Confusion on income and poverty

By Matt Nolan 27/09/2013


I have heard this sort of claim quite a bit from friends in recent months:

Doesn’t that sound grand – if the richest 100 people in the world gave up a quarter of their income then SLAM poverty gone.  Ez.

However, this isn’t quite right.  In fact it is very much not right.

Instead of thinking about quantities of paper money, we need to think about the underlying claim on real goods and services this presupposes – what exactly changes when we shift income this way.

Cut the income of the wealthiest and they will invest less and buy fewer nifty leisure goods (say boats).  Give this income to the poorest in the world (if that is possible, as in many of those cases people are stuck under a corrupt regime trying to extract anything) and they will demand food, water, and clothing.

And here is the little secret economists keep trying to make public, prices will change.  Without reference to a “set” of prices, income comparisons make no real sense. (Note:  For those who will note it, changes to labour supply would also occur in all of this, the wage is a “price”).

When I did the series on tax, especially here, I was trying to point out that if we try to do “large” changes to the structure of an economy, we are going to have much larger sets of unintended changes – many of the simulation and structural models economists use, even with all their complication, can often only sensibly discuss “small” changes in tax and benefit structure.  Trying to use a naive estimate (note this isn’t an insult, it is a technical term for modeling in the way suggested by the twitter quote) struggles even more with these changes in prices and the real values of incomes.

Many people who believe that we can take money off the rich to feed the poor simultaneously believe we are “stretching the limits” of the earth’s ability to produce food and other goods and services (such that the ‘costs’ of making more of these necessities will rise strongly if we aim to boost production significantly).  These two views implicitly contradict, and we can only understand and try to measure the true trade-off with an honest view of the change in prices!

Now don’t get me wrong, income transfers should still change the underlying production and claim on resources!  But how do they help?  By increasing the relative return (in terms of goods and services) for the thing the poor desire, and by decreasing the relative return for those who create boats and handbags and the such.

It is also a balancing act though – by trying to lower the income of those who do invest, we also reduce capital investment overall.  We change its composition and its level.  Furthermore, when we provide an endowment of income we change the incentive to supply labour.  This requires a view on societies underlying ability to produce, the underlying “production frontier” that exists, the way the “production frontier” moves, and the way relative prices and endowments will adjust as a result of these policies.  This is much more complicated – and also much more fundamental to actually understanding issues of inequality, opportunity, and capability – than what Max’s arithmetic example stated in the above tweet.

And I believe we have heard what this is before – it is the equity-efficiency trade-off from redistributing goods and services.  What do you know!

Note:  This is not a criticism of Max – it was just his post I spotted that helped bring up the issue.  I see this mistake happen CONSTANTLY, it can even be done inadvertently by economists I take incredibly seriously and find very insightful:

But it is still a relatively fundamental error.

Sidenote:  The World Bank discusses why their focus is on alleviating poverty rather than focusing on inequality when it comes to development economics here.

Update:  Dr Phil of Economics notes that, when it comes to global poverty, it is the messiness of institutions that is the most relevant issue – beyond what is described here:


0 Responses to “Confusion on income and poverty”

  • It is difficult to argue that the rich are not becoming richer, the poor are not becoming poorer. It is an unstable situation.

    From:http://www.populationmedia.org/2013/04/17/malthusian-darwinian-dynamics-and-the-trajectory-of-civilization/

    “Malthus, Darwin, and population dynamics: In 1798 Thomas Malthus laid out the concept of exponential population growth that became the foundation of demography and population biology. He noted that the ‘increase of population is necessarily limited by the means of subsistence.

    Population growth can thus continue only as long as environmental conditions remain favorable. As numbers
    increase, sooner or later environmental limits cause birth
    rates to decrease and/or death rates to increase, ultimately
    leading to an end to population growth. These concepts
    profoundly influenced Charles Darwin half a century later:
    because more offspring are born than can survive, only the
    fittest individuals reproduce and pass their superior traits on to their offspring.”

    It would be good to see how economics could handle the issue of population V resource of this meagre world. Capitalisim demands growth. It demands population growth. Somewhere down the line something has to give. Yes, the good ‘ol 70s book “Limits to Growth” seem to have been conveniently forgotten because (some) outcomes have failed to happen. But I suspect the premise of the book is still pretty true.

    Or will it just take a couple of good epidemics to “cure the problem” of this asymmetry of wealth? Will “Price” rule? Is this what economists are counting on?

    Should I worry for my offspring? Should you yours?

  • Ross, you have just mixed the inequality of incomes argument and the scarcity argument without reference to prices – just like I warned against in the post:

    “Many people who believe that we can take money off the rich to feed the poor simultaneously believe we are “stretching the limits” of the earth’s ability to produce food and other goods and services (such that the ‘costs’ of making more of these necessities will rise strongly if we aim to boost production significantly). These two views implicitly contradict, and we can only understand and try to measure the true trade-off with an honest view of the change in prices!”

    The post solely said that we can’t talk about significant movements in money income directly without accepting a “price response” – and when thinking about this price response we need to be aware of supply constraints. Either, we have little to fear about scarcity ramping up and the monetary transfers will work as mentioned in the tweets – or scarcity is a binding constraint with regards to food, and the tweet doesn’t hold at all (or some mix!).

    I offer no discussion of how prices will respond, as I do not have the data or an appropriate model (largely that models that offer sufficient heterogeneity between agents are not capable of dealing with price effects – especially for significant policy changes). As a result I can’t really answer your question about our children 🙂