Basic Economics

by Thomas Sowell

  In countries with high levels of corruption, the bribes necessary to get bureaucrats to permit the business to operate likewise have to be deducted from sales revenues and likewise reduce the value of the product and of the workers who produce it, even if these workers have the same output per hour as workers in more modern and less corrupt economies. In reality, Third World workers more typically have lower output per hour, and the higher costs of transportation and corruption which must be deducted from sales revenues can leave such workers earning a fraction of what workers earn for doing similar work in other countries.

  In short, productivity is not just a result solely of what the individual worker does but is a result of numerous other factors as well. To say that the demand for labor is based on the value of the worker’s productivity is not to say that pay is based on merit. Merit and productivity are two very different things, just as morality and causation are two different things.

  PAY DIFFERENCES

  Thus far the discussion has been about things affecting the demand for labor. What about supply? Employers seldom bid as much as they would if they had to, because there are other individuals willing and able to supply the same services for less.

  Wages and salaries serve the same economic function as other prices—that is, they guide the utilization of scarce resources which have alternative uses, so that each resource gets used where it is most valued. Yet because these scarce resources are human beings, we tend to look on wages and salaries differently from the way we look on prices paid for other inputs into the production process. Often we ask questions that are emotionally powerful, even if they are logically meaningless and wholly undefined. For example: Are the wages “fair”? Are the workers “exploited”? Is this “a living wage”?

  No one likes to see fellow human beings living in poverty and squalor, and many are prepared to do something about it, as shown by the vast billions of dollars that are donated to a wide range of charities every year, on top of the additional billions spent by governments in an attempt to better the condition of poor people. These socially important activities occur alongside an economy coordinated by prices, but the two things serve different purposes. Attempts to make prices, including the prices of people’s labor and talents, be something other than signals to guide resources to their most valued uses make those prices less effective for their basic purpose, on which the prosperity of the whole society depends. Ultimately, it is economic prosperity which makes it possible for billions of dollars to be devoted to helping the less fortunate.

  Income “Distribution”

  Nothing is more straightforward and easy to understand than the fact that some people earn more than others, for a variety of reasons. Some people are simply older than others, for example, and their additional years have given them opportunities to acquire more experience, skills, formal education and on-the-job-training—all of which allow them to do a given job more efficiently or to take on more complicated jobs that would be overwhelming for a beginner or for someone with only limited experience or training. It is hardly surprising that this leads to higher incomes. With the passing years, older individuals may also become more knowledgeable about job opportunities, while increasing numbers of other people become more aware of them and their individual abilities, leading to offers of new jobs or promotions where they are currently working. It is not uncommon for most of the people in the top 5 percent of income-earners to be 45 years old and up.

  These and other common sense reasons for income differences among individuals are often lost sight of in abstract discussions of the ambiguous term “income distribution.” Although people in the top income brackets and the bottom income brackets—“the rich” and “the poor,” as they are often called—may be discussed as if they were different classes of people, often they are in fact people at different stages of their lives. Three-quarters of those American workers who were in the bottom 20 percent in income in 1975 were also in the top 40 percent at some point over the next 16 years.{294}

  This is not surprising. After 16 years, people usually have had 16 years more work experience, perhaps including on-the-job training or formal education. Those in business or the professions have had 16 years in which to build up a clientele. It would be surprising if they were not able to earn more money as a result.

  None of this is unique to the United States. A study of eleven European countries found similar patterns.{295} One-half of the people in Greece and two-thirds of the people in Holland who were below the poverty line in a given year had risen above that line within two years. A study in Britain found similar patterns when following thousands of individuals over a five-year period. At the end of five years, nearly two-thirds of the individuals who were initially in the bottom 10 percent in income had risen out of that bracket.{296} Studies in New Zealand likewise showed significant rises of individuals out of the bottom 20 percent of income earners in just one year and of course larger numbers rising out of this bracket over a period of several years.{297}

  When some people are born, live, and die in poverty, while others are born, live, and die in luxury, that is a very different situation from one in which young people have not yet reached the income level of older people, such as their parents. But the kind of statistics often cited in the media, and even in academia, typically do not distinguish these very different situations. Moreover, those who publicize such statistics usually proceed as if they are talking about income differences between classes rather than differences between age brackets. But, while it is possible for people to stay in the same income bracket for life, though they seldom do, it is not equally possible for them to stay in the same age bracket for life.

