Inequality in Adam Smith’s World

Inequality is a fact of economic life and it is becoming more and more pronounced over time.  It’s not exactly clear why this is happening but it is clear that it is happening.  Inequality is certainly rising for pre-tax income measures and I’m virtually certain that it is rising for after-tax measures of income as well. 

There are many forces in our economy that create income inequality.  The most basic of these forces however, is tied to the nature of trade itself and can be traced all the way back to Adam Smith and the division of labor.  If you read the Wealth of Nations (something I told you not to do a few blog posts back …) you will find that Smith begins by marveling at the incredible increases in productivity that can be obtained by exploiting the division of labor, that is, by specializing.  The way Adam Smith envisioned it, a market system would be populated by specialists.  Each person would have a single craft that they would focus on.  This is a world with doctors, lawyers, carpenters, teachers, chefs, and so on.  A jack-of-all-trades is simply not valued in a market system.  (Renaissance men are dinosaurs in Adam Smith’s world.) 

The way you get the division of labor to work is by combining it with trade.  Once you get to the point where you conclude that the division of labor is something you want to take advantage of, trade is a necessary next step.  A physician cannot consume only her own medical advice – she must draw on the productivity of the many other specialists in society.  If you are willing to do trade, you can, by specializing, reach incredible levels of productivity.  As populations grow, and as the ability to trade grows, you should see more and more specialization and higher and higher productivity.  (Obviously the division of labor is not the only source of increases in productivity.) 

However, there is a downside to this plan.  Adam Smith’s plan exposes people to incredible variations in income and thus a market system possesses and important force which causes inequality.  Specialization ties your entire wellbeing to a single industry.  If you decide that you are going to become a web designer, your fate is very closely tied to the market for web designers.  As a result, while Smith’s plan dramatically increases overall productivity, it also exposes us to incredible risk. 

Of course, markets do have responses to risk.  The typical response is for the market to provide insurance contracts to reduce risk.  In this case however, the type of insurance needed is actually income or job insurance.  These types of insurance contracts are not typically available.  It is possible that you might be able to use the stock market to insure yourself against job risk.  For instance you might be able to short-sell claims on the company you work for.  I suppose I could short-sell stock based on the profitability of the University of Michigan Economics Department.  In the event that the U of M Econ department gets in serious trouble, my short position in these assets would have a huge payoff and I would be insured.  In reality, few people have asset portfolios like this.  Moreover, it doesn’t seem like insurance companies are able to provide “career” insurance.  (In part, this post is related to work in the so-called “New Dynamic Public Finance.”)

I don’t mean to imply that all or even most of the alarming increase in inequality is due to the division of labor and trade.  I would guess that modern technology (which allows people to leverage luck to extreme degrees by cheaply reproducing and transmitting ideas and information) and inheritance, both play a significant role in creating inequality.  However, living with income inequality is an implicit part of the deal we made with Adam Smith and it will be with us in some form for a long time.