policy means seeking to avoid cataclysmic risks even if their likelihood is extremely small. The closer we are to a tipping point, the higher the chance of unknowingly crossing it and finding it impossible to reverse the degradation and avoid a catastrophic outcome.

biodiversity loss (rate of)

Proportion of species that become extinct every year.

Planetary boundaries are defined for critical environmental variables (such as temperature and biodiversity loss) and give levels of these variables that scientists think will keep us sufficiently far away from potentially disastrous tipping points to be within a 'safe operating space'. Respecting planetary boundaries is a prudential policy.

The value of prudence has implications for which kinds of policies are most appropriate. To see this, suppose there is no uncertainty about either:

The state of the environment: How close to a tipping point the ecosystem was, for example.

The effect of tax incentives: What will the effect be on carbon emissions?

Given this level of certainty, a tax on carbon emissions or a cap and trade policy could obtain the same outcome. Cap and trade would impose the desired level of abatement and the carbon tax would set the right price for carbon emissions, also leading to the desired level of abatement. In both cases, the policymaker must decide on the desired level of abatement before selecting the most appropriate policy.

However, we are often highly uncertain about both the state of the environment and the effectiveness of tax or subsidy policies. In these cases, cap and trade is more prudent because it can guarantee a particular level of emissions (the cap), which can be set sufficiently far away from the possible thresholds.

Exercise 20.11 Representing regime shifts

The Regime Shifts DataBase documents different types of regime shifts (another word for tipping point) that we have evidence for in human-dominated ecological systems. Choose one from the database and describe the situation in your own words, including the types of equilibria and their characteristics, and how the system transitions from one equilibrium to another. Draw a diagram similar to Figure 20.23 to represent it, and explain the feedback loops that are involved.

Exercise 20.12 Self-reinforcing processes

Self-reinforcing processes, such as the ones described above, do not happen only in nature. In Unit 17, for example, we discussed how increases in house prices can reinforce a boom and become self-sustaining, leading to a housing price bubble.

Explain the ways in which the cumulative self-reinforcing processes described by environmental scientists are similar to (or different from) processes that occur in a housing or stock price bubble.

20.9 Why is addressing climate change so difficult?

While scientists agree that climate change is occurring and that our economic activity is contributing to it, there are large gaps in scientific understanding of the processes involved and the costs of containing them.

Moreover, as we have seen in Sections 20.3 and 20.4, conflicts of interest over the extent and methods of abatement make it difficult for national governments to adopt broadly supported strategies for mitigating environmental degradation. These conflicts include disagreements about what climate science has shown. In 2015 in the US, 64% of Democratic Party supporters were of the opinion that global warming is both occurring and a result of human activity, but the similar fraction among Republicans was 23%.

Also, owners and employees of companies producing or using fossil fuels anticipate income losses as the result of policies to reduce emissions, and spend heavily to influence public opinion on environmental questions. You can read about the impact of this spending in a New York Times article on lead poisoning and examine a list of chemical industry lobbying expenditure for 2015 on OpenSecrets.org.

Lack of adequate information and conflicts of interest are impediments to good public policy in many other areas, but climate change poses two unusual challenges: the problem cannot be solved by national governments acting alone, and those affected by our choices today include generations in the distant future.

International cooperation

Using the tools of game theory in Unit 4, we saw that avoiding the tragedy of the commons that affects the supply of public goods depends on the rules of the game (the institutions). Where there are repeated interactions of the players and there are opportunities to punish those who do not contribute to the public good, the socially optimal outcome can be sustained. The presence of sustainable water-use systems or fish stocks in several continents shows that the tragedy of the commons is avoidable.

dominant strategy equilibrium

An outcome of a game in which every player plays his or her dominant strategy.

In the case of climate change, game theory helps us understand the obstacles to its solution. Recall the way we modelled the climate change game as a prisoners' dilemma in which two countries (the US and China) can either restrict carbon emissions or continue with business as usual (see Figure 4.17). Complete self-interest makes the business as usual scenario the dominant strategy equilibrium.

To understand how an international agreement might be negotiated to avoid the business as usual outcome, we introduced inequality aversion and reciprocity. If citizens of the US and China give some weight to the wellbeing of citizens in the other country or experience less wellbeing when inequality rises, and if they are willing to implement costly measures as long as this is also done in the other country, then an outcome where both countries restrict emissions is possible.

Our hypothetical model of climate change negotiations between China and the US gave rise to two Nash equilibria if citizens had both inequality aversion and reciprocity. It is also not completely unrealistic: after intense negotiations following failed talks and a non-binding agreement in Copenhagen in 2009, all countries committed to eventual emission cuts at the United Nations Conference on Climate Change in Paris in December 2015, with the goal of stabilizing global temperatures at 2°C above pre-industrial levels. Virtually all countries also submitted their individual plans for cutting emissions, but these plans are not yet consistent with this temperature stabilization goal.

Unrepresented generations

Our economic activity today will affect climate changes in the distant future, so we are essentially creating consequences that others will bear. This is just an extreme form of external effects that we have studied throughout the course. It is extreme not only in its potential consequences, but also in that those who will suffer the consequences are future generations.

In many countries, public policies have been adopted to address other kinds of environmental external effects, such as local pollution, under pressure from voters bearing the costs of these effects. If you look ahead at Figure 20.25b, you will notice that many of the stars (well above the line) on the Environmental Performance Index are, and have long been, electoral democracies. This is not the case for most of the low performers.

But the future generations that will bear the consequences of our decisions are unrepresented in the policymaking process today. The only way the wellbeing of these unrepresented generations will be taken into account at the environmental bargaining tables around the world is the fact that most people care about, and would like to behave ethically toward, others, as we have seen in Unit 4.

These social preferences underlie the debates among economists about how much we should value the future benefits and costs of the climate change decisions that we make today.

discounting future generations' costs and benefits

A measure of how we currently value the costs and benefits experienced by people who will live in the future. Note that this is not a measure of individual impatience about one's own future benefits and costs.

discount rate

A measure of the person's impatience: how much the person values an additional unit of consumption now relative to an additional unit of consumption later. It is the slope of the person's indifference curve for consumption now and consumption later, minus one. Also known as: subjective discount rate.

In considering alternative environmental policies, how much we value the wellbeing of future generations is commonly measured by an interest rate, which is literally the rate at which we discount future generations' costs or benefits. There are, however, debates about how this discounting process should be done.

When economists disagree The discounting dilemma: How should we account for future costs and benefits?

When considering policies, economists seek to compare the benefits and costs of alternative approaches. Doing this presents especially great challenges when the policy problem is climate change. The reason is that the costs will be borne by the present generation but the benefits of a successful abatement policy will be enjoyed by people in the future, many of whom are not yet alive.

