Economic Theories On Inequality

Several theories deal with this subject, often providing a nuanced view on the social and economic ills of nations.  We begin the Classical theory, the school of thought that emerged in the 18th century, pioneered by social philosophers like Adam Smith and David Ricardo.  This fledgling account of poverty can help us move forward with more complex, detailed theories that naturally followed.

The Neoclassical school, led by Alfred Marshall provided an innovative framework that gave plausible explanations as to the existence of poverty in society.  Unlike the one-dimensional approach prized by Classical theorists, the neoclassical viewpoint provided a more scientific argument.

Afterwards, we shall deal with the Monetarist views and the Keynesian views about the subject matter.  The de rigueur consensus favours the latter quite a bit.  We shall see why.

We will also briefly review the Marxian stance on inequality, since communism is still a contentious school of thought.

Classical View

In the 18th and 19th centuries, Classical economists like Adam Smith and David Ricardo pioneered social theory frameworks to help us understand the flow of economic activity and its corollaries.  As such, inequality (in terms of poverty) figured in their analysis.  The theories focused on ‘value’ and ‘distribution’.  As Classical theorists opined that the value of a product depended exclusively on its costs, distribution was explained through that distinction,

Classical theorists theorized that landlords were remunerated with rent money, workers got their wages and capitalist farmers earned profits on their investment.  Thus began the framework that would include poverty as well.  No consideration was paid to the driving forces behind the distribution of the income going to each party.

According to them, the outcomes of the exchanges taking place were efficient and needn’t be explained, wages reflected individual productivity and wouldn’t reflect inequality, but rather lack of productivity.  As such, poverty was seen as a direct repercussion of poor individual choices and laziness, that affected productivity, and not the other way around.  Another reason put forth was that individual genetic abilities also affected productivity, but the conversation wasn’t really centered around ways to mitigate it in society.

Individuals’ wrong choices accounted for the ‘poverty trap’.  Aside from a consensus on minimum levels of government effort to prevent homelessness, state intervention wasn’t particularly favoured by Classical theorists as they thought it would lead to a dependence on welfare and that would lead to economic inefficiency, among other things.

The government was at most justified in intervening on behalf of the poor to remedy counter-productive economic incentives.  A lot of the policy requirements following this view focus on efforts to raise productivity in order to get to that efficient level of production, instead of really focusing on the causes of inequality.

This school of thought is still popular in the United States among the Republican Party, where prominent leaders often deride ‘welfare programs’ for incentivizing laziness.

Neoclassical View

Much of the literature stemming from the Neoclassical school has been attributed to Alfred Marshall, the researcher behind the ‘demand-supply’ framework.  The Neoclassical theory was built upon the foundations of Classical theory and it stresses the role of a difference in initial endowments as the cause of inequality.  Market failures such as externalities, external costs, moral hazards and adverse selection were also pinpointed for worsening inequality.

The Neoclassical school views inequalities in the distribution of income as differences occurring in value added by labour, land and capital.  When it comes to labour, income inequality is due to the differences in value added by different classifications of workers.  Through this theory, wages and profits are determined by the marginal value added of each economic actor (worker, entrepreneur, property owner).  Therefore, in a market economy, inequality shows the productivity gap that arises when highly paid professions are pitted against lower paid ones.

Much like Classical theorists, Neoclassical thinkers are often sceptical about the role the government should play in alleviating poverty but sometimes policies are advocated when dealing with market failure, in particular.

Although according to Pareto-efficient allocation theory, redistributive policies could very well be efficiency-neutral, when geared toward the eradication of inequality, Neoclassical thinkers do not endorse this idea.

Similar to Classical theory-based ideologies, Republican lawmakers are often impervious to the effectiveness of redistributive policies and in most cases, seek to decrease budgetary contributions to combat poverty and destituteness.

A neoclassical theory of poverty and social exclusion that’s been increasingly cited is the ‘incidence of asset scarcity.’  The underlying assumption is that households that own an adequate level of assets are less affected by fluctuations in their incomes since their asset holdings can be changed on short notice.  Ergo, they don’t have the same risk of poverty that asset-deficient households do.  They can face income shocks with stolidity.

Following this view, Ulimwengu (2008) posits that the lack of income diversification that results from having exiguous assets, in turn determines the probability of falling into poverty and the duration of poverty stints.  This is exacerbated even more so when a principal employment isn’t secure and a household’s internal environment is very unstable (a common trait among poor households).

Ulimwengu further opines that it isn’t just poor people’s inability to gather private assets but also social assets, such as, health and education, that leads to increasing levels of poverty and hence its persistence.

