Sunday, June 10, 2012

Consumption Inequality vs. Income Inequality vs. Wealth Inequality


The market economy largely requires one man to produce something of use in order to exchange for the productions of others [1].  However, before the creation of paper wealth---papers which grant a man ownership to another entity's future cash flow (think debt or equity shares)---a very productive person must either consume a lot now or horde and store consumption goods for his future consumption.  Production (real income) inequality would translate directly into consumption inequality.

The invention of paper wealth was instrumental in allowing the divergence between production inequality and consumption inequality.  A highly productive farmer does not consume a significantly larger quantity of farm produce or horde them and thus induce malnourishment for others; instead, he sells his "real" goods to others for "papers", which give him some (murky) ownership of future production of others (debt) and some control over productive resources (equity shares). The ownership of these "papers" makes him feel wealthy. A prolong divergence between income and consumption for the general population--that is after an extended period of income inequality between individuals and consumption equality for individuals--must create wealth inequality.

Let's examine the three kinds of inequalities, which exist in the modern market economy objectively, without the usual passion and prejudice commonplace in the popular press.

(1) Consumption inequality is mostly about the inequality in the quality of living for individuals. For example, if the top 1% eat most of the food, occupy most of the housing and use up most of the medical resources, while the middle class is under-nourished, live in mud huts and get low quality medical care---then there is great consumption inequality between the rich and the middle class. I think there is reasonable evidence to suggest that there is a bigger consumption inequality between the middle class and those below the poverty line than between the middle class and the 1%.

According to the 2006 CEX survey (*note this is a very noisy and statistically problematic survey), for households in the top 20% income bracket (average household taxable income: $150K) the per person consumption is estimated at $22.5K, as compared to $13.8K for the middle 20% income bracket (average household income: $45K). Surprisingly, the lower 20% income bracket (average household income: $10K) consumes $10.7 per household member.[2]  Note, this dollar value based consumption does not adjust for the fact that a $50 steak dinner is not 10x the real consumption of a $5 burger meal. (See my previous blog on income inequality)

(2) Income inequality is mostly about the inequality in the values that consumers attach to the outputs of individuals. Whether we agree, moralistically, with this outcome or not, a plastic surgeon makes significantly more money than a grade school teacher.  The difference in income is generally not related to work ethics or intellect (as some would like to claim); the difference is related to the price consumers are willing to pay for different skills and the scarcity in the supply of those skills.  Heart surgeons are paid well, because the skill is both valued by a large number of consumers and rare.  This is true of high caliber artists and musicians.  Yes, it is even true for bankers---if what they produce is not valued by a very significant number of people, then they simply wouldn't be paid the high salaries.

(3) Wealth inequality is mostly about the inequality in individuals' power to dictate the production of goods and services. A wealthy person is either in direct control of corporations or in a position to delegate control of corporations through voting his shares in appointing management.  This control influences what firms invest in and, ultimately, develop and produce for consumers. 

Yes, we should be troubled by substantial consumption inequality
I think it is clear that we, as a society, are opposed to very significant "real consumption" inequality---or inequality in the quality of living for our fellow men.  We would likely find it unacceptable if the upper income class live appreciably longer lives, are physically much healthier, are more comfortably shielded from the elements (in terms of housing, heating and clothing), have healthier children with greater life expectancy, have superior access to university admissions for their children, enjoy substantially earlier retirement, work far fewer hours per week, consume more quantities of key raw resources (petrol, foods, etc.), etc.  There is clearly consumption inequality, and it probably translates into inequality in the resulting human happiness.  We can all individually have our assessment on how inequitable is the quality of life for households.  However, it is probably unarguable that as a compassionate society, we should be concerned about consumption inequality.

Is income inequality unfair and wrong or is it just a coordination mechanism?
Are we really opposed to income inequality resulting from our market economy?  Meaning, do we expect to get better outcomes if we pay similar wages to all labor outputs?  In a market economy, high wage for a skill is generally driven by more demand than supply.  Some skills are rare---like making a 3-pointer over a leaping 6'6" defender in a basketball game.  Some skill are very expensive to acquire, like a Ph.D. in bio-medical science.  Since we have competing preferences and unlimited wants as a people, and since skilled labor is in limited supply, wage inequality arises as prices are set for various skills to induce more or less supply.  Note, grade school teachers are paid less well than pediatricians not because we value teachers less but because the cost of producing a doctor is significantly higher; if we pay doctors the same as we pay grade school teachers, we would have an insufficient supply of doctors.

I understand that most people probably don't object to the income disparity between teachers and doctors.  What angers them is the income inequality between teachers and bankers.  I am not interested in defending the value of the people working in the finance industry; I simply acknowledge that they too possess rare skills that are sought after, and they seem to produce products that our society willingly pays for.

