What purpose does economic inequality (inequality in wealth) serve?

Question

What purpose does economic inequality (inequality in wealth) serve?

While one can argue that it's a result of differing productive capability, this is not the case with e.g. inherited wealth. Also, when it grows so big that it may appear to start "exploiting" others, because the wealth bearers have so much power, then does it still serve useful purpose?

But particularly, does it serve some purpose for some to have more and some to have less? From a Marxist perspective one could interpret that having more leads to those having less having to do more in order to attain the position that those having more already have. So it's some sort of "pyramid scheme", where everyone rises, but those beneath the top are being scammed.

Answer 1

The conservative view on this topic is that wealth inequality allows to create incentive systems which encourage people to contribute to society in order to increase their wealth.

In other words: work more, work well, provide the goods and services other people demand and you will receive more wealth and live a better life than your peers. The conservative believe is that when you are poor, then you are being punished for not contributing to society. If you don't want to be poor anymore, look for a job which is in higher demand, get paid for it, and get rewarded with a higher standard of life.

The idea of inheritance is that people don't just care about themselves but also about their children and want them to live a better life, even when they themselves are not alive anymore. So working hard and well does not just improve one's own life but also the lives of one's children.

One of the most influential economists in this regard was Adam Smith who coined the term "free market economy" and recognized that it is a self-regulating and self-perpetuating system which automatically rewards those who optimize their personal contribution to society.

But the capitalist implementation of this idea is not without flaws. Those who already have wealth have more opportunities to increase their wealth even more while those who lack wealth face greater challenges to improve their social status. A capitalist system means that children of rich people have better access to education, which in turn allows these children to take on better paying professions. And those who already have capital have a better opportunity to try out new business ideas without endangering their existence. The result is a low social mobility (i.e. the social status of individual people is unlikely to change over the course of their life - for better or for worse) and an ever increasing gini coefficient (i.e. the income differences between rich people and poor people increase).

One of the most influential economic scientists who recognized and criticized this flaw in a free market economy was Karl Marx. He postulated that this system would eventually lead to a concentration of wealth in the hands of a small elite. This inequality would be unsustainable in the long term and collapse in what he referred to as a "communist revolution". The system would then be replaced by a "dictatorship of the proletariat". A centralized planned economy in which everyone would be obligated to work to the best of their ability and receive goods according to their needs.

However, those countries which tried to implement planned economies according to Marxist doctrine in the 20th century failed. Their governments ended up to be authoritarian regimes which committed some horrible atrocities and their economic output and median standard of living was below that of the capitalist economies in North-America and Western Europe. Near the end of the 20th century, almost all communist countries reconsidered and decided to reform their economic systems back to a free market economy.

Now you could speculate about whether this was a flaw in the Marxist idea, a flaw in the execution, or the result of external circumstances. Lots and lots of books were written about the downfall of communism and they tend to come to drastically different conclusions, depending on the political views of the author. Also, this website is not a discussion forum. So I don't want to waste any more keypresses on speculating about whether Adam Smith was right, Karl Marx was right, or if the optimal path lays somewhere in the middle.

Answer 2

Here's an example. Let's say we like lollipops, and sugar for one lollipop costs $1. We each have $1 and so we can each purchase sugar for one lollipop. Even if we pooled our money, there is no benefit in this case. If one person has more money, they just get a proportional amount of more sugar. So, wealth inequality does not make sense.

Now consider that we need a stove to melt the sugar for lollipops. A stove costs $100. Without the stove, we cannot have lollipops. Individually, none of us can purchase the stove, and thus none of us can get lollipops. We have to pool our money to get the stove. In this scenario, some kind of wealth aggregation is more useful than spreading the wealth evenly.

Finally, let's consider where the stove comes from. Someone (let's call him Steve) has to do all the work to invent and construct the first stove. Why would Steve do such a thing? It costs Steve $50 to create the stove, and thus he must forgo 50 lollipops worth of sugar. He already has his $1 of sugar, and can at least enjoy that, even if it is not a lollipop.

Idealistically, Steve has great goodwill, and will make the stove altruistically. More realistically, he is willing to work hard if he personally benefits in some way. Consequently, Steve sacrifices his $50 of sugar to create the stove. He then sells the stove for $100, so he doubles the sugar he would have gotten otherwise. Now, Steve has $100, which some people gave him, and thus Steve has more wealth than some other people. Wealth inequality has emerged.