Put yourself in the shoes of the impartial policymaker we studied earlier and ask yourself: are there any reasons why, in summing up the benefits and costs of an abatement policy, I should value the benefits expected to be received by future generations any less than the benefits and costs that will be borne by people today? Two reasons come to mind:

Technological progress: The people in the future may have either greater or lesser needs than we do today. For example, as a result of continuing improvements in technology, they may be richer (either in goods or free time) than we are today, so it might seem fair that we should not value the benefits they will receive from our policies as highly as we value the costs that we will bear as a result.

Extinction of the human species: There is a small possibility that future generations will not exist because humanity becomes extinct.

pure impatience

This is a characteristic of a person who values an additional unit of consumption now over an additional unit later, when the amount of consumption is the same now and later. It arises when a person is impatient to consume more now because she places less value on consumption in the future for reasons of myopia, weakness of will, or for other reasons.

These are good reasons why we might discount the benefits received by future generations. Notice that neither of these reasons for discounting is related to pure impatience.

This was the approach adopted in the 2006 Stern Review on the Economics of Climate Change ( read the executive summary on the UK National Archives website). Nicholas Stern, an economist, selected a discount rate to take account of the likelihood that people in the future would be richer. Based on an estimate of future productivity increases, Stern discounted the benefits to future generations by 1.3% per annum. To this he added a 0.1% per annum discount rate to account for the risk that in any future year there might no longer be surviving generations. Based on this assessment, Stern advocated policies that would have implemented substantial abatement investments today in order to protect the environment of the future.

Several economists, including William Nordhaus, criticized the Stern Review for its low discount rate. Nordhaus wrote that Stern's choice of discount rate 'magnifies impacts in the distant future'. He concluded that, with a higher discount rate, 'the Review's dramatic results disappear'.

Nordhaus advocated the use of a discount rate of 4.3%, which gave vastly different implications. Discounting at this rate means that a $100 benefit occurring 100 years from now is worth $1.48 today, while under Stern's 1.4% rate it would be worth $24.90. This means a policymaker using Nordhaus' discount rate would approve of a project that would save future generations $100 in environmental damages only if it cost less than $1.48 today. A policymaker using Stern's 1.4% would approve the project only if it cost less than $24.90.

Not surprisingly, then, Nordhaus' recommendations for climate change abatement were far less extensive and less costly than those that Stern proposed. When comparing the use of cap and trade with a carbon tax in Section 20.5, we referred to $40 per tonne as a low-end estimate of the external cost of carbon emissions. This is comparable to the carbon price of $35 per tonne in 2015 proposed by Nordhaus to deter the use of fossil fuels. Stern recommended a price of $360.

Why did the two economists differ by so much? They agreed on the need to discount for the likelihood that future generations would be better off. But Nordhaus had an additional reason to discount future benefits: impatience.

Reasoning as we did in Unit 10 for Julia's and Marco's consumption now or later, Nordhaus used estimates based on market interest rates as measures of how people today value future versus present consumption. Using this method, he came up with a discount rate of 3% to measure the way people discount future benefits and costs that they themselves may experience. Nordhaus included this in his discount rate, which is why Nordhaus' discount rate (4.3%) is so much higher than Stern's (1.4%).

Critics of Nordhaus pointed out that in evaluating the claims that future generations should have on our concern, a psychological fact like our own impatience is not a reason to discount the needs and aspirations of other people in future generations.

Stern's approach counts all generations as equally worthy of our concern for their wellbeing. Nordhaus, in contrast, takes the current generation's point of view and counts future generations as less worthy of our concern than the current generation, much in the way that, for reasons of impatience, we typically value current consumption more highly than our own future consumption.

Is the debate resolved? The discounting question ultimately requires adjudicating between the competing claims of different individuals at different points of time. This involves questions of ethics on which economists will continue to disagree.

Exercise 20.13 Simulating different discount rates

Download the simple discount rate simulation spreadsheet from our CORE website. The simulator allows you to calculate the present value of receiving $1 in one, 10, 50, and 100 years from now for four discount rates.

In the spreadsheet, the first three discount rates are fixed: zero, Stern's suggestion, and the alternative suggested by Nordhaus.

Explain the effect of different discount rates on the present value of receiving $1 in the future.

The fourth rate is your choice: use the slider in the table to choose a discount rate you think is appropriate for the evaluation of the benefits and costs of climate change policy in the distant future.

1. Justify your choice. Is it closer to the Nordhaus or Stern proposal? Or is it higher than or lower than both?

2. Try to find out what discount rate your government (or another government of your choice) uses to evaluate public investment projects. Do you think it is appropriate?

Question 20.10 Choose the correct answer(s)

The following table shows the present values of a $1 payment in the future, discounted at different rates. For example, $1 paid in 10 years' time is worth $0.82 today when discounted at 2% annually.

Based on this information, which of the following statements are correct?

True. Across the full range of discount rates presented, present values remain quite similar when payment is due in one years' time-for instance, the gap between the present value at 1% and 5% discounting is only $0.04. When the payment is in 50 years, by contrast, the gap between present value at 1% and 5% discounting has grown to $0.24.

False. For instance, at a 5% discount rate the present value of a $1 payment due in five years is $1 × (0.95)⁵ = $0.77. The present value of a $1 payment due in ten years is $1 × (0.95)¹⁰ = $0.60.

False. For instance, at a 1% discount rate, the present value of a $1 payment due in ten years is $1 × (0.99)¹⁰ = $0.90. At a 2% discount rate, the present value is $1 × (0.98)¹⁰ = $0.82.

True. A discount rate of 0% implies that you do not discount the future at all, so present values do not decline as the length of time until payment increases.

20.10 Policy choices matter

Differences between countries

Environmental policies make a difference. We can see that countries vary greatly in the global environmental damage they inflict and in their success at managing environmental quality in their country. Figure 20.25a shows CO ₂ emissions per capita for each country in 2018 alongside income per capita. Richer countries produce more CO ₂ per capita than poorer ones. This is to be expected because greater income per capita is the result of a higher level of production of goods and services per capita, with associated impacts on the biosphere. This is shown by the upward-sloped line that indicates the relationship between the two variables.

But notice, too, that among countries at approximately the same level of per capita income, some emit much more than others. Compare the high emissions levels in the US, Canada, and Australia with the lower emissions levels of France, Sweden, and Germany, countries at approximately the same level of per capita income. Another way to read the graph is horizontally: Switzerland has the same emissions level that would be predicted (by the line) for a country $40,000 poorer in per capita income. Oman pollutes as much as would be expected from a country $30,000 richer.