Incidentally, a household’s stock of wealth might also play a significant hand in the causation and prevalence of poverty for the simple reason that those assets are transferrable across generations; therefore, there’s a reduced social mobility when it comes to poor households.

To reduce asset poverty, the development of the ‘Individual Development Accounts’ put forth by the US would lead to matched savings accounts available to the poor (Johnson and Macon, 2012).  The poor would also benefit from hordes of services that banking might offer, such as, low energy prices, inter alia.

Furthermore, life insurance and pension schemes for the elderly, an especially vulnerable group when it comes to poverty, are very important (De Freitas et al, 2009).  Appropriate legislation would favour long-term accumulation of life insurance and pension stocks and this will have the beneficial impact of reducing poverty among retirees.  The lack of life insurance is a hallmark of poor retired households.  In that case, saving for the future should be advertised in the form of policy suggestions.

A general subsection of neoclassical theory is the Human Capital Theory that is based on the interactions of perfect competition and productivity.  The demand side of the labour market is ascertained to be determined by a number of characteristics or skills workers are endowed with.  Those skill sets and the importance assigned to them in that context led to the initiation and promulgation of Human Capital Theory (Becker, 1964).

One category of neoclassical economics therefore focuses much on the individual choice with regards to academic education, vocational education and general mobility, as the determinants of Human capital to expatiate on the differences and variegations in incomes.  Other factors like economic institutions and social norms are omitted from that theory.

Lydall (1968) posited that personal intelligence, environment and education formed the basis for almost all differences in the distribution of personal earnings.  This theory is however not applicable to other social poverty issues, including gender-based poverty or race-based poverty.

Machin (2009) observed that poor households in various countries tended to ‘under-invest’ in education.

Policy implications arising from the Human Capital view usually have to content with the fact that individuals’ incomes will not automatically equalize due to genetic differences in ability and skill sets.  Therefore, increased funding for education should be set aside for the poor so they can improve in terms of ability and therefore earning potential.

For those whose skills face a low demand, adult re-education should be emphasized (Scott et al, 2000).

In light of those recommendations, most authors concur that investing in one’s own human capital is quite a financial and emotional burden which can be too high for certain individuals, as they would have to leave their stable low-paying jobs and break social relationships in order to acquire those highly demanded skills.

Conversely, not investing in the re-acquirement of skills would further perpetuate the low paying conundrum and therefore poverty, contributing to a vicious cycle (Pemberton et al, 2013).  The equalization of skills among the population would only come about if an equitable redistribution of education would also target the poor.

Monetary View

The monetary view closely resembles the neoclassical tenets on inequality and is mainly explained in terms of ‘utility maximizing behaviour’; ergo welfare can be measured by consumption.

Income and consumption are simultaneously evaluated to determine the pattern of poverty, contrary to the neoclassical approach that states marginal productivity as the cause of poverty.

The main assumption according to this theory is that uniform monetary metrics can successfully capture all the relevant heterogeneous factors across individuals and their situations. Bhalla (2002) argues that income should be the primary consideration in the eradication of poverty as it enables the poor to gain purchasing power, gives them access to resources that would’ve been otherwise unavailable to them (therefore addressing the problem of resource inequality) and it enables the poor to purchase or receive free public goods. In their money-based measures, they also use different methods to input the value of non-marketed goods and services. (Laderchi et al., 2003).

Monetary measurements of poverty basically boil down to the measurement of total consumption, whence welfare can be quantified.  These measurements are estimated from income data or expenditure and poverty is then calculated as the baseline of resources that individuals are failing to meet.

A ‘minimum rights approach’ came about from the seminal work of Rowntree (2011), which likewise, took income as the main determinant of poverty (minimum level of resources individuals should be entitled to).  Rowntree figured out the poverty line by calculating the required nutritional needs of individuals, as well as their requirements of other basic human needs, such as clothing and shelter- in that case-rent.  Those falling below that line were considered to be in ‘primary’ poverty, those whose living conditions weren’t up to par fell into ‘secondary’ poverty according to the framework proposed by Rowntree.

Critiques of that framework include the subjectivity espoused by the researcher, as he didn’t include first-hand experiences of those living in poverty.  Rowntree was also criticized for his own biased, individualistic take on the problem.  Those issues were mainly targeted at Rowntree’s version of a monetary view, not the monetary ideology itself.

The Monetary approach has been pilloried quite a few times.  The relevancy of the approach is based on a number of ‘ab initio’ unknown assumptions, such as whether utility as used in consumption can be reliably defined as a metric of wellbeing.  Also, a money expenditure is ambiguously stated as being able to capture the level of consumption and lastly whether a shortage of resources is tantamount to poverty (Laderchi et al, 2008).