But, on the flip side, lollipops now exist, and people can enjoy their sugar in a more preferable form.

So, in this scenario, for everyone to get something they want, wealth inequality was the most effective way for it to happen.

Answer 3

Wealth inequality is a consequence, not a goal. No political system in the world explicitly takes action to increase wealth inequality, their stated goals are (depending on ideology) to either decrease or ignore it.

Since the conspicuous examples of wealth inequality in functioning states usually involve the latter, we can consider: Why wouldn't a government reduce inequality? Or alternatively, why would they tolerate it?

The first benefit is stimulating innovation. The people at the top have it really good. A lot of other people want to be like them really bad. They will try any perceived avenue of getting there with much enthusiasm. If the market is functioning reasonably well, the chief ways of getting very rich would involve somehow improving the economy as a whole: Whether by making the whole system or part of it more efficient (thus collecting profit from arbitrage), or by inventing some new service or product that answers a previously unsatisfied demand. Thus everyone benefits from the market being more efficient, by being able to buy nicer things for less. Of course, this breaks down if there are perverse incentives. For instance if corruption is a viable and profitable activity, many will try to get rich by this parasitic activity rather than something that benefits the economy. Or if rule of law is poor, crime lords will proliferate and prey on citizens. Moreover, it must actually be possible to innovate and compete in the market, the government for instance must not bog down new companies with red tape.

Without inequality, there are still other motivations to innovate, like personal satisfaction, desire for fame or legacy, and a sense of civic duty. But the motivation of wanting to be very rich is gone. Thus it is not accurate to say that no innovation would happen, but we could expect that less of it would happen in proportion to the lack of inequality. In practice, this has occurred to some extent. For instance the selection of products available to consumers in the USSR was notoriously small (disregarding their availability, which was also poor) compared to the West where often countless different competing products or services are available, and it was difficult to find high quality products (while in the West you have the option to pay a little for poor quality, or pay a lot for exceptional quality, and everything in between).

The second benefit is that everybody tries to do their best. Obviously few want to end up at the bottom, so no matter what job you do, you will try to work really hard and do your best, hoping to get a promotion, a raise, a bonus, or in the least to not get fired for poor performance. Again, this requires that good work actually be rewarded to some extent. If there is a widespread culture of nepotism in every major industry and hard work is never rewarded, then this point does not apply.

In more egalitarian systems, such as the USSR, there is a problem of getting people to work. Again, some people will work for non-economic reasons, but there are others who won't bother unless they have something to gain (or lose). Thus egalitarian systems often punish people who don't work hard enough. You could say that under inequality, productivity is maintained with the carrot, and under equality it is maintained with the stick.

Lastly, and probably most controversially, it allows society to remove or minimize the least productive elements of society. For obvious reasons, proponents of less-egalitarian systems will downplay this, but it is inevitably an important economic consideration. In any egalitarian system there will always be people not pulling their weight (due to inability or unwillingness), and each such person is essentially a drain on the collective resources of society.

In an egalitarian system, such people would be entitled to some decent standard of living, so it might be necessary to ensure that they have nice houses, eat nice food, send their kids to good schools, can get quality medical treatment, etc. Of course someone has to pay for all this. Arguably many people, when provided with a decent life, will become more productive - but not all. If the system is less egalitarian, the least productive people are not expected to receive these niceties, typically they will at most get a basic food allowance and a bed at a homeless shelter. This is naturally a lot cheaper, though arguably less ethical. In support of this, tax rates tend to be much higher in places with less inequality, while the standard of living for the poorest people is higher.

So it's some sort of "pyramid scheme", where everyone rises, but those beneath the top are being scammed.

In a pyramid scheme, most people involved get less out of it than they put in, while being promised otherwise, hence the scam. A few rise, everyone else falls. If everyone rises, how can it be a scam? Sounds more like a win-win to me.

One could argue that people are being scammed in the sense of not rising as much as they could have. But in many systems with inequality (assuming they function well in the sense of the three points above), you can obtain a pretty decent standard of living with a reasonable amount of work, so I wouldn't call that a scam. In the US, for instance, median household income is $60k - which while not extravagant, certainly would not leave you starving in the streets.

