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.
Lane Kenworthy proposed wage insurance in his recent book, but I’m not sure how you’d go about doing it. Insurance companies would have to tie it to the acquisition of Unemployment Insurance or some other metric so that it only activated if a person was laid off or fired as opposed to quitting, and even then I don’t know if it makes business sense.
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This is an odd mixture of human-condition abstraction and just one aspect of recent history.
Why focus on trade instead of coercion or social bonding?
And why focus on recent winner-take-all technology instead of, say, recent globalization technology or recent ethnic-solidarity technology?
Same answer to both questions, right? Great big world, itty-bitty economics.
It would seem reviewing John Roemer would help here.
The problem with all these discussions is they talk about inequality as if the alternative is equality.
No one wants or expects equality, no one objects to inequality.
Clearly the objection is to the DEGREE of inequality. and even here the objection is really relative. No one cares if an individual is vastly and incomprehensibly wealthy – the concern is, can I achieve reasonable economic outcomes for myself, AND do I have reasonable optionality to achieve great outcomes with some probability and with some measure of input.
To simply say that we’ll have inequality is dumb, and to somehow attribute it to Smith is dumber still – Jesus even said the poor you shall always have with you. there has always been inequality.
The level and extent of inequality, and more importantly of reasonably broad and achievable economic outcomes for individuals are the issues and also not predetermined
The only rational purpose for selectively quoting Adam Smith to reinforce what everyone knows – that there will always be inequality – is to defend today’s inordinate degree of inequality in terms that sound respectable.
Better to wonder what Smith might have made of mass global markets and multinational corporations.
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” 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. ”
I guess we stiffed Adam Smith for the three decades post-FDR , huh ?
Why can’t we do it again ?
We made conscious choices that took us from those comparatively egalitarian times back to a repeat of the roaring 20’s ( which culminated in the Depression …. just a coincidence ? I think not.)
The U.S.( and U.K ) deftly led the race-to-the-bottom on inequality among the advanced economies. We can just as easily lead the race back up.
If you cruise over towards book 3, where Smith discusses corporations, religious associations, and universities – you’ll see he sets forth a pretty compelling, early case against “rent seeking” by those who strip returns from productive activity by grace of (artificial?) government intervention. And it’s not just about the classic “agency costs”; intervention that creates monopolies (or, arguably, any imbalance in market power), whether de facto or de jure, is something this night-watchman liberal abhorred.
To the extent that “artificial” government interventions in the market helps create inequalities, Smith, I posit, would *not* be on board. Public equity in companies? Complex financial derivatives? Corporate personhood and limited liability? There’s a strong case to be made that these aren’t the “natural” result of the division of labor, but benefit from some pretty artificial legal rules and government grants of power.
“A physician cannot consume only her own medical advice…”
Why are doctors unfailingly female these days? 🙂
“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 … and inheritance, both play a significant role in creating inequality.”
What about policy? Surely, policy could counteract the disequalizing effects of technology and inheritance and division of labor and trade. If policy fails to counteract, must one not say the fault lies in policy?
Rich and concise, with something on inequality for both left and right here:
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