Another criticism states that assets, including income are key to poverty and that there’s a plethora of factors not included in current income, namely; savings, debt, consumer durables, rent, sundry expenses, inter alia.

The spread of the mean income is considerable.  This is dependent upon the diversification of income sources and any hindrance to invest in human capital and the likes.  The poor are more affected by shocks such as childbirth, divorce, sickness and recession.

There arises a need to measure poverty in an intertemporal framework to differentiate between transitory poverty and abject long-term poverty (Ulimwengu, 2008).

The glaring omission of the flow of services arising from social goods and services generally means that policy prescriptions are biased in view of favouring private income and against the provision of public goods.  This is synonymous with Dollar and Kray’s (2004) view that ‘’growth is good for the poor.’’

Generally the Monetary approach presupposes that poverty is an individual rather than a societal occurrence.  Under this approach, nutritional requirements undergird the poverty line.  However, this too varies in terms of metabolism, activities, size, gender, age; which in turn suggests that this unitary measure mirroring as the poverty line isn’t reliable.

Parallel to that view, differing tastes and prices really affect how much income is needed to allow for the necessary nutrition in different cases.

Insofar as this theory focuses on the individual, it fails to recognize that only household data can be used in the calculation, which goes to prove that distribution may be highly uneven between men and women, children and adults and so forth.

The whole premise of this theory relies on external extrapolation, without first-hand testimonies from the poor themselves.  Those are a few drawbacks and issues with the Monetary Approach.

In short, the Monetary Approach deals with poverty as a direct link between consumption and current income, supposing that individuals are identical in terms of needs and preferences and it doesn’t take into account important aspects in the community (social goods).  It is an individualistic view.

The policy requirement stemming from the Monetary View suggests the need to target a higher GDP so as to increase wages and employment for the poor.

Keynesian/Liberal View

The main approach of this theory is to hold both macroeconomic and microeconomic factors that thrust people into poverty, accountable.  This can be done at the governmental level, through policymaking and examples of such policies include; providing a decent minimum wage to workers, relieving unemployment by creating jobs, promoting economic growth, inter alia.

The Liberal pioneer was none other than John Maynard Keynes himself and he believed that market forces would promote economic development and it could be the single most important tool in the fight against poverty.  He borrows a little bit from the neoclassical view in that it’s the same logical process whereby economic growth is perceived as the most cogent tool to eradicate poverty.

Keynes was very much influenced by Alfred Marshall’s work, who is known as the father of neoclassical economics, which maybe explains their similar rhetorical ‘point of departure’ in explaining poverty.

As opposed to neoclassical theory, a much greater focus is placed on the macro side rather than the micro view favoured by the latter theory.  Keynes understood the fundamental importance of education but didn’t embrace a ‘human capital-based’ individualistic theory but rather, he embraced a notion of human capital development through increased funding in public education.  Thus, government’s role in alleviating poverty is quite crucial.  Keynes posited that government intervention in various economic affairs (ranging from tackling unemployment to promoting education) would lead to economic growth through multiplier effects.  This is diametrically opposed to the classical and neoclassical view that government’s role ought to be restricted.

Public investment is more effective when funnelled in certain sectors, for the purpose of boosting economic growth and tackling poverty, as its multiplier effects act the strongest.  These sectors are namely infrastructure and education.  More funding in those areas would help alleviate poverty by generating value-added.

If a developing economy succeeds in stimulating job growth and hence reducing poverty, it’s a very consequential way of doing so without raising taxes and hence, with lowered demands for welfare (Jefferson, 2012).

Growth sure does help in reducing absolute poverty but for the annihilation of relative poverty, the variance in the income distribution shouldn’t be too high as to offset the change in the average income level (Granville and Mallick, 2010).

The increase in wages that follows growth in GDP can cause relative poverty to rise if wage dispersion rises alongside that wage increase.  Thus, its nebulous effect on absolute poverty can actually lead to a ‘growth wagon’; a theory that supposes that poverty might still persist despite GDP growth (Dickens and Ellwood, 2001).

The Liberal view contends that poverty is simply described as a misfortune of certain people who lose their jobs, cannot work or aren’t expecting to, although they want to.  Following this view, the state ought to regulate and remedy this situation (Townsend, 1979).

This theory ratiocinates that poverty is simply a reflection of market failures and could be solved through redistributive forms of taxation. Therefore, investment is the key variable that would generate growth and eradicate poverty.  Government should raise revenue and channel it towards public investment; also known as ‘socialization of investment’, a term coined by Keynes himself (Jung and Smith, 2007).