In egalitarian systems, the equality is often achieved by confiscating part or all of the income of people who produce the most value, and then distributing it to those who produce the least. These people get less out of the system than they put in. The very bottom stratum places a disproportionate strain on the welfare system, getting free things at the expense of everyone else. If anything, this seems like a better candidate for a pyramid scheme.

Answer 4

Paul Graham (a fairly famous - though may be in narrow circles) Silicon Valley venture capitalist, enterpreneur and hacker extraordinair - who cofounded and runs a very influentual venture company "Y-Combinator" - has posted on his blog about this topic.

In a 2016 essay "Economic Inequality", he argues a couple of things:

1. Most importantly, that "economic inequality" is a complex issue, not just a single-dimension simple problem.

   The solution to this puzzle is to realize that economic inequality is not just one thing. It consists of some things that are bad, like kids with no chance of reaching their potential, and others that are good, like Larry Page and Sergey Brin starting the company you use to find things online.

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2. That many cases where people criticize economic inequality result from applying wrong basic assumptions - namely, committing a logical fallacy named "Pie Fallacy" (aka zero-sum fallacy).

   In short, people assume that there is only a fixed set of goods/benefits/etc.., and that if one person gets more of them (or a bigger share of them), that this necessarily means that others must get smaller share of them.

   While the latter sort of logic correctly applies in zero-sum situations, it frequently and usually does NOT apply to typical economic situation, which is rarely zero-sum.

   (There's much more to say on the topic, but since the core question was "what purpose does economic inequality serve", it is somewhat tangential and should be discussed in a separate Q&A).

   The important point for this discussion is that, one of the main factors here is that certain people enlarge the whole pie as a result of their activity, thereby resulting in a situation that objectively, in absolute terms, benefits everyone, or at least many if not most people, who now have more pie to divide between themselves.

   To use a not-always-accurate but crude analogy, yes, someone may have a house-sized piece of pie. However, in the process of getting it, they had to bake a 2-house-sized pie, and now every one of their neighbours can have a whole box of pie instead of a small slice (or no pie at all) they would have had before. The important part is that everyone else is better off for having a whole box of pie now (disregarding higher dental care costs :).

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3. Now, we get to the "benefits" of economic inequality.

   I'll try to phrase this as precisely as possible, and will paraphrase what Graham was saying.

   The benefit of economic inequality is the fact that lack of economic inequality necessarily requires you to live in a system where everyone's well being does NOT constantly improve as a rule.

   In other words, economic inequality by itself is not necessarily beneficial per se nor is the end goal - however, the goal is the type of socioeconomic and political system in which economic inequality happens to be an unavoidable consequence of. The main consequence of such a system is that (nearly) everyone's lives keep improving, regardless of the inequality that happens at the same time, and that latter improvement is the goal. Inequality is merely a symptom/byproduct.

   Quoting from Graham himself:

   Variation in productivity is far from the only source of economic inequality, but it is the irreducible core of it, in the sense that you'll have that left when you eliminate all other sources. And if you do, that core will be big, because it will have expanded to include the efforts of all the refugees. Plus it will have a large Baumol penumbra around it: anyone who could get rich by creating wealth on their own account will have to be paid enough to prevent them from doing it.

   You can't prevent great variations in wealth without preventing people from getting rich, and you can't do that without preventing them from starting startups.

   So let's be clear about that. Eliminating great variations in wealth would mean eliminating startups. And that doesn't seem a wise move. Especially since it would only mean you eliminated startups in your own country. Ambitious people already move halfway around the world to further their careers, and startups can operate from anywhere nowadays. So if you made it impossible to get rich by creating wealth in your country, people who wanted to do that would just leave and do it somewhere else. Which would certainly get you a lower Gini coefficient, along with a lesson in being careful what you ask for.

   I think rising economic inequality is the inevitable fate of countries that don't choose something worse. We had a 40 year stretch in the middle of the 20th century that convinced some people otherwise. But as I explained in The Refragmentation, that was an anomaly—a unique combination of circumstances that compressed American society not just economically but culturally too.

