The assumption that each extra dollar provides the same increase in well-being at all levels of income makes no sense. Yet it is fundamental to economics.
Much of the discourse on inequality treats the distribution of income as separate, or at least separable, from its growth, often suggesting (implicitly or explicitly) a trade-off between the two. Growth is seen as a matter of efficiency, distribution as a separate (and generally secondary) issue of equity, which can be dealt with separately by add-on measures.
This is problematic on at least two levels. At the most basic level, growth and distribution are summary measures of the same set of variables (individual incomes). As incomes change over time, the average level changes; but, unless all incomes change by exactly the same percentage (which is clearly not the case), so does distribution. Moreover, policies designed to promote economic growth inevitably affect the incomes of different individuals in systematically different ways. Some gain more than the average, while others gain less, or may even lose in absolute terms. Since gains and losses typically depend on the nature of engagement in economic processes, which is itself closely related to initial income levels, an effect on distribution is inevitable. It thus makes no more sense to think that growth can be pursued without affecting distribution than it does to assume that distribution can be changed without affecting growth.
Second, the consideration of distribution only as a matter of equity, and not of efficiency, is erroneous. It is clear that an extra $100 of income has an immeasurably greater impact to a landless labourer living on less than a dollar a day (whose life and prospects could be permanently improved) than it is to a billionaire, to whom it would make no difference whatsoever. Thus the value of the additional income generated by economic growth, in terms of its effect on human well-being, is critically dependent on whether it accrues to someone on a high or a low income.
Thus, while distribution is certainly important to equity, it also has a major impact on efficiency – the efficiency with which a given level of aggregate income is translated into well-being. The scale of such efficiency effects is difficult to assess, depending on the nature of the relationship between income and well-being; but the sheer magnitude of global inequality (and the still greater inequality in the distribution of the proceeds of global growth) suggests that it is considerable, and could well be comparable to variations in productive efficiency.
Even setting aside equity considerations, and even to the extent that there is a trade-off between distribution and productive efficiency (which is itself questionable), it follows that consideration of any economic policy designed to increase productive efficiency must also take account of any off-setting effect on distributional efficiency – otherwise, its net effect could well be negative. Moreover, even if the net effect is an increase in overall efficiency, this would need to be set against any adverse effect on equity.
If we accept that the value of each dollar of income varies (inversely) according the total income of recipient, this clearly undermines the usefulness of national income as an indicator of economic performance, let alone as an objective of policy. However, its implications are much more far-reaching than this. It requires us very largely to rethink economics as it is generally used in policy.
For example, the standard economic response to externalities is the use of “market-based” policies, which ultimately rely on pricing mechanisms to change behaviour (particularly consumption patterns). The underlying rationale is that this is economically efficient: those who value their consumption most will continue to consume, while those who value their consumption less will be less willing to pay the additional cost, and will be priced out of the market. Overall consumption will thus be reduced by eliminating that consumption which is least valuable.
However, if we take account of the differential value of money according to who receives it, then the picture becomes very different. Suppose, hypothetically, that we were to decide to apply a price to the extraction of raw materials to discourage over-exploitation. Take the example of iron ore:
Consider two individuals, one a wealthy individual planning to buy a second Mercedes, the other a poor resident of an urban slum hoping to buy a corrugated iron roof for her home. If the price of iron ore is doubled, the price of the Mercedes will barely be affected, because it is such a small proportion of the total price; and even if the price rises a little, it is most unlikely that the purchase decision will be affected, because the price elasticity demand for prestigious cars is very low. (It is quite possible that it is negative, to the extent that higher prices add to the car’s status value – but that is a separate issue.) And even if the purchase decision is affected, the most likely effect is a switch to a cheaper product (e.g. a BMW) which may or may not have a lower iron content.
Our poor urban resident, on the other hand, will face a much greater increase in the price of her new roof, because the cost of iron ore represents a much greater proportion of its total cost. Moreover, her very limited means make it much more likely that she will be unable to afford it (or at least have to delay the purchase); and it is likely that this is already the cheapest available option, limiting the possibility of substitution.
Thus, far from pricing out the least valuable consumption, pricing mechanisms may systematically price out the consumption which would contribute the most to well-being.
In fact, this goes beyond the use of “market-based mechanisms” to the operation of markets themselves. As the opening chapter of Global Health Watch 3 (discussing the interplay of the financial, food, fuel, climate and development crises) points out in the context of the major rise in cereal prices after 2005:
“The amount of maize required to produce enough ethanol to drive one mile in an SUV in town is approximately the amount needed to feed someone for a day. It seems beyond question that having enough to eat for a day rather than nothing at all provides vastly more benefit than driving one more mile in an SUV. But the purchasing power of poor people who depend on maize as a staple is very limited, while that of SUV owners is much greater. Those whose need is greatest are priced out of the market as prices are forced up by the consumption of those whose use is most trivial”.
The assumption that each extra dollar provides the same increase in well-being at all levels of income is fundamental to economics; and yet this assumption appears wholly unfounded and counter-intuitive. In a relatively equal society, this might not matter very much. But in a world where 1.3 billion people below the $1.25-a-day line, with an average purchasing power of around $300 per person per year, must compete in an increasingly globalised market with 1,426 billionaires, with a combined net worth of more than $5,300,000,000,000, it matters very much indeed.
So, this assumption seems quite untenable in the contemporary world. But if we relax it, and think of the economy’s purpose as being to maximise overall well-being rather than simply to maximise total production, regardless of what is produced or who consumes it, then we are forced to rethink, not only certain economic policies and approaches, but the whole basis of economics as a discipline.
People’s Health Movement, Medact, Health Action International, Medico International and Third World Network (2011) Global Health Watch 3: an Alternative World Health Report. London: Zed Books, p. 35.
Forbes (2013) The Richest People on the Planet, 2013.
Photo credit main picture: World Bank Photo Collection