How Much Inequality Is Needed to Support a Strong Economy?

And what bearing does the behavioral economics of social interaction have?

Posted Jul 14, 2012

Advocates of a free market economy often argue that “human nature as we know it” necessitates a close connection between effort and reward. Taking the argument to its limits, some assert that if we really wanted a more equal society, we’d have to pay for it by accepting a less productive one. The problem is compounded by the fact that since effort is largely unobservable, what we actually try tying rewards to —productivity—confounds differences in effort with differences in innate abilities and in skills that partly reflect advantages in access to schooling.We can try to reduce inequalities by designing policies that increase equality of schooling. But any tinkering with rewards themselves, whether with the multi-million dollar payouts of CEOs and financial wizards or with the minimum wages earned by hamburger flippers and floor moppers, will mean less bacon and tofu for everyone. That, at least, is the view from some quarters.

But the sharpness of the equity-efficiency trade-off is a strong bone of contention among economists. A forceful rejection of the view that we need something like the recently escalated levels of inequality to make our economy work has been laid out in Nobel laureate Joseph Stiglitz’s new book The Price of Inequality. Stiglitz held important positions both in the Clinton administration and at the World Bank, so he’s not your garden variety “lefty” and might be thought by the staunchest Occupiers to have sins of his own to atone for.Yet he marshals the evidence that high levels of inequality are both unnecessary and harmful to our economy and society with impressive intelligence and persuasiveness. Both over time and across countries, Stiglitz shows, societies marked by considerably more equal income distributions than what’s come to prevail in the U.S. in the most recent decades have enjoyed higher economic growth along with increased social harmony and higher well-being for low and middle income households. At least at levels such as those of the U.S. forty or fifty years ago, or those of many European economies today, greater equality is not the enemy of a prosperous economy. Moreover, much of the inequality we observe today isn’t attributable to market forces at all, but rather to the manipulation of the political process by those whose money gives them undue influence.

Some of the evidence that increasing equality can sometimes enhance rather than undercut efficiency comes from decision-making experiments of the sorts I’ve been discussing in recent postings. Consider the “efficiency wage” games pioneered by economists including the University of Zurich’s Ernst Fehr. In a series of experiments, they showed that subjects assigned the role of “worker” rewarded others dubbed “employers” with more “effort” (money tokens) when the employers offered better pay, even though the “workers” couldn’t be penalized, either directly or by loss of future work opportunities, for choosing lower effort. In-built human reciprocity seemed to underlie a win-win dynamic benefiting all participants relative to the outcome that would be predicted were the workers to act based on narrow self-interest alone. Questions can be raised about whether the behaviors of university student subjects extrapolate to real world situations, so experimentalists like Fehr also recruit non-students, including factory workers, truck drivers, executives, and even fishermen and herders in poor countries for whom the money at stake is far from trivial, to corroborate their results. Corresponding evidence of efficiency wage dynamics, whereby better treatment of workers induces higher productivity, has also been generated by field studies in real workplaces and companies.

Perceptions of fairness have importance in their own right. Both experiments and surveys show widespread support for reducing income differences and helping those who are poor due to circumstances beyond their control. Equally important is the fact that experimental subjects show much greater desire to redistribute earnings garnered by chance or opportunism than those associated with performance in tasks such as quizzes, games, and solving of math problems. Indeed, most strongly support the rewarding of achievement, at least within limits. The perceived bailing out by the government of those seen as responsible for the financial crisis of the past five years, and the government’s failure to prevent executives in bailed out companies from rewarding themselves handsomely, has cost the current administration heavily in terms of popular support.

The new behavioral economics of social interaction certainly doesn’t suggest that self-interest is absent in human nature. It merely indicates that self-interest takes many forms—including desires for recognition and self-respect—some of which can be effectively harnessed for the good of society as a whole. It also shows that self-interest co-exists, in normal individuals, with concerns for fairness and inclinations towards reciprocity.

Some evidence of self-interest might be found in today’s political marketplace, where wealthy individuals pour millions into think tanks and super-PACs in efforts to sway public opinion. Millionaires advocating for lower taxes may have come by their ideologies via dispassionate analysis, but it’s hard to rule out the possibility that self-interest is at work as well. Self-interest might also help to explain why a much larger fraction of the donations going to the party that defends progressive taxation than to its anti-tax opponent come from small donors.

At the end of the day, psychology and behavioral economics can't tell us how much inequality is good for society unless they're given a weighting function to determine how much to count the interests of those at each of the varying points in the social distribution of income, wealth, and skill. The principle of one person, one vote suggests giving each person's interests precisely equal weight, but as Stiglitz point out, it takes more than nominal one-person-one-vote rules to assure that such weighting applies in practics. People need to understand what their true interests are, something that might require a modicum of economic literacy. And they need to avoid becoming so disenchanted with a system that seems rigged against them that they relinquish their say by not bothering to participate in the political process.

More Posts