Though richer countries emit more CO ₂ per capita, they have also adopted more effective policies to manage their own environmental resources, such as forests, soil, biodiversity, and water. Figure 20.25b plots the Environmental Performance Index (EPI) against GDP per capita. The EPI is a broad index of country-level environmental health and ecosystem vitality, including the state of wastewater treatment, fisheries, and forests. It brings together 20 different country-level indicators including trends in carbon emissions, fish stocks, changes in forest cover, quality of wastewater treatment, access to sanitation, air pollution, and child mortality. In this case, a curved rather than straight line fits the data better, indicating that differences in per capita income are associated with major differences in the EPI for very poor countries, but not as major for the richer countries, on average.

As in Figure 20.25b, Oman underperforms, with the Environmental Performance Index expected of a country 25% as rich. Notice that Australia, which is an unusually big emitter of CO ₂ (Figure 20.25a), is a top performer on the national environmental amenities measured by the EPI. A good part of the environmental damage done by economic activity in Australia is thus imposed as a cost on those outside the country.

The message of Figure 20.25b is similar to the previous one. Countries, even at similar levels of income per capita, differ greatly in their environmental performance. Compare Switzerland with the US or Spain with Russia, for example. Both India and China are substantially below the line. These country differences suggest the importance of the kinds of policies that are adopted and enforced.

Lessons from the existence of win-win policies

We have introduced many difficult trade-offs confronting environmental policies, for example, between our consumption now and our environmental quality now. But we have also uncovered some evidence of win-win opportunities.

In Figure 20.26, we look again at the estimates of the marginal abatement costs that we previously saw in Figure 20.9. The global abatement cost curve is displayed vertically in Figure 20.26. In Figure 20.9, we only included measures that are costly and would have to be promoted as an objective of government policy. In Figure 20.26, when the monetary benefit is greater than the cost, the bar extends to the left of the vertical axis. When cost is greater, it extends to the right.

All of the actions to the left of the vertical axis in Figure 20.26 would not only accomplish significant abatement, but would also be privately beneficial in the sense that they result in monetary benefits greater than the costs. These are win-win actions because they improve the environment, and their cost savings also allow greater consumption.

Replacing incandescent light bulbs with LED bulbs in our houses is one of these win-win opportunities. It is the most cost-saving policy of all but it is a narrow bar, meaning it does not have a big abatement potential. Fuel-efficient vehicles, insulation in houses and offices, and other technologies with bars to the left of the axis are also cost-saving. Note that if we were only to adopt cost-saving policies between now and 2030, we would still achieve more than a quarter of the total potential abatement shown in the figure.

We can represent the unrealized abatement potential of these changes in the feasible set figure. The dashed line in Figure 20.27 is the feasible frontier that we have been using thus far, which ignored the win-win opportunities shown on the left side of Figure 20.26. The solid feasible frontier takes account of the possible use of these win-win options.

Start at point C on the horizontal axis in Figure 20.27. The evidence from Figure 20.26 is that implementing the measures (starting at the top of Figure 20.26, with replacement of incandescent bulbs by LEDs) will generate abatement benefits and at the same time allow for higher consumption of other goods and services.

This produces the positively sloped part of the feasible frontier, with both environmental quality and consumption rising from C to D. Once all the win-win measures have been introduced, at D, it begins to be costly to achieve further abatement and the feasible frontier is negatively sloped, as we saw when we analysed the implications of Figure 20.9.

The unrealized abatement potential of changes, that would save money for the individuals or firms implementing them, suggests that implementation by market incentives may be slow and incomplete. The fact that environmental benefits could be generated by economic decisions that would provide monetary benefits (not costs) to the decision-maker means mutual gains are feasible but are not being realized. Thus, Figure 20.27 provides another piece of evidence that contemporary economies are often not even close to being Pareto efficient.

These factors point to a primary advantage of policies to make some environmentally harmful practices illegal rather than simply making them more expensive. In those cases where the government has the necessary information and enforcement capacities, implementation can be rapid and complete. An example is the dramatic reduction in the use of lead in petrol in many countries around the world, following a ban. But as we will see in Unit 22, governments often lack the information and administrative capabilities to design and implement effective policies of this kind.

Is 'make the polluter pay' fair?

polluter pays principle

A guide to environmental policy according to which those who impose negative environmental effects on others should be made to pay for the damages they impose, through taxation or other means.

Think about the polluter pays principle. This principle can be interpreted as an application of the basic economics of environmental policies. Environmental external effects often impose costs on others, and making the polluter pay for these external effects is a way to internalize (and therefore eliminate) them.

This could be accomplished by taxing the polluting activity so as to equate the marginal private cost with the marginal social cost. This may be an efficient way to abate the pollution. But as we saw in Unit 12, the same abatement could be accomplished by providing the firm with a subsidy for the use of an alternative technology that resulted in a lower level of pollution.

The firm's view of these two policies may be that the tax is the stick and the subsidy the carrot. The tax, which reflects the polluter pays principle, lowers the profits of the firm. A subsidy raises the firm's profits. Whether the carrot or the stick is the right policy depends on the feasibility and cost of implementing the subsidy compared to the tax, and whether raising or lowering the income of the target of the policy is desired on fairness grounds.

Seen in this light, the polluter pays principle is not always a good guide to the best policy. Think of a large city in a low-income country in which much of the cooking is still done over wood fires, generating high levels of airborne particulate matter and causing asthma and other respiratory illnesses:

Fairness: It is mostly poor families who lack the income or access to electricity that would allow them to cook and heat their homes with fewer external environmental effects. In this case, many would object to making the polluters pay on the grounds of fairness, and instead favour subsidizing kerosene or providing a better electricity supply.

Effectiveness: Subsidizing kerosene is likely to be cost-effective in reducing smog, compared to tracking down and extracting payments from hundreds of thousands of people who are polluting the city's air with wood fires.

This example is helpful because it shows not only the value of considering fairness as well as efficiency, but also the importance of being clear about which objective we are pursuing when we design policies.

Exercise 20.14 High and low performers

Consider the labelled countries above the best-fit curve in Figure 20.25b and those below it.

1. What characteristics about the countries and the way they are governed do you think might explain their status as high and low performers respectively?

2. Find out about the environmental policies and political systems of one or more of these countries using the World Bank Development Indicators, the Freedom in The World data, and your own research. What information from these sources helps you to explain the differences between high and low performers, and how does it help?

20.11 Conclusion

For 100,000 years or more, humans-like other animals-lived in ways that modified the biosphere but did not substantially and irreversibly degrade its capacity to support life on the planet. Starting 200 years ago, humans learned how to use the energy available from nature (burning carbon) to transform how we produced goods and services, radically increasing the productivity of our labour.

