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Sunday, May 13, 2007

Understanding inequality

There is a lot of concern that high GDP growth in recent years has been associated with higher inequality. Gary Becker and Kevin Murphy have a fascinating and different take on understanding higher income inequality. They say that the bulk of the phenomenon of recent increases in inequality are caused by bigger skill premia in the labour market. Also see this New York Times article by Tyler Cowen.

I'm faintly reminded of the argument by Montek Ahluwalia in the late 1990s on the subject of rising inequality between states of India. He pointed out that it was only after liberalisation that the opportunities became available for some better governed states to do better than the rest, so it's natural that in the early period of market-oriented policies, inequality should have gone up. The forces which reduce inequality - the `equalising differences' of the price system (see the comments on this post for more on `equalising differences'), and the feedback loop influencing governance through the political system - impact with a lag.


  1. This is absolutely true. Such lag has the following effects.
    There would be political pressures from the areas not so developed agains the policy measurs that enable better managed regions. (Crab syndrom) If the lagging regions have 'numbers' supporting, then it will be difficult to fight them.
    We need to find way to address this. What kind of sops would you suggest for this. ??

  2. I personally think that there is always going to be inequality of income in a market economy, in an ever increasing globalizing and liberalizing world. it is an inherent tendency of the price system to allocate scarce resources to the best possible use, this is valid for both the factor market and the product market.

    the one thing i would like to understand that how can there be The forces which reduce inequality - the `equalizing differences' of the price system.

    i haven't seen the data on inequality but i guess that most of the country with close to free market economy will have high inequality.

    so does government intervention in order to reduce inequality with fiscal measures would lead to lesser inequality.

    the two most important thing for reducing inequality is privatization of infrastructure development and investment in human resource development in rural india.

  3. Explaining `equalising differences'.

    The basic logic of capitalism is that firms try to minimise cost. This pushes firms to exploits gaps in factor prices. If labour is costly in New York but cheap in New Jersey, firms will tend to shift operations from New York to New Jersey. These decisions of firms will drive up the price of labour in New Jersey and drop the price of labour in New York, thus equalising the differences.

    When labour is cheap in India and costly in Germany, firms will tend to take production out of Germany and place it in India. When labour is cheap in Aurangabad but costly in Bombay, firms will tend to take production out of Bombay and place it in Aurangabad.

    The same story applies for other factors of production. If a production process is land intensive, it will tend to get taken out of venues where land is costly and placed where land is cheap.

    These ceaseless cost-minimising decisions of firms tend to equalise differences (whenever they surface).

    Equally important are factor movements. Labour tends to shift from low-wage locations to high-wage locations. Capital tends to migrate from low-return locations to high-return locations. Once again, the owner of the factor of production is only selfishly maximising for himself, but the result is equalising differences.

    Two responses can attack low wages in Madhya Pradesh: people moving out and factories moving in. The latter requires infrastructure and law & order. The former is assisted by education and by competitive product markets, which put pressure on firms to be meritocratic in recruitment.

  4. I strongly believe inequality growth between states are inevitable in India.We all know that some of the states are over-performing than rest,Example:Mumbai,Karnataka(Bangalore),Tamil nadu(Chennai)and few.But rest of the states are struggling to perform..So its hard avoid inequality economy between states...
    Breakdown Insurance

  5. With the modern IT ifnrastructure and risk managment tools will we be able to develop some risk managment tools to address this issue. SOmething more sophisticated Marshel Plan as suggested by Rober Shiller of Yale university in his book new financial order?


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