The moral case for income inequality

This month Slate.com featured a massive 10-part series of articles on income inequality in the United States. The widely-linked articles by Timothy Noah make the case that it's wrong for some Americans to earn hundreds of times what others make.

People who say inequality is a problem often end up implying that salaries should be as close to equal as possible, that zero inequality should be our goal. I make the case that this is unfair and immoral.

Imagine three high school students; Tom, Dick and Harry. Tom studies hard in school and goes to a Ivy league school. Dick takes the vocational program and becomes a laborer. Harry does not study and never graduates. What do their lives look like after about ten years?

Tom becomes the vice president of his firm. He works at least 60 hours every week. He is forced to miss his wife's birthday at the last minute because he has to fly to the west coast to negotiate a contract in person. He gets to see his kids about seven hours every week.

Dick becomes a carpenter. He works about 40 hours a week. He loses the last joint on two of his fingers to a circular saw accident. He gets to see his kids about 20 hours every week.

Harry becomes a clerk at a chain store. He works 35 hours each week. He stops thinking about his job the moment he leaves work. He gets to see his kids about 30 hours each week.

It's clear that Tom, Dick and Harry have very unequal lives. Tom's marriage is strained by his job while Dick and Harry are free to have rich personal lives. Dick is at serious risk of injury at work, something Tom and Harry don't have to worry about. The amount of time they get to spend with their kids varies. Tom enjoys more prestige with his job than the other two.

It's clear that these three live very unequal lives, so why should their pay be the same? Tom would be sacrificing all the extra school he paid for, all the time he doesn't spend with his family and the difficult nature of his job for nothing. Why should Harry get five times as many hours to spend with his kids as Tom does? It's magical thinking to believe that the prestige and job security Tom enjoys perfectly balances the sacrifices he makes.

Imagine the trouble a central planner would have trying to put a dollar amount on all of these factors. How much is Dick's risk of injury worth an hour? How much should Tom get for taking his job home with him and on vacations? How often does he only work 60 hours, and how much should he get in case he has to work 70 hours one week? Should Harry lose some wages for never finishing high school? How much money is an hour with ones kids worth? What if someone doesn't have a family?

Any attempt to put a dollar amount on one of those values will be arbitrary. Different people will value things differently. The fairest solution I know of is to let different wages attract people to the jobs they are willing to do.

I hear people talk about wages as if they measure someones contribution to society, like when people lament that athletes make more money than teachers.

But the flaw is that wages are not simply something given to reward people for their role in society. Instead, wages are something an employer gives up to attract people to a position.

The metaphor I like is to ask why diamonds cost so much more than water. Water is clearly more important to our existences - we have to consume it daily to stay alive, while diamonds are mostly used for aesthetic purposes. Shouldn't water be worth more, as it's in higher demand?

Well "worth" and "price" are too different things. The supply of water is much higher, and as long as it's easier to find that next glass of water than that next diamond, water will be cheaper. But if water was rare enough, the price would exceed the diamond price.

Zero-sum game nonsense

I think one of the reasons there is so much focus on inequality is that people have a zero-sum game bias; the belief that inequality is the result of the rich taking money from the poor. This is true in some examples, like the rich mayor and part-time city councilors of Bell California, but not in a free market.

David Henderson writes:

Is inequality of wages and incomes bad? The question seems ludicrous. Of course inequality is bad, isn’t it? Actually, no. What matters crucially is how the inequality came about.

Inequality of wages and incomes is clearly bad if it results from government privileges. Many people would find such an outcome unjust, but even more important to many economists is that such inequality sets up perverse incentives. Instead of producing valuable products and services for their fellow citizens, as people tend to do in free economies, people in societies based on government-granted privileges devote much of their effort to pleasing, or outright bribing, government officials. In many African countries, for example, such as Côte d’Ivoire, Ghana, and Zaire, there are stark inequalities because the government has the power to take a high percentage of the wealth of the already poor and give a large amount of it to government officials or their cronies. And in many Latin American countries, for many decades a few families have had most of the wealth and have used government power to cement their privileges.

Companies create more wealth in the world by creating something of value. Some of that wealth ends up in the hand of the company, but certainly not all of it. Therefore, it's good for society to create more wealth.

The assumption most people make is that the rich are getting richer while the poor get poorer. Anyone who studies growth understands this is not true - everyone is in fact getting richer. Noah's piece on Slate.com seems to imply something in the middle - that the poor have stagnated while the rich have taken off.