The capitalist economy provided both the carrots and the sticks that made the technological revolution profitable to private firms and hence a permanent feature of our lives. The result was a sustained increase in the output of goods and services per person.

In many countries, the extension of the vote to people who worked as employees, and their organization into trade unions and political parties enhanced the bargaining power and the wages of workers (Figure 2.19). The increasing costs of hiring labour provided ongoing incentives for owners of firms to seek innovations that would use less labour, replacing human labour with machinery and the non-human energy of coal and other fuels that powered them.

In many countries, this process of increased productivity and bargaining power of labour resulted in growing living standards for workers. But the replacement of human labour by non-human energy to power the machines also led to an impoverishment of nature.

A degraded and threatened environment cannot be reversed, however, by the same mechanism that created this affluence. When it came to developing an economically equitable society, workers were their own advocates, and their success in pursuing their private interests of seeking a higher living standard led to wage increases and a pattern of technological change in which less labour was used in production.

You could imagine that a similar process would raise the price of using our natural environment, leading to nature-saving technical change, just as higher wages led to labour-saving innovations. But the biosphere does not have the vote. Political organizations of soon-to-be-extinct animals will not be formed. Future generations of our own species and non-human elements of the contemporary and future biosphere are not capable of advocating for saving nature in the same way that workers indirectly advocated for saving labour, that is, by raising its price.

Public policies to impose prices on the use of nature sufficient to deter the degrading external effects of the production of goods and services today will be propelled not by the silent voices of the biosphere and generations unborn, but by people today, concerned not only about their private interests, but about the preservation of a flourishing biosphere in the future.

Economists along with other scholars can clarify the costs and benefits of alternative environmental policies and practices and help to inform public debate on these policies.

Concepts introduced in Unit 20

Before you move on, review these definitions:

20.12 References

Consult CORE's Fact checker for a detailed list of sources.

Ackerman, Frank. 2007. 'Debating climate economics: the Stern Review vs. its critics'. Report to Friends of the Earth, July 2007.

EconTalk. 2015. 'Martin Weitzman on Climate Change'. Library of Economics and Liberty. Updated 1 June 2015.

Fehr, Ernest and Andreas Leibbrandt. 2011. 'A Field Study on Cooperativeness and Impatience in the Tragedy of the Commons'. Journal of Public Economics 95 (9-10): pp. 1144-55.

Freedom House. 'Freedom in the World'.

Nordhaus, William D. 2007. 'A Review of the Stern Review on the Economics of Climate Change'. Journal of Economic Literature 45 (3): pp. 686-702.

OpenSecrets.org. 2015. 'Lobbying Spending Database Chemical & Related Manufacturing'.

Porter, Michael E., and Claas van der Linde. 1995. 'Toward a New Conception of the Environment-Competitiveness Relationship'. Journal of Economic Perspectives 9 (4): pp. 97-118.

Rustagi, Devesh, Stefanie Engel, and Michael Kosfeld. 2010. 'Conditional Cooperation and Costly Monitoring Explain Success in Forest Commons Management'. Science 330: pp. 961-65.

Schmalensee, Richard, and Robert N. Stavins. 2013. 'The SO2 Allowance Trading System: The Ironic History of a Grand Policy Experiment'. Journal of Economic Perspectives 27 (1): pp. 103-22.

Smith, Stephen. 2011. Environmental Economics: A Very Short Introduction. Oxford: Oxford University Press.

Stavins, Robert N., Gabriel Chan, Robert Stowe, and Richard Sweeney. 2012. 'The US Sulphur Dioxide Cap and Trade Programme and Lessons for Climate Policy'. VoxEU.org. Updated 12 August 2012.

Stern, Nicholas. 2007. The Economics of Climate Change: The Stern Review. Cambridge: Cambridge University Press.

Wagner, Gernot, and Martin L. Weitzman. 2015. Climate Shock: The Economic Consequences of a Hotter Planet. Princeton, NJ: Princeton University Press.

Wilkins, Barbara. 1974. 'Lead Poisoning Threatens the Children of an Idaho Town'. People.com.

World Bank, The. 2011. 'The Changing Wealth of Nations'.

World Bank, The. 2015. 'Commodity Price Data'.

World Bank, The. 2015. 'World Development Indicators'.

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How economic activity affects the fragile biosphere of our planet, and how the resulting environmental problems can be addressed Production and distribution of goods and services unavoidably alter the biosphere. Climate change resulting from economic activity is a major threat to future human wellbeing, and it illustrates many of the challenges of designing and implementing appropriate environmental policies.

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United Nations - Sustainable Development Goals (SDG)

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United Nations - Sustainable Development Goals (SDG)

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The Economics Network - Embedding Sustainability in the Curriculum

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The Economics Network - Embedding Sustainability in the Curriculum

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This Handbook chapter addresses the challenge of incorporating sustainability into Economics curricula. There is considerable evidence that there is demand for sustainability education. According to Forum for the Futures Future Leaders Survey of UCAS applicants in 2007/8, students are very concerned…

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A playable post on how harmless choices can make a harmful world.

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The Economics of Sustainable Development - Dr. Lisa Ryan Webinar 

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The Economics of Sustainable Development - Dr. Lisa Ryan Webinar 

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Economics Webinar 4 Economics of Sustainable Development

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Dr Lisa Ryan Webinar Presentation Slides

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Dr Lisa Ryan Webinar Presentation Slides

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NCCA Education for Sustainable Development

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NCCA Education for Sustainable Development

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National Council for Curriculum and Assessment (NCCA)

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ESD International Curriculum Audit | NCCA

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This desktop review examines how six unique international jurisdictions integrate the teaching and learning of ESD within their curricula (early childhood, p...

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The concept of a universal basic income has already been suggested for arts workers hit by the pandemic, but what if there was a constant security and safety net for all, a payment always delivered to all citizens with no strings attached?

The idea was first floated by Thomas More in Utopia in 1516, is now being advocated by Pope Francis and President Michael D Higgins and is being considered by governments across the world. The basic income guarantee is frequently referred to as universal basic income (UBI).

UBI is a periodic payment paid at regular intervals as a cash payment without conditions, allowing those who receive it to decide what to spend it on. It is paid individually without a means test and is unconditional - without a requirement to work or demonstrate a willingness to work.

In Ireland, the Green Party fought for a trial run for UBI to be included in the Programme for Government, and there is to be one at some stage over the next five years.

UBI would be given to each recipient from birth or point of residency, from 'cradle to grave', with the amount given to those under 26 years of age varied depending on wages

Among its most ardent supporters is Green Party Dublin Central TD Neasa Hourigan, co-author of the party's policy. The Green Party proposes a system of UBI in Ireland for all citizens in 2024, pending a successful trial. She envisages that the trial in Ireland will take between 18 and 20 months to plan and that the trial itself would run for two to three years.