Answer 5

I know this is a politics site, but since (some) politicians are influenced by economists, it pays to recall the view of the topic by economists, as outlined in a fairly recent World Bank blog:

Inequality can be both good and bad for growth, depending on what inequality and whose growth. Unequal societies may be holding back one segment of the population while helping another. Similarly, high levels of inequality may be due to a variety of factors; some good, some bad for growth. [...]

Early thinking viewed inequality as a positive factor. Kaldor (1956), for example, considers income inequality as necessary in order to provide for savings (the rich save more than the poor), and thus key for capital accumulation and economic growth. Also, more unequal societies may provide stronger incentives which ultimately motivate individuals to work harder in order to succeed.

More recent studies explore the conditions under which inequality may act as a negative factor. One strand of this literature appeals to the Meltzer-Richard’s median voter hypothesis[...] It is argued that high inequality leads a relatively poor median voter to vote for high tax rates, which in turn reduce incentives for investment and cause low growth. [...]

Marrero and Rodríguez (2012, 2013) decompose total inequality into an inequality of opportunity (IO) component (Roemer, 1993), the inequality that is due to circumstances outside the person’s control such as parental education, race, country of origin, and a residual inequality component that is assumed to be due to effort and luck (Bourguignon et al., 2007). In two separate applications, one to the European Union member countries and one to the US states, they find strong evidence that levels of inequality of opportunity are negatively correlated with growth while the residual (“good inequality”) tends to help growth. The rationale is that IO may harm economic growth because it favors human capital accumulation by individuals with better social origins, rather than by individuals with more talent. [...] It has proven harder to reproduce the negative relationship between IO and growth using cross-country data, see Ferreira et al. (2014), either because the relationship does not hold true in all countries, or because the data are not strictly comparable across countries.

So the recent research trend (according to that World Bank blog) is to try to identify the good vs. bad inequality. The blog spends quite a bit more space on why IO (inequality of opportunity) is bad... but since this question asked only why inequality is good, I've mostly snipped the parts arguing (mainly) for the opposite. I would not be too surprised if the mainstream/centrist political view is close to this recent research trend of focusing on the "bad"/IO inequality, or will converge to it.

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It occured to me that Macron might be a good example of the above trend. First cue Macron's discourse on (IO) inequality:

"One thing is unbearable in a society," Macron said in February. "It's saying 'you are from a certain place so you don't have the same access as the others. You don't have the same opportunities to succeed."

And he did make kindergarden mandatory, as well as halve some class sizes in certain high-priority zones, mostly poor neighborhoods. (Smaller classes generally lead to better outcomes.) Macron's discourse on these specific changes

“If you want to fight social inequalities, you must first of all fight against inequalities in the field of education, starting with the youngest ages,” he said, describing the aim as giving pupils from disadvantaged backgrounds “a good start.”

And then consider his actions on other/wealth inequality, (which came before the education changes mentioned above):

Macron’s bloc in the French parliament voted on a new budget [...]. It slashed the corporate tax rate down to 25 percent (from 33 percent), scrapped a longstanding “solidarity tax on wealth” (France was the last EU country to have a wealth tax), cut 1.7 billion euros in housing aid, and eliminated 120,000 public contract jobs.

This led the well-respected French economist Thomas Piketty to compare Macron to Trump, who just passed a $1.5 trillion tax giveaway to the rich and corporations in the United States.

To those who don't know, Piketty is one of the best known (French) researchers on inequality in recent times.

Also, I haven't found an explicit discourse of Macron on wealth inequality, but an opinion poll left little uncertanty how these tax measures were received:

69 percent of the French believe Macron’s plan to trim the wealth tax will increase inequality, while only 31 percent agree with the government’s argument that it will foster investment.

Anyway, my point is that Macron seems to follow a policy of IO-inequality-bad, wealth-inequality-not-so-bad (or even good), seems to be in tune with some fairly recent economics research in the area.

Answer 6

While one can argue that it's a result of differing productive capability, this is not the case with e.g. inherited wealth.

The purpose of inherited wealth is to incent wealth producers to keep producing wealth after they are in a position to stop on their own account. I.e. it's not recipients but the givers who are impacted by inherited wealth in a way beneficial to society.

Basically if you are so rich that you can live off your wealth for the rest of your life, what incentive do you have to keep working? Inheritance offers one. It's imperfect, as the wealthy may not care about their heirs or may be willing to keep working for reasons other than wealth (power, influence, etc.). But pretty much every incentive is imperfect like that.

