1.2 What do we mean by inequality?

Interest in economic inequality has been rising in recent years. Look at the chart below, which shows the Google keyword search trends around three terms: ‘income inequality’, ‘relative poverty’ and ‘the one percent’.

In discussing inequality as a social problem, we need to be very careful about what we are looking at. Firstly, we should distinguish between inequalities in income and wealth. A good definition of income can be found in the Dictionary section of the Investopedia website, as can one for wealth. The key distinction is that income is a flow of resources (usually money) to a person in a specified period of time, while wealth is a stock of those resources. Income, when not immediately used for spending, can be converted into wealth through saving or investing it. That wealth produces an income in the future – as interest payments, dividends, rents or capital gains if the asset purchased rises in value, and is then sold.

This course looks at income inequality. Specifically, it looks at the portion of income that comes from working in a job. These are called wages. Many people get the majority of their income from wages, but other sources of income exist. Some of those were mentioned above as returns on holding wealth, but there are others – people running their own businesses earn profits, while individuals can receive gifts or inheritances from relatives. When the proportion of income coming from wages changes compared to non-wage forms of income, we may get a different story about patterns of inequality – for example, if wages became less equal, but more people started owning portfolios of shares with largely similar returns, then income inequality may not increase by as much as wage inequality has.

In terms of comparing income over time, it is usual to take account of the fact that prices change. If all prices of all goods doubles, along with the wages of people involved in producing those goods, then nothing fundamentally has changed. If wages increase relative to prices, then something has changed – people will be able to buy more goods and services than before. Therefore, when looking at income, we want to adjust for changes in the level of prices, which is called price inflation. Read this note on the way statisticians try to do this in practice: Consumer Price Indices: A Brief Guide on the UK Office of National Statistics website.

A third issue is about what economists call the ‘unit of analysis’. The simplest thing we can do is to look at the individual and his wage, income or wealth. This would make sense for certain questions – for example, if we were to ask about what the labour market is doing and what people’s jobs and job opportunities looked like. However, we might also be interested in an individual’s standard of living. For a person who lived on their own, her income and living standards go pretty well together. However, if a second person moved into that household and shared that income, each person’s living standards would not be cut in half. Many costs of living do not increase in proportion to the number of people affected – for example, housing costs would be identical in this example, while things like heating, electricity and other bills probably wouldn’t double when there are two people under one roof. Read about the way the Office of National Statistics ‘equivalises’ household income to take account of the composition of that household in the Family Spending review on their website.

A final issue is about the role of government in determining income. Through taxation and financial transfers provided by a welfare state, there is a difference between the income a person is paid for working or investing, and what they have available to spend. Most tax and transfer systems are redistributive – individuals and households with very low incomes pay little tax and receive financial support, while high income households pay a much greater share in tax. When talking about income inequality, we should distinguish between pre-tax, post-tax, and post-tax and transfers. Again, the measure we focus on depends on the question being asked.