"A basic provision of economic resources would address poverty and economic inequality even though it doesn't promise to eradicate either," Hourigan says. She says that in Ireland we already recognise payments like these - child benefit and state pension - but UBI would close the gap between the two.

"I am particularly wedded to UBI because it would have the greatest uplift for people on the margins of existing social welfare bands. The lowest income families should already be within the support network but those in part-time employment often find themselves just outside State help. UBI would address that and be particularly important for women and those who care."

'[UBI is] a big idea but a transformative idea, in the way bringing in an old-age pension would have been seen as radical more than 100 years ago'

The Greens are not alone in supporting UBI. It also has advocates in Fianna Fáil such as Willie O'Dea, while outside government the Social Democrats have also expressed interest. The Department of Social Protection has said that the Low Pay Commission will examine UBI "in due course".

It has been tested elsewhere. The longest trial run for UBI in the world is in Alaska. Since 1982, the state has been giving every woman, man, and child between $1,000 to $2,000 per year. A 2016 study by the University of Alaska found it reduced poverty up to 20 per cent.

In Finland, a two-year UBI study in 2017 and 2018 saw 2,000 unemployed Finns receive the payments of €560, with no obligation to seek a job and no reduction in payment if they accepted one. Participants reported greater feelings of autonomy, financial security, and confidence in the future, although it did not make them any more likely to find work.

"[UBI is] a big idea but a transformative idea, in the way bringing in an old-age pension would have been seen as radical more than 100 years ago," says Bobby Lambert, joint co-ordinator of Basic Income Ireland, a campaign group for UBI in Ireland.

Lambert would rather the Irish trial did not focus on a group like the unemployed and rather a more general group of people, preferably a geographical area. To pay every resident in Ireland the basic income would cost an estimated €6.5 billion per annum.

Some taxes suggested to raise for money for UBI in the Green Party policy include pension funds, site value tax, speculative transaction tax and stamp duty for property trades that are not the principal private residence.

UBI would be given to each recipient from birth or point of residency, from "cradle to grave", with the amount given to those under 26 years of age varied depending on wages - in a similar way to how social welfare exists today - with a set rate given to all adults over 26. Children under 18-years-old would receive €32.31 per week, according to the Green Party plan, with €112.70 for 18 to 21-year-olds, €157.80 for 21 to 25-year-olds and €203 for adults over 26 years old.

'It's giving everyone a low amount of money and we will give unemployed people less than they need and unnecessarily so'

UBI is not without its critics. Laura Bambrick, the head of social policy and employment affairs at the Irish Congress of Trade Unions, finds the idea of replacing existing welfare safety nets concerning. The money needed to pay adequate UBI, she says, "would be better spent on reforming social protection systems and building better quality public services".

"Our welfare system is complex precisely because the root causes of poverty are complex," Bambrick says. "A one-size-fits-all payment will hurt those with the greatest risk of poverty."

She believes that no UBI payment would work as well as an average European welfare system for the most vulnerable people. And she contends that providing welfare top-up's on top of UBI, as advocated by some proponents of this system, would end up being far too costly. "[It] would make for a uniquely Irish UBI, and I look forward to seeing their maths." Hourigan says that the difference between the current welfare rates and UBI will be made up by further State payments.

Welfare and efficient use of resources also concerns Ian Goldin, Professor of Globalisation and Development at Oxford University, who has spoken against UBI in the past.

He says that if you gave everyone half the minimum wage in Ireland, it would be bigger than the budget of all social welfare. He points out that UBI is favoured by tech billionaires and right-wing libertarians as well as left-wing progressives, and it may be used by the rich to normalise the automation of employment and abolish existing welfare supports.

"It's giving everyone a low amount of money and we will give unemployed people less than they need and unnecessarily so. That is not the answer to either poverty inequality or the future of work."

Goldin also takes issue at the universality of UBI, saying it is a waste of needed funds to give the income to the wealthy. He says that societal safety nets and raising the wage of low-paid and vulnerable workers through the current system would be a more worthy use of resources.

'UBI is not going to solve the housing crisis. But it is part of a general investment for a better and fairer society'

The other issue frequently brought up by critics of UBI is the danger that an unconditional payment would disincentivise work, even though the trials done so far suggest that payments have little effect on employment.

Danny McCoy,chief executive of the Irish Business and Employers Confederation (Ibec), says UBI would "undermine our current active labour market policies" which would "result in labour supply challenges and could diminish overall labour cost competitiveness in the economy".

He says that Ibec remains open to debate on the merits of UBI and research that indicates it could be positive for entrepreneurship. On that point, Lambert highlights a UBI project in Namibia, which found it helped local business as they had the financial security to work on business ideas.

Hourigan says that Covid-19 has changed the discussion and been valuable to the UBI debate. "There has always been a real resistance to the idea that our current tax system and economic models could support such a payment. The Covid-19 crisis has refocused the minds of many towards the well-being of communities.

"UBI is not going to solve the housing crisis," says Lambert. "But it is part of a general investment for a better and fairer society."

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Basic income for all: Has the Covid crisis given us a new economic model?

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The concept of a universal basic income has already been suggested for arts workers hit by the pandemic, but what if there was a constant security and safety net for all, a payment always delivered to all citizens with no strings attached?

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An Integrated Approach to Teaching, Learning and Assessment

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An Integrated Approach to Teaching, Learning and Assessment

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Economics Digital Coursework Booklet 2023 (3)

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ESRI examines International Evidence on UBI

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ESRI examines International Evidence on UBI

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New ESRI research examines the international evidence on universal basic income (UBI) and identifies key issues for consideration in the design of any future UBI pilot for Ireland

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The section maintains close links with the National Council for Special Education (NCSE)

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EAL Infographic - Supporting Culturally and Linguistically Diverse Learners

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EAL Infographic - Supporting Culturally and Linguistically Diverse Learners

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Examples of Dual-coding in the Classroom

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Examples of Dual-coding in the Classroom

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It can be argued that Dual Coding is a teaching and learning strategy that teachers have been using for years and years. Yet the term and the discussion around this approach has only become widespread in recent years (despite the work of Allan Paivio with his dual coding theory dating back to 1971 and he states that dual coding has its roots in the practical use of imagery as a memory aid 2500 years ago!). There are now lots of videos, blog posts, podcasts and presentations shared by educators about how dual coding can be used effectively in the classroom.
The video below is a brief yet useful introduction to dual coding.
For anyone unfamiliar with the term dual coding the Learning Scientists, a group of cognitive psychological scientists interested in research on education, define dual coding as:

" The process of combining verbal materials with visual materials. There are many ways to visually represent material, such as with infographics, timelines, cartoon strips, diagrams, and graphic organizers. When you have the same information in two formats - words and visuals - it gives you two ways of remembering the information later on. Combining these visuals with words is an effective way to study."