This morning Tyler Cowen shared a link disproving the Marxist notion that CEO's make more money because they take wages away from their own workers. First Cowen quoted blogger Adam Ozimek:

If the top earners are screwing over their wage earners in the big companies, by pulling in excess wages, options, and perks, we should observe non-stagnant median pay for people who avoid working in firms with fat cat CEOs. Or we should observe talented lower-tier workers fleeing the big corporations, to keep their wages up. Yet no evidence for these predictions is given, nor are the predictions considered. It is likely that the predictions are false.

Then Cowen added:

And in fact isn't this precisely the opposite of what the evidence on the employer size wage-premium tells us? If large firms were better at keeping wages down, then the employer size wage-premium would be negative, since small firms would pay more for comparable workers.

Cowen proceeded to list studies going all the way back to 1911 that made the same conclusion, yet people - even those with a world view that prizes empirical evidence - continue to believe that inequality exists because CEO's cannibalize their employees.

Gauge the status of the poor, not the rich

Instead of focusing on how good the rich have it, the real measure of improvements to a society are in the living standards of the poor. Checking to see if the poor are suffering is more important than envying the rich.

A college astronomy class I took described the observation that all other stars appear to be moving away from us, as if the Earth were the still center of the universe. But all positions in space are relative, and my professor said our solar system and all the stars are moving away from the spot where the Big Bang took place. The reason some seem to be moving towards it and some away from it is differences in speed. The stars moving the fastest appear to be moving in one direction, while from our position the slow stars appear to move in the other way as we outrun them.

The same thing is true for standard of living. The rich are getting richer much faster than anyone else, while the poor are getting richer at a slow rate. But most of the wealth increases the poor have enjoyed have been in the form of quality of life improvements, and as Brad Delong revealed in his famous Cornucopia paper, it's impossible to gauge standard of living increases in a meaningful way.

The way the Bureau of Labor Statistics measures standard of living increases is to compare how much it would cost to purchase a collection of common items. A major flaw here is that it ignores improvements in technology. A car from 1940 is vastly inferior to a car from 2010 that has airbags, a CD player, cruise control, low gas mileage and an alarm, but they are cast as the same item in government statistics. A computer from 1990 had a fraction of the power of a modern one. Even an iPod from a 8 years ago is vastly inferior to one from today. As these better versions replace the old ones, the poor experience an invisible standard of living increase.

Increased inequality as a natural phenomena

The most concise explanation for rises in inequality was made by economist Alex Tabarrok in his post about the gulf between Harry Potter author J. K. Rowling and classic writers like Shakespeare.

J.K. Rowling is the first author in the history of the world to earn a billion dollars. I do not disparage Rowling when I say that talent is not the explanation for her monetary success. Homer, Shakespeare and Tolkien all earned much less. Why? Consider Homer, he told great stories but he could earn no more in a night than say 50 people might pay for an evening's entertainment. Shakespeare did a little better. The Globe theater could hold 3000 and unlike Homer, Shakespeare didn't have to be at the theater to earn. Shakespeare's words were leveraged.

Tolkien's words were leveraged further. By selling books Tolkien could sell to hundreds of thousands, even millions of buyers in a year - more than have ever seen a Shakespeare play in 400 years. And books were cheaper to produce than actors which meant that Tolkien could earn a greater share of the revenues than did Shakespeare (Shakespeare incidentally also owned shares in the Globe.)

Rowling has the leverage of the book but also the movie, the video game, and the toy. And globalization, both economic and cultural, means that Rowling's words, images, and products are translated, transmitted and transported everywhere - this is the real magic of Ha-li Bo-te.

Rowling's success brings with it inequality. Time is limited and people want to read the same books that their friends are reading so book publishing has a winner-take all component. Thus, greater leverage brings greater inequality. The average writer's income hasn't gone up much in the past thirty years but today, for the first time ever, a handful of writers can be multi-millionaires and even billionaires. The top pulls away from the median.

The same forces that have generated greater inequality in writing - the leveraging of intellect, the declining importance of physical labor in the production of value, cultural and economic globalization - are at work throughout the economy. Thus, if you really want to understand inequality today you must first understand Harry Potter.

Clearly, J. K. Rowling did not steal wealth from Shakespeare, and most readers are happy to buy her books over other authors. Both libertarian Russ Roberts and progressive Matthew Yglesias chimed in with the same idea of larger consumer pools and smaller marginal costs as a main component of inequality. Yglesias captured the idea as a justification to redistribute wealth - probably the most compelling argument for that policy idea I've ever heard.

I'd like people to shift their focus from inequality and back to the standard of living. Natural inequality does not lower the standard of living, but forced equality will as top producers will innovate less if they are not rewarded. Thwarting high wages for rare skills is a recipe for poverty, not prosperity. As Milton Friedman said:

A society that puts equality before freedom will get neither. A society that puts freedom before equality will get a high degree of both.