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The Sources of Inequality

Inequality takes many forms: racial, gender and political, to name a few examples. Among them, economic inequality—the unequal distribution of the national economic “pie” across different households—has gained a lot of attention in recent years. That is no doubt due in part to a wealth of new research on the topic that demonstrates that inequality has increased over the past generation. It is for this reason that the Federal Reserve Bank of Minneapolis has decided that its 27th annual essay contest will ask students: What are the most important influences on economic inequality in the United States?

Though other forms of inequality are important, this question is specific to economic inequality. And rather than debate the moral or political aspects of the question, we are asking students to think like economists about the causes of economic inequality. Indeed, students might well focus on other forms of inequality as determinants of economic inequality.

This primer is intended to get students thinking about the topic. It is far from the last word on the subject of economic inequality, but rather is a stepping-off point for students who want to write a good essay.

Inequality at distinct points in time

Economic inequality can be measured in two general ways. One is wealth inequality, or the differences among people in what they own. Another is income inequality—the differences among people in what they earn. This distinction can be important, but the two are closely related.

At first glance, the source of income differences (taking into account taxes paid to the government and transfer payments, such as Social Security income or food stamps, received from the government) may seem obvious. College graduates typically earn more than high school graduates because they have obtained a set of skills that are valued in the “market” for workers. Actually, there is no single market for workers but, rather, many markets—such as the market for doctors, plumbers, basketball players, restaurant workers or Ph.D. economists.

Economists have shown that the forces of supply and demand play a big role in determining the wages or income in each market. In particular, the availability of good jobs suitable to potential workers, the tax rate and the opportunity cost of working (in terms of lost leisure) help determine the supply of workers. And the demand for workers by firms is closely tied to the value of what they produce. The differences in these supply and demand factors within and between labor markets will lead to inequality in income.

Why, then, has inequality changed over time? Students might argue that there has been a growing gap between the productivities and skills of different kinds of workers and/or a change in how the market values these different productivities and skills. What might account for these changes?

A different argument, one that has been put forward by some economists who study inequality, would be to argue that the connection between earnings and productivity has changed or is not as straightforward as previously thought. Is it really the case that high-income workers are much more productive relative to low-income workers than they used to be, or have some other factors distorted the relationship between productivity and pay? What might those factors be?

Inequality over the very long run

Because low-income workers tend to consume a bigger share of their earnings than high-income earners, it is more difficult for them to accumulate wealth. The rich can also invest their wealth to earn substantial income that is not available to the poor, who have little wealth to invest. This has led some economists to study how differences in income and wealth might “snowball” over time.

Discussions of economic inequality therefore often deal with issues of economic mobility or intergenerational inequality. High-income parents can pass more wealth on to their children, and they also might pass on nonmonetary resources like human capital and social connections that give wealthy children advantages over their peers later in life. Do the rich (or their children) get richer, as the old cliché says, while the poor get poorer?

There are also important economic forces pushing against this concentration. Innovation and technological change are always producing new wealth, while at the same time making previously valuable assets outmoded—a process known as “creative destruction.” Gone are the wealthy traders shipping spices and other riches on the silk road, for example, and the wealthy steam engine manufacturers who replaced them are gone as well. History is also rife with stories of wealthy heirs who squandered their fortunes. Students may choose to focus on these sorts of dynamic issues in their essays.

The role of government

Government also plays an important role in income inequality. First and foremost, through taxation and provision of services, the government serves as a redistributor of wealth and income. That is why statistics on economic inequality that don’t include government taxes and transfers can be misleading. Students may focus on how the importance of government redistribution has changed over time.

Another basic role the government plays in addition to redistribution is in setting the “rules of the game.” Policies such as regulation, taxes and trade restrictions form the basic structure within which the economy functions. Changes in these policies may therefore change the way the market rewards different kinds of productive activities. Perhaps students can think of some examples that have important consequences for the distribution of income and wealth.

A wealth of possibilities

This is just a brief introduction to a very rich subject. Many other resources are available to draw upon (some of which we’ve included in our bibliography), and essays can take many other angles. Our judges will reward creativity in addition to hard work, persuasive writing and solid economic thinking. Good luck!

If you have any questions, contact Joe Mahon at or call 612-204-5254