Sachs (2005) identified the main signs of poverty in a country or region and those include; poor levels of health, skills and education, low investment in machinery and buildings, subpar infrastructure, poor enforcement of the rule of law and exiguous technological knowhow.

Although these signs are more appropriate for developing countries, the patterns hold true in regions and localities of some developed countries as well.  This theory emphasizes the provision of capital goods (education) to increase human capital and infrastructure to help the poor out of poverty.  The development of markets is also crucial to that view.

This approach has been termed ‘innovative’ as it is quite lapidary in designing protocols to curb poverty.  Economies are complex systems where failures in one area can lead to failures in other areas (Davis, 2007).

There is a number of factors to consider such as; the prevalence of a poverty trap, economic policies put in place, the fiscal health, geographical attributes, government patterns, geopolitical stability, among other things.  Poverty in any given country would be heavily dependent on the aforementioned factors, as well as corruption which is inimical to the good functioning of markets.  In other cases, it might be geographical isolation that is the cause of economic gridlocks; import of basic goods might be forbidden and as such individuals fail to keep an adequate standard of living.

Detractors of Sachs’ approach argue that the efforts to get the poor out of poverty by means of massive aid was in vogue back in the 1950s but showed little evidence to have worked (Davis, 2007).  Black markets might emerge due to capital goods being redistributed.  Likewise, welfare abuse would have to be closely monitored (Lal, 1995).

The capital goods mentioned can also be termed as public goods, as defined by Samuelson (1955); a product that one individual can consume whilst not reducing its availability to another individual and it’s non-excludable and non-rivalrous.  Examples of such goods are the rule of law and security in a country.  This distinction made by the liberal theory demonstrates that it’s partly similar to Sen’s ‘capability approach’.  The underlying idea is that it is the adequacy of resources rather than their sufficiency that matters for ‘desire fulfilment’ (Laderchi et al, 2003) and therefore both externalities and public goods matter when it comes to poverty being understood in the context of the ‘capability approach’.

Growth must be sustainable for it to eradicate poverty and it would be more so if a rise in demand is accompanied by a concomitant rise in aggregate supply of factors like labour and capital.  It’s been noted that often demand rises ahead of supply, which culminates into unsustainable booms followed by economic crises, in a pattern accompanying financial liberalisation.  Cline (2002) noted that the effect of financial crises affect the poor in a more disproportionate manner, whereby 5% decline in GDP would be accompanied by a 10% rise in the poverty rate in the same year.

Financial liberalisation could also bolster poverty, if poorly implemented (Arestis, Caner et Arsena, 2004).  Conversely Dollar and Kraay (2002) conjectured that there is a one-to-one relationship between income of the bottom fifth of the income distribution and per capita GDP.  As opposed to Cline (2002), they found no evidence that economic crises affect the poor more disproportionately.

Therefore, this view gauges all these macroeconomic factors and their relevance concerning poverty and only then can we devise poverty curbing agendas to help in its elimination.  Even in developed countries, at the regional level, the same arguments apply.

Marxist View

The Marxist view blames unfettered capitalism and related social and political factors based on class stratification as the cause of poverty.  Those who subscribe to this view believe that ‘markets are inherently dysfunctional’ (Blank, 2010).

Marx believed that the presence of unemployed workers in an economy is caused by the need of capitalists to have surplus workers, which then leads to lower wages.  He believed that this was an innate dysfunction of the labour market which ought to be regulated by the state.

One of the most important elements of Marxist theory is that the primary goal of this state regulation is to improve the working conditions of labourers and vie for higher wages among themselves (Blank, 2010).

The Marxist school attributes rising inequality to automation and increased dependence on capital goods within the free-market framework.  The process of job automation is at odds with the capitalist property form and its attendant system of wage labour.

According to Marxist analysis, capitalist firms usually substitute capital equipment for labour input (workers) when they’re under competitive pressure to cut costs and maximize profits.  In the long-run, this trend leads to the increase in the organic composition of capital which means that less and less workers are needed with respect to the capital inputs, leading to rising unemployment.  Following this process, there’s a downward pressure on wages.  This mechanization and automation at the expense of labour input leads to a rise in the productivity of each worker, resulting in a situation of relatively sticky wages for the working class and rising levels of property income for the capitalist class.  Therefore, inequality rises.

Capitalist societies keep the cost of labour unnaturally lower than its value-added, under the threat of unemployment and thus poverty in a capitalist environment can only be alleviated through minimum wage prescriptions and the likes.

Other authors believe that poverty is the result of structural factor, including stratification in the labour markets, prejudice and corruption.  Policies that would constrain those behaviours include anti-discrimination laws and labour market reforms.