Inequality, Part One: the greatest market failure?

  

Income inequality arises when different consumers have different incomes, and different people have different talents. It could also arise because of the source of income or the value of the talents. For instance, employees might have different incomes from each other because of different marginal labour products, different factor returns to their labour, or different elasticities of labour. People might have different skills for which there is a greater or lesser need and employers, or the purchasers of labour might have different demands.

Equally, entrepreneurs often take greater risks than others, and thereby expect and receive greater rewards than those who do not take risks. There might be different factor returns to capital or land, which result in various levels of profit, dividend, or rent, for those who do not live by the return to their labour value. A functional market would bring all these diverse groups together as suppliers and consumers and would match their combined effective demand with actual supply.

The existence of inequality also allows for innovation, adaptation, and growth on the part of companies. This innovation reflects the dynamic nature of markets. A market in which a few people or companies receive most of the income is not guaranteed to last. IBM fell from dominance. So will Google, Amazon, and Twitter, unless governments act to ‘protect’ the public which result in barriers to entry arising for any competitors.

The Kuznets curve, and the Lewis model of development, both suggest that people in poor countries might abandon land in agricultural areas or sell it, move to areas where their productivity is higher, and accept a temporarily lower standard of living so long as their productivity is rewarded by higher incomes which allow them to save. At some point, they will rise in income and wealth, and the gap between them and the previously very wealthy will close. Things change.

If the growth of the economy in such circumstances is export-led and accompanied by mild but consistent inflation, which lowers the fixed returns to those who own assets or land whilst empowering those who receive wages, workers will be rewarded according to their talents.

Even in the allocatively and productively efficient model of perfect competition, economists assume that companies wish to gain abnormal profit, raising the returns to their owners and allowing for a degree of differentiation in income and wealth. This is done by finding ways either to lower average cost and marginal cost in production, or to raise revenues through advertising, marketing, or the development of differentiated products.

In the long run, this is a good and dynamic thing, not a market failure, because the rewards which can be gained from the competition and innovation advance society towards more efficient allocation and production. Consumers get the benefit of more supply, at lower real prices given rising incomes. As societies become richer and savings and wealth advance, a functional financial centre can also provide credit and investment markets and products at a steady real rate of interest which can help people leverage their assets and ideas.

Problems arise when suppliers and the owners of capital and land are allowed to raise barriers to entry, or when markets are distorted by government policies or cartels. This can result in a situation in which oligopolies and monopolies arise. If these oligopolies and monopolies are allowed to develop monopsony power, they will capture the labour value of workers and will not reward effort. Instead, workers will be held to lower wages with a higher level of unemployment.

In such circumstances, innovation, and business growth outside of the oligopolies will be discouraged because there will be lower credit, lower savings, and less investment outside of the big companies. The companies themselves will integrate vertically and horizontally, leading to economies of scale which deliver greater and greater returns to fewer and fewer owners, whose sheer wealth and market power will be barriers to entry towards any small player.

Those on lower incomes will rely increasingly on giffen goods like rented property, which will be more in demand as property becomes more expensive. Real disposable income will be lower, as will growth, leading to a dependence on low welfare payments, low tax income, and limited governments dependent on borrowing. The market will come to be characterised by inferior goods for the majority, and luxury goods for the rich and foreign consumers of great wealth.

If such a situation arises, capitalism and the prosperity that comes from enterprise, saving, small business, property ownership, and innovation and competition will turn into a system of rent-seeking oligopolies and cartels owned by a few extraordinarily rich people or families. Such economies will lose their competitive edge, and increasingly will approach their terms of trade as a matter of tying low-wage labour to exports. This will lead to productivity gains and improved competitiveness, but at the cost of negative externalities like pollution, low saving, and higher domestic prices for normal goods.

In these circumstances, income inequality will reinforce a market failure. Like the idea of vice, one failure will lead to others. Cartels will become reinforcing, suffocating small companies, and buying up or copying those which manage to start up, preventing savings, allowing for the whims of the very rich to override sensible investment and improvement, and trapping everyone in a world of low returns, unaffordable prices, and low growth.

