Economics and income distribution

In economic analysis .income interpreted in two principal ways:

the functional distribution of income .i.e. the distribution of income among

factors .and the size distribution of income (or distribution of income among



I briefly deal with the way each of these is conventionally handled in

economics, focusing on the forces that determine the shape of the income dis-

tribution Then, i will look at challenges to the orthodoxy and the way these challenges have enhanced our understanding about the analysis of income distribution in recent years.


  1. 1.  The standard approach


Functional distribution. The functional distribution of income is an inte-

gral part of the economic analysis of relative prices, output and employment.

In this sense there are several theories of income distribution corresponding to

di¤erent theoretical and ideological stances on these central issues. However,

these various analyses usually focus on the same basic economic concepts: em-

ployment of the factors of production .land, labour and capital .and the rates

of remuneration of their services .rent, wages and proofit.


The conventional approach is to treat questions of distribution as part of

the neoclassical analysis of prices and resource allocation in a story such as

the following. A competitive .rm takes the price it can get for its output and

the prices it must pay for inputs as given in the market: it selects its level of

output and adjusts its demand for inputs so as to maximise pro.ts at those

prices; each household takes as given the prices paid to it for the labour services

supplied by members of the household just as takes as given the prices to be

paid for goods and services it needs, and: it adjusts the quantities of the goods

and services demanded or supplied in the market so as to maximise satisfaction

within the limitations imposed by its budget. In this story prices adjust so as to

ensure equilibrium in all markets: equilibrium means that aggregate supply of

each commodity is at least as great as aggregate demand. In particular factor

incomes, the reward for each type of labour, each natural resource and capital

asset is determined by its market clearing price. So the functional distribution

of income .the issue referred to directly by Ricardo in the epigraph .is in this

way automatically determined by the market mechanism. Shocks to the system

.for example changes in the stock of natural resources alters, or a shift in the

preference patterns of consumers .will change the income distribution through

this mechanism as prices adjust to new equilibrium levels.


Personal distribution. The distribution of income between persons or be-

tween households can be .tted into the above scenario. Key decisions that

determine incomes in the long run can each be analysed as particular cases of

the household.s optimization problem: household saving, self-investment in hu-

man capital or the purchase of education for children are determined by price

signals. To complete the theory of income distribution within this framework

one also needs a description of the system of property rights that prevails within

the community. The question of who owns the natural resources, the capital

equipment and the pro.ts of the .rms is central to the determination of house-

hold incomes: household budgets are jointly determined by market prices and

property rights and will be a¤ected by a change in the pattern of ownership, or

in the system of ownership.


However, more is required to complete the personal income distribution

story. In order to draw conclusions about the distribution of income in the

long-run one also needs to consider the evolution of property rights across the

generations.(Piketty 2000).This will depend, among other things, on how fam-

ilies are formed (do the rich predominantly marry the rich?2 do the poor have

more children?) on the motives for bequeathing wealth to the next generation

(do parents compensate disadvantaged children? is the amount bequeathed the

outcome of dynastic optimisation or largely a matter of chance? ) and the role

of the State through taxation (Cremer and Pestieau 2006).


  1. 2.   Challenges and developments


The orthodox neoclassical story outlined in section 1 has been called into ques-

tion on account of its restrictive assumptions concerning the economic processes

involved. Because these assumptions are central to the theory rather than be-

ing merely convenient simpli.cations, many economists have questioned the

relevance of various aspects of the standard account of income distribution. I

may briefly mention three points of focus.


The role of prices. The predominant interest of neoclassical orthodox the-

ory of income distribution in smooth adjustments to market clearing equilibria

may be inappropriate to a theory of the functional distribution of income. As a

response to this, economists who are strongly in.uenced by Keynes.s approach

to macroeconomics have developed a number of alternative theories of the func-

tional distribution of income using components of the Keynesian system, for

example the work of Kaldor (1955) and Pasinetti (1962). Key features of such

alternative theories are rule-of-thumb savings decisions by capitalists and work-

ers and a rigid technique by which labour and capital are combined to produce

output; they play a role in some of the modern theory of growth and its rela-

tionship to factor incomes (Bertola 1993).


Monopoly power. The standard theory neglects barriers to competition and

the monopoly power as of secondary importance in the competitive market

story. Restraints on competition .in the form of segmentation of the labour

market and outright discrimination .are of major importance in analysing the

lower tail of the size distribution of earnings; and monopoly power may be

particularly important in the upper tail, for example, in the determination of

earnings in professions with restricted entry. Monopolistic pricing by .rms has

also been seen as of prime importance in the functional distribution of income

(Kalecki 1939): such power plays an important part in the Marxian concept

of exploitation and in distribution theories based on struggle between classes

representing di¤erent factors of production. The assumption of competition

is also likely to be inadequate in analysing economics that have a substantial

public sector.


Modern treatments of the labour market take seriously the problem of monop-

sony by powerful .rms in determining labour incomes and the potential role for

a minimum wage (Manning 2003).


Information. The standard story in section 1 assumes e¤ectively perfect

information on the part of economic agents. However, uncertainty is itself a po-

tent force generating inequality in both labour income and income from assets,

in that the rich not only are better able to bear risk but also may have superior

information which can be exploited in the stock market and the labour market.


Moreover, some of the barriers to competition may have been erected by firms

in response to uncertainty. Hence considerable interest has developed in the

distributional implications of theories of output, employment and the structure

of wages that explicitly incorporate imperfect information, in particular screen-

ing and signalling, phenomena that may result in equilibrium income inequality

(Salanié 1997). Because of imperfect information it is in the interest of economic

agents to make use of social networks formed from social contacts which may

also buttress equilibrium (Ioannides and Loury 2004, Manski 2000).



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