From a Marxist perspective one could interpret that having more leads to those having less having to do more in order to attain the position that those having more already have. So it's some sort of "pyramid scheme", where everyone rises, but those beneath the top are being scammed.

Well, if you believe that, stop trading with the wealthy. Tell them you don't want their money and goods, as it's just a scam. Instead trade only with other people of similar or lower financial status.

Of course, countries that have actually tried that have tended to do less well than those who trade with the rich. Most commonly they enter that state somewhat involuntarily. E.g. sanctions against North Korea, Iran, Russia, and Cuba.

I remain unconvinced that voluntary trade exchanges leave either side worse off. If they did, then why would people engage in them?

Answer 7

For the most part, the "Marxist" perspective, as you put it, does not advocate income inequality in and of itself. It advocates positions that result in income inequality. That is a distinction that unfortunately both sides of the spectrum are all to willing to ignore.

In the case of inheritance, what is the alternative? The government seizing everyone's assets when they die? That goes against conservative principles several ways.

First, there is a distrust of government, and giving the government another means of grabbing resources doesn't sit well with them. Also, note that liberals often treat the government as being simply a manifestation of "the people", so an inheritance tax means that "the people" in general get the money, rather than a small number of people who happened to be related to the person who died. If you reject that framing, and consider the government to be an entity in and of itself distinct from the people, then you have money being poured down the maw of the bureaucracy rather than being used to help actual people.

Second, ownership of property means the right to use it as one sees fit. If you can't decide what happens with your property after you die, then there is an argument that you never truly owned it; the government was simply letting you temporarily use it. To many conservatives, this looks like the government claiming to be the ultimate owner of all property, and people are allowed access to it only as the government sees fit.

Third, enforcing an estate tax has consequences that ripple out. One way to get around it is to give the money to your heirs while you're alive, so now we have a tax on gifts. So that then encourages finding loopholes, like selling property to your heirs for below market value, which now means that we have the government poking its nose into sales to decide whether they're "fair market value", and so on. This means more money spent by rich people finding loopholes, more money spent by the government trying to close those loopholes, and an expansion of the bureaucracy and an increase in government involvement in people's lives.

That being said, there are arguments that inequality has positive effects. If a project costs a million dollars, you basically have three options: find an ordinary person who's willing to put their entire life savings into it, form some sort of collective such a corporation and then deal with all the principal-agent issues that involves, or find a rich person for whom a million dollars is a drop in the bucket. During the Renaissance, most art and science was done either by people who were so rich they didn't have anything to do all day but read books, do experiments, and make painting and sculptures, or by people hired by people who had enough money to pay people to do nothing but read books, do experiments, and make paintings and sculptures. Now, scientists have to deal with trying to get grants, and dealing with all the bureaucracy involved in getting the government and other institutions to fund their research.

Answer 8

does [inequality] serve some purpose for some to have more and some to have less?

Imagine a world without inequality. Such a world must be one where no matter how hard you try to accumulate more wealth and/or earn greater income (whether labor income or profit) than others, you must fail. You would quickly realize this impossibility and rationnally give up these pursuits: give up saving, give up increasing your skills, give up increasing your work hours. That world would be a nightmare.

At the very least, inequality serves the purpose of improving on that nightmarish world.

Answer 9

Inequality in wealth serves no purpose in the sense I think you mean. Wealth inequality is an effect, not a cause. This is true whether you think is inequality is morally wrong, morally necessary, inevitable, or an artifact of a society not yet at the post-scarcity stage of development.

Which is not to say that wealth inequality cannot be causal of some effect, but rather that from the standpoint of some anthropomorphized society-as-entity it does not necessarily have a useful function (although the processes that produce it might).

Answer 10

From a Marxist perspective one could interpret that having more leads to those having less having to do more in order to attain the position that those having more already have. So it's some sort of "pyramid scheme", where everyone rises, but those beneath the top are being scammed.

Economically a pyramid scheme is one where the lowest level pays and gains nothing, and is guaranteed to collapse. If the lowest level gains, it's not a pyramid scheme. That is the difference between Amway, Tupperware and Avalon from true pyramid schemes -- the lowest level can benefit. Not necessarily a whole lot, but enough to make it worthwhile.