The work of the Learning Scientists is a great starting point for teachers as their website contains a wide range of materials and resources to share with pupils and parents too. Dual coding is one of the six study strategies that they promote. To read more about another effective strategy you can read my retrieval practice post here. You can download free materials, as shown below, from the website - www.learningscientists.org.

Dual coding is sometimes referred to as 'multimedia learning' (or 'multimedia cognition' in research papers) because the material used and represented can be in multiple forms.

The work of Oliver Caviglioli, former Headteacher turned information designer, has also been incredibly helpful, informative and insightful in regards to dual coding. I was very excited to finally meet him in person recently at ResearchEd Dubai and listen to him explore and explain the power of dual coding for learning. There is a wealth of information, useful visual resources ( as shown below) and a great video explanation and discussion about dual coding that can all be found on his website www.olicav.com

Like all educational research, dual coding has teachers (including myself) asking - what does this look like in the classroom? I have included a range of examples below of my students' work (mainly in history but other examples are included from politics and social studies) using the dual coding strategy - combing written text and visual images. Dual coding can also be used to improve teacher explanation in the classroom which is discussed below with several books, blogs and recommended articles.

Timelines

Timelines are obviously an activity that work well with the study of chronology in history and politics. Timelines can also be used in other subjects, for example, I have seen impressive timelines used in English Literature and Drama illustrating the chronological order of events of a plot using both visuals and text.

Comic/Cartoon Strips/Storyboards

I have blogged previously about how I use this technique in my classroom, you can read that post here. Comic strips can be used as a form of timeline or to demonstrate a sequence, story, events, etc.

Note-taking & revision

Other examples from my classroom ...

Reflection

I still have a lot to learn about dual coding. Whilst it may seem a simple strategy there is more to it than combining writing and drawing. The more I read the more I learn about the complexities of the different channels connected to memory and how dual coding can lead to cognitive overload and how there are ways to ensure clarity and improve effectiveness ( I share the links that explore these below).

My students also need to persevere with dual coding too. There is a misconception that dual coding means you have to be a good artist but that isn't true. Also, some students would rather just make written notes and others have spent far too long on the visuals. One of my students said it was a stressful strategy because she is a perfectionist and wanted her notes and illustrations to be beautiful but also informative. We discussed that this was a learning strategy in the same way retrieval practice is, not an assessment judging her illustrations and notes- far from it! Some students have fully embraced this study strategy whereas others don't like it. This isn't about "learning styles" but simply personal preferences. Students don't always enjoy retrieval practice either and whilst I want to promote a love of learning it's important to recognise the reality that learning can be challenging and difficult at times too.

I have noticed an improvement with effort and concentration when students are using dual coding in the classroom. A lot of students are really pleased with their outcomes and this strategy does provide the students with an opportunity to be very creative too.

Dual coding can be used at different stages of the learning process, for example, it can be used to record new information or as a retrieval practice strategy writing and drawing relevant information and images from memory.

Recommended Reading

If you are keen to learn more about educational research, cognitive psychology and how this can be applied in the classroom then I can highly recommend the book Understanding How We Learn: A Visual Guide. The Learning Scientists Yana Weinstein and Megan Sumeracki have teamed together with Oliver Caviglioli. Firstly, the book is a great example of how complex and perhaps difficult concepts and content can be made easier to understand when supported and combined with relevant visuals. The book builds on the work of the Learning Scientists in much more depth and detail. It is also very well referenced. There are tips for teachers, tips for students and tips for parents. I also liked the glossary of key terminology too. This book isn't specific to dual coding but learning in general, as dual coding is just one example of a research-based method that helps students learn.

You can also order the new book, soon to be published, by Oliver Caviglioli and John Catt Publishing entitled Dual Coding With Teachers I have already pre-ordered this book and I am looking forward to reading it as there is a wide range of contributors featured as well as the words of wisdom from Caviglioli.

To find out more about dual coding there are a vast amount of useful, interesting and insightful blog posts available to read online that I have listed below.

A great introduction for teachers to dual coding, with a clear explanation focusing on dual coding and memory, is a blog post by Rufus Johnstone that you can read here. This post was a reflection on a presentation Rufus delivered to his colleagues about dual coding and the implications this has on learning. I found this very helpful with references to Caviglioli, Daniel T Willingham, Nick Rose and David Didau, explaining how this strategy supports learning/memory in a clear and concise way. Read and share it with your colleagues.

The example of dual coding above was taken from a blog post by one of my favourite educational bloggers Blake Harvard. In this blog post, US blogger and teacher Harvard reflects on introducing dual coding and its application in the classroom with his students. I like how Harvard introduces a new strategy, communicates with other educators to seek feedback then reflects on this. You can read the interesting post here.

Head of Geography and author Mark Enser has written a very useful article for the TES entitled Why every teacher should be using dual coding in the classroom. This article provides some do's and don'ts from a teacher who has embraced this strategy in his classroom and is clearly very knowledgable about dual coding.

I have already praised and shared the work of the Learning Scientists but another blog I discovered by Learning Scientist Megan Sumeracki was Dual Coding: Can there be too much of a good thing? In this blog post, Sumeracki states "if a student experiences cognitive overload trying to process all of the information in a meaningful way then dual coding can harm learning". However, Sumeracki does provide solutions and advice as to how to tackle this which are very helpful and practical.

A post I recently discovered on Twitter was written by History Teacher and author Chris Runeckles. I liked the examples and practical tips included in this post as to how dual coding can support and enhance teacher explanation, which Rufus also discussed in his blog too. Runeckles writes about the importance of explaining over images rather than teacher talk over written content which I know for many years I was guilty of! Runckles writes about how teachers can consider dual coding in their lesson planning and how this can help the teacher to reflect and consider which content can be cut from presentations and explanations. You can read Explaining through dual coding here.

Another excellent blog post that explains the importance and impact of using visuals in the classroom can be read here - which urges teachers to think about using more visuals in their classroom instruction.

I am a regular reader of the blog posts written by Tom Johns and this post does exactly what the title states - 20 ideas & strategies for Student Led Dual Coding. These ideas can be applied across the curriculum they are not subject specific to science. Some of the ideas shared in the post you may already be familiar with such as mindmaps, diagrams, Pictionary and Venn diagrams. Other strategies could be new to you, to try in your classroom or share with your students. In addition to the ideas Tom also shares a link to 14 research papers on dual coding for anyone really interested in this field - I am still making my way through the research but it does make for some educational reading.

