Government Intervention and Inequality: Question 4

Worked solution

Part (a): Distinguishing income from wealth

Income is a flow concept, the amount of money a person or household receives over a given period of time, such as a week, month or year. An example is a worker’s salary of $2,500 per month.

Wealth is a stock concept, the total value of the assets a person or household owns at one particular point in time, built up (potentially) over a whole lifetime. An example is the value of a person’s house, savings and shares, say $180,000, measured today.

The key distinction is time period versus point in time: income is earned continuously, while wealth is a snapshot of what has been accumulated so far, and, importantly, wealth itself can generate further income (for example, interest on savings or rent on property).

Part (b): Two reasons for income and wealth inequality

1. Unequal ownership of factors of production and differences in human capital. People differ in their education, training, skills and natural ability, so they command different wages in the labour market. A highly trained specialist typically earns far more than an unskilled worker. In addition, some individuals own land, shares or a business, earning rent, dividends or profit on top of (or instead of) wage income, while others own no such assets and rely solely on labour income. Because these forms of income accrue only to the owners of scarce or productive factors, this naturally produces an unequal distribution of income and, over time, wealth.

2. Inheritance. Wealth (property, savings, a family business, valuable possessions) can be passed down from one generation to the next. Someone who inherits substantial assets starts from a position of far greater wealth than someone who inherits nothing, and this inherited wealth can itself generate additional income (such as rent or interest), compounding the initial advantage over time. Because inheritance depends on family circumstances rather than a person’s own effort or ability, it is a major source of inequality that can persist across generations.

Part (c): Discussing the effectiveness of a minimum wage

Case for effectiveness. A national minimum wage sets a legal floor under hourly pay, directly raising the income of the lowest-paid workers above what firms would otherwise choose to pay them. Since it targets exactly the bottom of the income distribution, it can narrow the gap between the lowest and average earners, and may also strengthen work incentives by making formal employment more attractive relative to unemployment benefits.

Limitations. If the minimum wage is set above the wage that would otherwise clear the labour market, firms may respond by employing fewer workers, cutting hours, or substituting machinery for labour, particularly for low-skilled jobs (this could leave some workers unemployed and worse off, which would increase, not reduce, inequality for that group. A minimum wage also only helps people who are already in formal employment; it does nothing for the unemployed, informal-sector workers, or those outside the labour force altogether. Most importantly, a minimum wage affects only the flow of wage income) it leaves the stock of wealth (inherited property, shares, savings) completely untouched, so it cannot address wealth inequality, one of the two dimensions of inequality identified in part (a).

Judgement. A minimum wage is likely to be a partially effective tool for reducing inequality in wage income among those who remain employed, but its overall effect on income inequality is uncertain if it causes job losses, and it has no direct effect at all on wealth inequality. Its effectiveness therefore depends heavily on how far above the market-clearing wage it is set, and it is likely to need to be combined with other policies from part (b) (such as transfer payments or progressive taxation of income, inheritance and capital) to make a substantial dent in a country’s overall Gini coefficient.

Final answers

• (a) Income $=$ a flow (e.g. a $2,500 monthly salary); wealth $=$ a stock (e.g. $180,000 of housing and savings).
• (b) (i) Unequal ownership of factors of production/human capital; (ii) inheritance of wealth across generations.
• (c) A minimum wage can reduce wage inequality among the employed but risks unemployment if set too high, and does not touch wealth inequality, so it is only partially effective on its own.