Which is why marxist rhetoric may make for effective political motivation, it makes for bad economics. Inequity is not a political goal, it is a economic reality, economically it is even somewhat desirable -- if supply exactly equals demand, there is no incentive to adjust the price or cost, which results in a cost to society.

Trading is beneficial to society as a whole, which means that unequal outcomes can benefit even those that objectively "loose" in a particular transaction.

In every way except personal power and prestigue todays charity case is better off than top of society 4 or 5 thousand years ago. God emperor or unemployed welfare dad -- it's a no brainer, as long as you don't value bossing people around more than eating, travelling, entertainment and personal comfort.

Answer 11

The first purpose of inequality is that it serves freedom of the individual. It is the cornerstone of the Lockean Enlightenment, and is better understood as the Right to Property or to one's one labor (From Locke's Second Treatise):

Though the Earth, and all inferior Creatures be common to all Men, yet every Man has a Property in his own Person. This no Body has any Right to but himself. The Labour of his Body, and the Work of his Hands, we may say are properly his. Whatsoever then he removes out of the State that Nature hath provided, and left it in, he hath mixed his Labour with, and joined to it something that is his own, and thereby makes it his Property. It being by him removed from the common state nature placed it, it hath by his labour something annexed to it, that excludes the common right of other Men. For this Labour being the unquestionable Property of the Labourer, no Man but he can have a right to what that is once joined to.

Locke included life, liberty, and estate (goods that are man-made) in his generic property defintion. When he argued that the primary purpose of government is to protect property rights, he meant Life, Liberty and Property, the orignal coda of the Declaration. He, and the FOunders, also meant that a government should protect those fundamental rights (including the right to enjoy the fruits of our labor) that are essential to life, self-preservation and happiness.

Almost this exact maxim is shared by Lincoln, the first Republican President, as a refuation of slavery. Indeed, Lincoln's philosophy is a re-imaging on the goals of the Enlightenment echoed in the Declaration of Independence.

You will find that all the arguments in favor of king-craft were of this class; they always bestrode the necks of the people, not that they wanted to do it, but because the people were better off for being ridden. That is their argument, and this argument of the Judge is the same old serpent that says you work and I eat, you toil and I will enjoy the fruits of it. Turn in whatever way you will, whether it come from the mouth of a King, an excuse for enslaving the people of this country, or from the mouth of men of one race as a reason for enslaving the men of another race, it is all the same old serpent, and I hold if that course of argumentation that is made for the purpose of convincing the public mind that we should not care about this, should be granted, it does not stop with the negro.

What Lincoln and Locke understood is that the most important of freedoms is to be free in one's own person as an individual, and that one should own one's own labour. To not be so, means to be a slave, to not be free. While there are certainly other conservative claims to be made about equality of outcomes being not desirable, the central and pivotal one is the right to property.

A Burkean view on the matter is encapsulated in Michel Houllebecq quote:

Children existed solely to inherit a man’s trade, his moral code and his property. This was taken for granted among the aristocracy, but merchants, craftsmen and peasants also bought into the idea, so it became the norm at every level of society. That’s all gone now: I work for someone else, I rent my apartment from someone else, there’s nothing for my son to inherit. I have no craft to teach him, I haven’t a clue what he might do when he’s older. By the time he grows up, the rules I lived by will have no value—he will live in another universe. If a man accepts the fact that everything must change, then he accepts that life is reduced to nothing more than the sum of his own experience; past and future generations mean nothing to him. That’s how we live now. For a man to bring a child into the world now is meaningless.

Other conservative claims include: 1) that property held in common is property unkept and unwisely leveraged; 2) that innovation is maximized only when individual outputs are felt and owned; 3) that creative obsolesence is a profound good of a vibrant society; 4) that reckless risk taking is minimized when the individual actor is concerned; 5) that guarantees of equal outcomes actually means a monolithic government that virtually guarantees poverty, misery and decay; 6) subsidizing poverty and sloth (which is basically the same thing as making things equal), just like anything else you subsidize, will result in more of the thing you are subsidizing; 7) capitalism actually rewards societal good; 8) it's a societal measure of evolutionary fitness in the individual.