Finally, another blog written by a classroom teacher that I enjoyed reading was written by teacher Ian Taylor entitled Dual Coding - A Concrete Example that you can read here. This blog is particularly useful for science teachers as it explores dual coding in that subject-specific domain.

Moving forward I will continue to learn more about dual coding and reflect on my classroom practice using this strategy. I also want to be able to make sketch notes with written text and visuals when I attend conferences and listen to presentations. I often take photos of slides as an audience member, I may tweet or share the image but I rarely go back through my camera roll to view the photos as I perhaps would revisit if I made notes with visuals. Dual coding will also make the presentation content more memorable for me too.

Below is the sketch by Caviglioli when he attended my recent session at ResearchEd Dubai. During another presentation, I was sat next to him and it was amazing to watch him do this live! I won't ever be the next Oliver Caviglioli but he has inspired me to try this now myself.

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Examples of Dual Coding in the classroom

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It can be argued that Dual Coding is a teaching and learning strategy that teachers have been using for years and years. Yet the term and the discussion around this approach has only become widespr...

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Agricultural Price Indices November 2022

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Agricultural Price Indices November 2022

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Agricultural Price Indices November 2022

Agricultural Input Price Index was up 33.4% in the 12 months to November 2022 while the Agricultural Output Price Index rose by 25.3% over the same period.

Input price increases can be seen in fertiliser prices (+93.9%), energy prices (+36.6%) and feed prices (+32%) over the last 12 months.

Output price increases were recorded in milk prices (+39.9%), pig prices (+42.6%) and cereal prices (+47.5%) for November 2022 when compared with November 2021.

The annual terms of trade fell 6.1% when compared with November 2021.

On a monthly basis, the Agricultural Input Price Index increased marginally (+0.4%) when compared with October 2022.

The November 2022 Agricultural Output Price Index was up by 0.8% in comparison with October 2022.

The monthly terms of trade increased by 0.4% when compared with October 2022.

Figure 1 shows the increase in both the Agricultural Input Price Index and the Agricultural Output Price Index since 2020. It shows that from 2020 to the start of 2021 prices were relatively stable. While prices started to rise from January 2021, the largest price increases have occurred since the start of 2022.

Show Table: Table 1 Agricultural Output Price Index (excluding VAT)

Show Table: Table 2 Agricultural Input Price Index (excluding VAT)

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Agricultural Price Indices November 2022 - CSO - Central Statistics Office

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Agricultural Input Price Index was up 33.4% in the 12 months to November 2022 while the Agricultural Output Price Index rose by 25.3% over the same period.

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Home / Interactive Zone / Statistics Explained / National Accounts Explained

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Read blog posts from the Central Bank of Ireland Governor Gabriel Makhlouf.

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Natalia Fabra | Karsten Neuhoff | Nicolas Berghmans

An EU-wide gas price cap with binding gas-saving targets and a continued strong price incentive for users to cut gas consumption could work together, enhance credibility, address concerns about implementing a price cap, and accommodate the needs of different EU member states

European economists for an EU-level gas price cap and gas saving targets

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An EU-wide gas price cap with binding gas-saving targets and a continued strong price incentive for users to cut gas consumption could work together, enhance credibility, address concerns about implementing a price cap, and accommodate the needs of different EU member states European economists for an EU-level gas price cap and gas saving targets

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8 September 2023

How are Executive Board members chosen?

21 April 2023

What are climate disclosures?

29 November 2022

Profits and losses of the ECB and the euro area national central banks: where do they come from?

07 November 2022

Why does climate change matter to the ECB?

27 October 2022

What are minimum reserve requirements?

21 October 2022

What is the deposit facility rate?

05 October 2022

The digital euro and the importance of central bank money

01 October 2022

How are we decarbonising our corporate bond holdings?

23 September 2022

We have raised interest rates. What does that mean for you?

28 July 2022

What is forward guidance?

28 July 2022

The ECB's negative interest rate

18 May 2022

What are currency swap lines?

16 November 2021

20 October 2021

Why do statistics matter?

25 August 2021

Why are stable prices important?

25 August 2021

How does the ECB's asset purchase programme work?

25 August 2021

Five things you need to know about the ECB

25 August 2021

Is the ECB "expropriating" savers?

25 August 2021

What is monetary policy?

28 July 2021

14 July 2021

30 March 2021

What are targeted longer-term refinancing operations (TLTROs)?

30 January 2021

What the European Central Bank does and what it means for you

14 January 2021

What are additional credit claim (ACC) frameworks?

20 November 2020

12 August 2020

What are TARGET2 balances?

27 April 2020

What does a country need to do to join the euro area?

1 February 2020

Five things you need to know about the Maastricht Treaty

1 February 2020

What are instant payments?

30 January 2020

13 December 2019

How you benefit from the euro

13 December 2019

The euro area in comparison

15 November 2019

26 August 2019

What is a lender of last resort?

11 July 2019

What are benchmark rates, why are they important and why are they being reformed?

29 January 2019

What is the quiet period?

13 September 2018

What is the marginal lending facility rate?

13 September 2018

What is the main refinancing operations rate?

18 July 2018

11 April 2018

What is a deposit guarantee scheme?

10 April 2018

Why is cyber resilience important?

28 December 2017

What is excess liquidity and why does it matter?

18 October 2017

What are structural reforms?

27 June 2017

How does innovation lead to growth?

20 June 2017

24 May 2017

A quick guide to macroprudential policies

19 April 2017

How could new technology transform financial markets?

7 April 2017

16 February 2017

Does the ECB make a profit?

12 January 2017

Why is the ECB independent?

8 December 2016

What is securities lending?

3 November 2016

28 September 2016

Why does the ECB conduct research?

12 September 2016

What are non-performing loans (NPLs)?

29 June 2016

28 June 2016

What is the role of exchange rates?

25 May 2016

What are interest rates and what is the difference between nominal and real interest rates?

31 March 2016

What is the expanded asset purchase programme?

10 July 2015

How is the ECB accountable for its actions?

1 December 2014

Rotation of voting rights in the Governing Council

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The European Central Bank (ECB) is the central bank of the European Union countries which have adopted the euro. Our main task is to maintain price stability in the euro area and so preserve the purchasing power of the single currency.

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Nevin Economic Research Institute " Home Page

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The draft budget for 2018 to be yet approved by the European Commission has arrived. Still, some working out of detail in the Finance Act and various other legal measures remains. The build-up, the leaks, the drama, the instant analysis, the soundbites and the slowly emerging aftermath is part of the annual cycle of media news and lobbying by various interest groups.

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There are four modules in this course:

1. Introduction to Digital Citizenship Education

An introduction to digital citizenship education, what it is and why it is important. This module also provides ideas on how it can be integrated into classroom practice as well as signposting specific supports available to teachers.