But for the sake of argument, let's assume that the world would be better off if we reduce bankers' compensation and therefore reduce supply of bankers to our economy.  Is that reason enough to argue that the market economy is broken and that pays should be regulated by policy makers (central planning economy)?  Perhaps the market has made a mistake in its banker allocation; is that proof that income inequality is then generally unable to produce a thriving and harmonious human society? 

Who's the boss? Do consumers or business owners call the shots in a market economy?
Are we actually opposed to wealth inequality? Paper wealth are generally debt that we lend to others, equity ownership that we hold in businesses or ownership of collectible items of amusement value (like fine art).  A wealthy person can either consume a lot more now or maintain a modest consumption and lend to others to consume (i.e. lend to the government to fund welfare program or to banks for making loans to consumers).  Of course, if a wealthy person consumes a lot all the time, he wouldn't be wealthy for much longer.  As I indicated before, wealth inequality is a natural consequence of relatively high income inequality with relatively modest consumption inequality.  Of course, we could accomplish the same high income inequality with low consumption inequality through aggressive income taxes as well, without creating wealth inequality.  So it is important to examine the other benefits of maintaining wealth inequality in the population.

We are probably quite pleased that the wealthy trade in their claims to consume goods and services for ownership in Monets and Van Goghs. It is especially good when they lend out their art collection to museums for the rest of us to enjoy. 

The overwhelming benefit from wealth inequality is that valuable businesses are directed by people who are far more successful at investing and running businesses than the rest of us.  It is worth asking why we don't see large corporations build giant pyramids in the dessert or whimsical castles perched on top of tall mountains and other wasteful projects, which serve no value to the broader population other than amusing its management?  Because shareholders wouldn't allow it.  Because wasteful and poorly though-through projects cause the firm to lose money, which result in the firing of management or in the firm being eliminated through competition, etc.  In a market economy, you only get to stay wealthy and stay in control of productive assets, if you are continually good at producing what is desired by society.  The wealthy may have control over the "how" but not the "what"---that is, the heads of corporations get to decide on how to deliver goods and services to consumers, but they are beholden to the tastes of consumers in what they deliver.  In a sense, the "how" to produce is determined in a central planning/totalitarian system, but the "what" to produce is determined in a democratic system.

Would we be better off as a society, if there were significantly less wealth inequality? That is would businesses and firms be more productive for society, if ownership and decision rights were more equally distributed across the population?

So what?
I think the negative attention heaped on income and wealth inequality is dangerous.  Let's focus on a goal that is far more agreeable to the most of us---more consumption equality.  Indeed, let's acknowledge that income inequality and wealth inequality are not problems in and of themselves and are probably very desirable in reality.  Can we have more consumption equality without disrupting our market economy, which is almost predicated on having income and wealth inequality?  I would simply caution us against a naive and emotional assumption that consumption inequality can only be eliminated through eliminating income and wealth inequality.


by jason c. hsu


[1] The focus of this article does not allow it to touch on welfare recipients and trust fund babies.
[2] See http://economistsview.typepad.com/economistsview/2008/02/consumption-and.html for a debate on the CEX statistics and an explanation on how lower income households can spend more in consumption than their taxable income.

22 comments:

Anonymous said...

Good article. At least it's making me think.

But what are the creative solutions to address consumption equality? I'm not seeing many right now. As you suggested, they all go back to fixing income inequality and redistribution.

The best consumption equalizer is making things affordable through competition and the free market. That's the only one I'm seeing. For example, China and Walmart have made things affordable to many people. Whereas any government scheme to equalize consumption usually doesn't. And that includes a public healthcare system: some French people go to Thailand to get better treatment while getting a nice vacation now. And medication price control in Europe usually result in higher prices in countries like the US.

Olivier

rhdevries said...

Excellent post. What matters most to the very poor is that the consumption gap can narrow, not whether Bill Gates has more $$ in the bank than they do.

R Vogel said...

I too am struggling with how consumption inequality can be viewed separately from income inequality. Based on your consumption/income numbers, the top 20% only consume 30% of their income, assuming a 2 person household, the middle consumes over 60% and the lowest consumes 214% (not even sure how this is possible) - add another household member and the numbers completely blow up for all but the highest 20%. And do you consider saving for retirement part of consumption, becasue if you don't there is precious little left for any but the highest 20% to do that, which, of course, explains the lack of retirement savings that everyone is wringing their hands about. I don't know any but the most ardent marxist that are completely against income inequality, but why should the average CEO salary versus average worker have balooned from 24 times 40 years ago to over 200 time today?

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