Inequality Rises in the U.S.

This report (click her) ran a while back on NPR's Morning Edition. (For the numbers the report was based on click here.) The bounty going to the top 1% of Americans has pushed past that of even the 1990s. What was offered as an explanation was the simplistic notion that the demand for services of highly skilled labor was rising faster than the economy overall was growing. However with even a basic background in economic theory it should be apparent that higher returns in a competitive market invites entry. (In point of fact, one definition of competitive market is that free and easy entry into a market is possible) All else equal, as suppliers exit the market with lower returns and enter the market with higher returns the value of the former should rise and the latter should fall. Persistent inequality is a sign of failure of the market system rather than the price to be paid for all the very real benefits markets provide. Skills mean in essence education and so the issue of persistent inequality begs the question of why access to quality education is so inequitably distributed. To focus on the competition that unskilled labor faces from technological change or from abroad diverts our attention from this much more awkward question. The poor cannot afford to live in areas where the property tax base is high enough to support good public schools. It is even less likely that the poor can afford to send their children to private schools. And most importantly, despite whatever unrealized potential a given student might ultimately have, the poor cannot hope to leverage this potential into the sorts of loans that would fund that child's education and lift that child and her family out of poverty. Given the imperfections that exist in credit markets this is out of the question. Add to these financial constraints families at the top end of the income distribution have accumulated many advantages over the years . These advantages include the skills required to negotiate the educational system to our childrens' advantage and you have a fairly complete explanation of why inequality is so persistent in America. (See Annette Lareau's Unequal Childhoods or her earlier book Home Advantage) It is important to note that despite the very real problem that persistent inequality presents, the IRS numbers overstate the degree of inequality. Many students and other young adults from middle class and wealthier families file returns. The adjusted gross income of a graduate student with a tuition fee waiver and a monthly salary for working as a teaching assistant or research assistant or, more importantly, the college student who works part time as kitchen help or as janitor will be pitifully small. However, their poverty is only temporary and not very real. As they go to school or work part time and try to find some direction in their lives they live comfortably and securely.

on market falure, game theory, and government policy

Markets are efficient when they are able to communicate information at the lowest cost possible. Therefore one way of characterizing market failure is to describe it as a situation in which markets do not or cannot communicate information effectively. When markets fail there is possibly some benefit to government intervention. However, to the degree that markets communicate information, one should be leery of government intervention. Goverment intervention may disturb the delicate process of communicating information between buyers and sellers. There is also the very real potential of policy makers acting in their own self-interest rather than working for the general good. Communication failures 1: Unable to communicate, negative externalities. In the case of negative externalities, such as pollution, markets fail because prices do not convey full information of the costs of their activities to buyers and sellers. Polluters and their customers consider only the costs they have to bear. Why do they fail to take into account the total cost of their actions ? The principle reason is that other parties cannot accurately express what share of the resources harmed by pollution are theirs. And it is often too costly for individuals hurt by pollution to form a block that could effectively communicate to the polluting company the total costs of its activities. (For more on these problems click here.) Government steps in to supply this information to polluters, most commonly through emissions taxes. Communication Failures 2: Unable to communicate, missing information. There are many instances where markets not only do not communicate information efficiently but in which they cannot. The facts are simply not there to be uncovered. What happens as a result of one’s own actions are contingent on what everyone else does. In turn, what others plan is contingent on their expectations of what still others will do. There is absolute ignorance of what the future will bring. The future is not something to be uncovered through careful study but rather it is something we create. From an individual perspective, this lack of information means that often it is far better to wait than to act. Economists have experimented with all sorts of terms to capture this: for example, linkages (Hirschman), circular and cumulative causation (Myrdal), and most recently, complementarities (development economist), reciprocal externalities (public choice theorists), and network externalities where you capture benefits being part of the same group or network; investing businesses, educated workers, and so on (economists working in the field of industrial organization).