2. Being Online

Module 2 explores the Being Online theme, focussing on the area of media and literacy as the key digital citizenship competence within this theme.

3. Wellbeing Online

Module 3 provides an overview of the Wellbeing Online theme, focussing on managing your online wellbeing as the key digital citizenship competence within this theme.

4. Rights Online and Next Steps

Module 4 will provide an overview of the Rights Online theme, focussing on rights and responsibilities as the key digital citizenship competence within this theme.

Participants will also learn about further supports and resources to help plan their next steps with integrating digital citizenship in the post primary classroom.

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What is Digital Citizenship and How to Teach it (Post Primary) - PDST Technology in Education

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There are four modules in this course: 1. Introduction to Digital Citizenship Education An introduction to digital citizenship education, what it is and why it is important. This module also provides ideas on how it can be integrated into classroom practice as well as signposting specific supports available to teachers.

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Plastic bottle and can recycling scheme being launched today Nov 22

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Deposit Return Scheme - How will it work?

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Deposit Return Scheme - How will it work?

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Plastic bottle and can recycling scheme being launched today

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Ossian Smyth, Minister of State with responsibility for Communications and Circular Economy, discusses the Deposit Return Scheme.

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Primark, which trades as Penneys here, has launched a new denim collection designed and created to show what circular fashion means in practice.

The new collection is part of The Jeans Redesign, a project from the Ellen MacArthur Foundation's fashion initiative, and it features denim that has been designed, produced and created to align with the vision of a circular economy for fashion.

Based on the principles of the circular economy, the clothes are made to be used more, made to be made again, and are made from safe and recycled or renewable inputs.

The jeans are made from 70% organic cotton, 29% recycled cotton and 1% elastane and the jackets are made from 80% organic cotton and 20% recycled cotton.

The new denim products are also metal rivet-free, a common design element that can make jeans difficult to recycle.

Labelling also includes guidelines on removing buttons and zips before sending to recycle to ensure this product has another life.

The new circular denim collection follows on from the launch of Primark's sustainability strategy launched in September.

The new strategy includes plans to reduce fashion waste, halve carbon emissions across its value chain and improve the lives of the people who make Primark products.

Key commitments include using recycled and more sustainably sourced materials in all of its clothing by 2030, up from 25% today.

It is also working to reduce carbon emissions by half across every stage of Primark product - from the farms where raw materials are sourced, through production and manufacturing, to when a customer purchases a Primark product in-store.

Lynne Walker, Director of Primark Cares, said that Primark is committed to making changes to the way we make our clothes, ensuring that that they are recyclable by design by 2027, that they are made from more sustainably sourced or recycled materials by 2030, and that they last longer by 2025.

"Denim is a wardrobe staple for our customers, from denim jeans to denim jackets, and I am proud of this new collection, which brings to life our ambition and shows what these changes look like in reality," she added.

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Primark launches new circular denim collection

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Primark, which trades as Penneys here, has launched a new denim collection designed and created to show what circular fashion means in practice. The new collection is part of The Jeans Redesign, a project from the Ellen MacArthur Foundation's fashion initiative, and it features denim that has been designed, produced and created to align with the vision of a circular economy for fashion.

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The Least Developed Countries Report 2022

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World Investment Forum to mobilize financing for climate, energy, health and food

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The Human Cost of Rising Prices for Developing Countries

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The Human Cost of Rising Prices for Developing Countries

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1. Going up: The human costs of rising prices

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In the first episode of the Weekly Tradecast, UNCTAD Secretary-General Rebeca Grynspan talks about the global cost-of-living crisis triggered by the war in Ukraine and what can be done to help vulnerable countries and people who will suffer the most from rising food, energy and fertilizer prices.

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The wealthiest 1% of Irish society now own more than a quarter of the country's wealth or €232 billion, a new report from Oxfam claims.

The research also shows that with €15 billion between them, the two richest people here have 50% more wealth than the poorest half of the population.

In total the study, based on data collated from Forbes, Credit Suisse and Wealth-X, found eight Irish people are worth over a billion euro, down one from last year.

But 1,435 individuals here are worth over €47m while 20,575 own over € 4.7 million.

Over the last decade, the numbers in both those categories has more than doubled the analysis finds, as wealth creation here grows.

Laying out how new wealth is distributed, the study claims that for every $100 or €93 of wealth created in Ireland over the past decade, a third has gone to the richest 1% and less than 50c to the bottom 50%.

The richest 1% have therefore gained 70 times more wealth than the bottom 50% in the last 10 years, Oxfam states,

While the top 10% of the population now owns nearly two thirds of the wealth, totalling €547 billion, but the bottom 50% of Irish society owns only 1% of wealth.

"This rising wealth at the top and rising poverty for the rest are two sides of the same coin, proof that our economic system is functioning exactly how the rich and powerful designed it to," said Jim Clarken, chief executive of Oxfam Ireland.

"As crisis after crisis hits the poorest people hardest, it's time for Governments, including Ireland's, to tax the rich."

"The very existence of billionaires while out-of-control inequality rises, is damning proof of policy failure."

Overall the international report, released to coincide with the start of the annual gathering of the global elite at the World Economic Forum in Davos, finds that for the first time in a quarter of a century, the rich are getting richer while at the same time the poor are getting poorer.

Indeed the study entitled "Survival of the Richest" claims that over the past two years, the richest 1% of the world's population have acquired nearly twice as much wealth as the rest of humanity put together.

It says even though inflation is outpacing the wages of at least 1.7 billion workers, billionaire fortunes are increasing by $2.7bn a day.

Food and energy companies more than doubled their profits in 2022, paying out $257bn to wealthy shareholders, while over 800 million people went to bed hungry, it states.

It finds that although the fortunes of billionaires have fallen slightly since their peak in 2021, they remain trillions of dollars higher than before the Covid pandemic began.

As a result, Oxfam is again calling for an international approach to taxing the super-rich, with both permanent wealth taxes and temporary windfall taxes.

It wants to sees a halving of the wealth and number of billionaires between now and 2030.

Here in Ireland, Oxfam calculates that a wealth tax with graduated rates of 2%, 3% and 5% above a high threshold of €4.7 million would raise €8.2 billion annually.

It claims this money could be used to transform healthcare, housing and education while also enable Ireland to deliver on its international and climate commitments.

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1% of Irish population owns 27% of the wealth - Oxfam

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The wealthiest 1% of Irish society now own more than a quarter of the country's wealth or €232 billion, a new report from Oxfam claims. The research also shows that with €15 billion between them, the two richest people here have 50% more wealth than the poorest half of the population.