The appropriate solution is to raise taxes on unearned wealth and inheritance, and to raise marginal tax rates on the very wealthy. This should be accompanied by stable real interest rates and a policy of balancing the budget, either over the economic cycle or immediately, and low debt. Then, gradually, the economy will become prosperous, competitive, and entrepreneurial.

Unfortunately, governments have a tendency not to pursue such policies but instead to intervene in markets in ways which lead to distortion and new market and government failures. For instance, to cope with the unreasonable prices and monopolistic behaviour of natural monopolies such as railways or energy providers, governments might introduce ‘price caps,’ artificial market forces via franchises and RPI-K pricing formulas, and subsidy which distort markets, depress research and development, and which are open to regulatory capture.

Governments can suffer from decision failure where, for example, they identify a problem which is not static but dynamic, take time to develop a solution, then take more time to implement it. By the end of the process, the original problem might have disappeared and been replaced by another one. One justification for government policy to reduce income inequality, for instance, is the way that energy prices in a distorted market can become regressive and hurt vulnerable groups. Often, the ‘solution’ is not to deal with the inequality, but to further distort the energy prices (a feature of policy in agricultural markets too.)

When oil and gas were abundant and cheap in the global market, Britain had a surfeit of coal and nuclear power. So, ministers concentrated on removing the surplus in the name of efficiency and the environment, whilst guaranteeing cheap prices. This took several decades and resulted in a deficit of energy, a world of predictably high power prices, structural unemployment, and a reliance on ‘green growth’ which was something of a delusion. The energy system was also ‘capped’ in ways that discouraged the development of storage systems and encouraged rent-seeking companies to buy up cheap international energy to sell at a profit, which was presented as ‘enterprise’ and encouraged until the rent-seeking companies went bankrupt, and the energy market became a cartel distorted by government subsidies and rules. Pensioners and the poor were colder and more vulnerable, nor warmer and safer at the end of the process.

Similarly, energy companies were forced to charge in such a way that returns to ‘green’ energy suppliers were great whilst those to fossil-fuel sources were small and non-existent to nuclear providers. This was achieved by a marginal pricing formula for energy which added expensive green power to cheap gas and nuclear costs. When gas and nuclear rose, ‘green’ power was still soaking up this subsidy, but was not able to provide an energy uplift, transmission of power across distances, or storage of power. All these measures were tied to the need to ensure cheap power because of income inequality in a distorted market of financialised products, high house prices fuelled by lending, and waste. Governments chose the wrong policies.

Policies focussed on allowing only a small but widely rewarding amount of inequality, steady real interest rates, high marginal taxation on unearned capital gains, steady tax income rather than the encouragement of tax avoidance, and lower taxes for the majority with higher and steadier taxes on the wealth and income of the very rich, would have been much better. Public-private ownership of nationalised natural monopolies which allowed for some private returns on the provision of public and merit goods, maintaining security and low prices, would have been better than false ‘markets’ based on franchises and over-complex regulation which needed and encouraged high prices to create a return for shareholders. Pensions and financial regulation which encouraged saving, and which subsidised health insurance rather than a vast monopoly NHS employing over a million people at low wages and rent-seeking GP franchises would have tackled income inequality and low savings in every town and city.

Income inequality is not therefore a necessary market failure. It might be useful, in a balanced and moderate amount, to markets and society. Government intervention is not necessarily a solution if the policies employed are stupid and destructive, or uninformed by economic logic. Very often, the wrong policies to tackle income inequality would make income inequality and problems of access to normal goods and energy a consequence of government failure. The regulation of companies is also prone to regulatory capture and government’s demonstrated comfort with bigger rather than smaller companies (a failure noticed by public choice theory.)

Income inequality in lesser amounts is tolerable, and a good thing. It is better than other market failures such as pollution, the over-provision and under-pricing of demerit goods, and distorted market structures. Equally, larger, and more destructive income inequality can be part of a parcel of government failures created by poor or lagged government decisions, moral hazard (for instance in the case of reckless bank lending where states guarantee banks) and externalities created by government choice and public choice theory.