Why better safe than sorry rather than nothing ventured nothing gained? There are of course many transactions which are small and routine and the potential costs of mistakes are therefore small. Here one can experiment. One needn't rely on trust or extensive experience. Say that I spend $1 to buy new brand of cola rather than Coke. I discover that I don’t like it nearly as much as I do Coke. The next opportunity I have I will simply remember to buy Coke rather than the new brand and my loss, the cost of my mistake, is at most the $1 spent. However, there are many transactions that are infrequent and that are far from routine. Basically whenever it is the case that a transaction is large (large from the perspective of the individual involved) and, at least at first, the transaction is far from routine the costs of making a mistake are quite high. We see people hesitate for this reason. Whether a given choice has been a wise or a foolish choice hinges crucially on what others do. Your assessment of the wisdom or folly of a particular decision then hinges crucially on what you think others will do. Before deciding to reenter the bond and stock market (and to therefore begin to take greater risks again) in the wake of a bear market, a financial investor must be confident that others will soon begin to feel bullish as well . In an economy where, even with education, jobs opportunities are scarce, a poor family sending their children to school (and in the process foregoing the income they would otherwise help bring in depends on) hinges on being confident that jobs will be there. Residents living in the vast slum of Dharavi in Mumbai agreeing to move into smaller living spaces, doing their handicraft work in the centralized location promised, hinges crucially on their being confident that the promised work space will materialize. In all of these cases resistance to change is far from irrational. The costs of mistakes are so great and the decision to heavily invest in bonds, to take years out of one’s earning life for education , or to agree to move if markets remain bearish, job opportunities scarce, or promises are not kept impose costs too great to absorb. Game theory. Game theory focuses on such situations.* In the classic prisoner’s dilemma criminals face potentially tremendous costs. To minimize the damage that might occur to them individually they confess rather than stay quiet. A socially efficient decision (from the standpoint of this society of two criminals at least) would be to keep quiet. However not knowing what the other prisoner is doing to do, the equilibrium solution is to confess. Both do so and both are far worse off than they would have been if they had just kept quiet. The reason they don’t is in part because they do not know what the other will do. However, the choice made is more importantly due to the fact that they make this decision only once, and that the costs of mistakes are very high indeed. Contrary to the typical examples of market efficiency in a prisoner's dilemma rational self-interest leads to socially poor results. If you keep the same fundamental structure of a prisoner’s dilemma (choices/decisions are not small routine ones and where mistakes are relatively expensive and are not quickly or easily corrected) but alter the payoffs in such a way that the actions of decision makers (players of the game) are complementary you move from a prisoner’s dilemma to what are called coordination games.** To say that the payoffs are complementary means that they are very much contingent on what others do. Good or bad, decisions reinforce one another. If we are able and willing to take risks and are fairly confident that others will act in such a way that their choices positively reinforce our actions then we will go ahead. If we are not confident of this, it is better to wait.

In classic examples of market efficiency, no one need think strategically at all and the environment is truly a competitive one in which the gains of some are offset by the losses of others. We do not have to think strategically because the costs of mistakes are so small. In a prisoner’s dilemma we think strategically at first but ultimately decide that regardless of what others might do it is best for us to protect ourselves whatever might be the long-run costs to society and to ourselves. In a coordination game , we think strategically throughout and must trust others to act in a certain way before we are willing to move in a positive direction. Unless confident of what others may do, their actions materially altering the payoffs of our taking on greater risks, we are better safe than sorry. Nothing ventured nothing gained is too dangerous a philosophy for us to follow. Understanding the obstacles to forward movement government can act as a catalyst to decisions taken by private citizens and businesses and can improve on market outcomes. In the process the payoffs change in such a way that sellers’ costs, the prices buyers must pay, the uncertainty of markets materializing and the contingency of individual decisions are reduced. President Clinton’s Aids/HIV initiative can be viewed in this light. With private donations and government grants he provided a guarantee to drug companies that if they were to ramp up production and, in so doing, realize large enough economies of scale to lower costs demand would be sufficient to absorb the added production. The guaranteed demand was made possible though the Clinton foundation support that supplemented recipient countries’ funding. By guaranteeing a market President Clinton broke the deadlock that otherwise would have gone on for far longer. *The late British economist G.L.S. Shackle wrote of "crucial experiments" which by their very nature are nonroutine and potentially very costly if they fail. Although I am not aware of anyone doing so, one might draw a direct link between Shackle's crucial experiments and nonrepeated games. Also, in mainstream economic theory, there is Christina Romer's irreversibility hypothesis -that decision makers confronted with uncertain situations rationally will delay committing to making any decision and spending when such commitments are costly to reverse. (see " Irreversibility, Uncertainty, and Investment" Pindyck,Robert S., Journal of Economic Literature, 1991, 29, 3, 1110-1148 and "Uncertainty as a Propagating Force in The Great Depression" Ferderer,J.Peter; Zalewski,David A., The Journal of Economic History, 1994, 54, 4, 825-849) For more on coordination games see "Coordination" by C. Monica Capra and Charles A. Holt Southern Economic Journal, Vol. 65, No. 3 (Jan., 1999), pp. 630-636 or Debraj Ray, Development Economics, Princeton University Press.