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  • The Invisible Hand

Is Inequality Important?

Updated: Dec 2, 2018

Some of the most controversial economic ideas relate to inequality. It is the focus of socialist economics while it is blissfully ignored by free market economics. Socialists such as Piketty believe inequality can only get worse while free market economists console themselves with the fact that inequality does not matter if everybody is experiencing rising incomes. This is wrong. This post will explore the costs of inequality irrespective of whether incomes at the bottom are rising or not. Extreme inequality represents one of the most damaging types of economic inefficiency and it is a topic which must be tackled.

I will begin first by examining the flaws with the arguments in favour of high inequality. The main argument I hear is that solving inequality only makes the rich poorer while doing nothing to help the poor. Therefore, lower inequality is only achieved by making society poorer. However, clearly this ignores the benefits the poor receive from redistribution.

When inequality is high this redistribution is efficient because money does not have a equal value to everybody. £1000 is much more valuable to an unemployed person than a millionaire because it makes up a large percentage of income so it has a greater impact on their life. Therefore, the total utility of a society is improved from redistribution. The gain in utility from giving £1000 to a poor person exceeds the loss of taking £1000 from a rich person so there is a net gain in utility.

However, there is also another effect acting in the opposite direction which is the lost utility from a lack of incentives in the economy. This reduces the total utility of all.

These two effects act in opposition to each and there will be an equilibrium where these two effects are in balance and the utility of society is maximised. This will be at the peak of the inequality-utility curve.

On the diagram the point of zero inequality (communism) produces no utility because there is no incentive to produce anything. Meanwhile the point of high inequality represents no utility because almost all of the population are suffering in poverty and deprivation.

The same theory can be applied to happiness. Happiness theory says that income is important for determining happiness but only to a certain point. As income passes this point extra income makes little difference to happiness. Therefore, the happiness of the poor will be greatly increased from greater income than the happiness of the rich will be diminished from a lower income.

However, when considering happiness there is another effect. Happiness isn't just dependent on absolute income but on relative income; people care about how rich they are compared to their peers. Therefore, there is an additional benefit of lower inequality if happiness is considered. Therefore the peak of the happiness-adjusted curve is at a lower level.

This type of analysis suggests inequality is important for maximising the utility of society; not irrelevant as many suppose. What determines the right amount of inequality is the equilibrium point. The right say the incentive factor is more powerful while the left will say the redistributive factor is more important. Inequality in the UK and the US recently seems to be out of equilibrium because there is already plenty of incentive for workers and yet there is much suffering from poverty while others live lives of excess. This represents an opportunity cost equivalent to the extra net utility which could be gained by those in poverty from redistribution. There is an advantage to making the rich poorer which is making the poor richer which shouldn't be ignored especially if it improves the overall happiness of society..