  Because of the movement of people from one income bracket to another over the years, the degree of income inequality over a lifetime is not the same as the degree of income inequality in a given year. A study in New Zealand found that the degree of income inequality over a working lifetime there was less than the degree of inequality in any given year during those lifetimes.{298}

  Much discussion of “the rich” and “the poor”—or of the top and bottom 10 or 20 percent—fail to say just what kinds of incomes qualify to be in those categories. As of 2011, a household income of $101,583 was enough to put those who earned it in the top 20 percent of Americans. But a couple earning a little over $50,000 a year each are hardly “the rich.” Even to make the top 5 percent required a household income of just over $186,000{299}—that is, about $93,000 apiece for a working couple. That is a nice income, but rising to that level after working for decades at lower levels is hardly a sign of being rich.

  Describing people in certain income brackets as “rich” is false for a more fundamental reason: Income and wealth are different things. No matter how much income passes through your hands in a given year, your wealth depends on how much you have retained and accumulated over the years. If you receive a million dollars in a year and spend a million and a half, you are not getting rich. But many frugal people on modest incomes have been found, after their deaths, to have left surprisingly large amounts of wealth to their heirs.

  Even among the truly rich, there is turnover. When Forbes magazine ran its first list of the 400 richest Americans in 1982, that list included 14 Rockefellers, 28 du Ponts and 11 Hunts. Twenty years later, the list included 3 Rockefellers, one Hunt and no du Ponts.{300} Just over one-fifth of the people on the 1982 Forbes list of the wealthiest Americans inherited their wealth. By 2006, however, only two percent of the people on the list had inherited their wealth.{301}

  Although there is much talk about “income distribution,” most income is of course not distributed at all, in the sense in which newspapers or Social Security checks are distributed from some central place. Most income is distributed only in the figurative statistical sense in which there is a distribution of heights in a population—some people being 5 foot 4 inches tall, others 6 foot 2 inches, etc.—but none of these heights was sent out from some central location. Yet it
is all too common to read journalists and others discussing how “society” distributes its income, rather than saying in plain English that some people make more money than others.

  There is no collective decision by “society” as to how much each individual’s work is worth. In a market economy, those who get the direct benefit of an individual’s goods or services decide how much they are prepared to pay for what they receive. People who would prefer collective decision-making on such things can argue their case for that particular method of decision-making. But it is misleading to suggest that today “society” distributes its income with one set of results and should simply change to distributing its income with different results in the future.

  More is involved than a misleading metaphor. Often the very units in which income differences are discussed are as misleading as the metaphor. Family income or household income statistics can be especially misleading as compared to individual income statistics. An individual always means the same thing—one person—but the sizes of families and households differ substantially from one time period to another, from one racial or ethnic group to another, and from one income bracket to another.

  For example, a detailed analysis of U.S. Census data showed that there were 40 million people in the bottom 20 percent of households in 2002 but 69 million people in the top 20 percent of households.{302} Although the unwary might assume that these quintiles represent dividing the country into “five equal layers,” as two well-known economists have misstated it in a popular book,{303} there is nothing equal about those layers. They represent grossly different numbers of people.

  Not only do the numbers of people differ considerably between low-income households and high-income households, the proportions of people who work also differ by very substantial amounts between these households. In the year 2010, the top 20 percent of households contained 20.6 million heads of households who worked, compared to 7.5 million heads of households who worked in the bottom 20 percent of households. These striking disparities do not even take into account whether they are working full-time or part-time. When it comes to working full-time the year-round, even the top 5 percent of households contained more heads of households who worked full-time for 50 or more weeks than did the bottom 20 percent. That is, there were more heads of households in absolute numbers—4.3 million versus 2.2 million—working full-time and year-round in the top 5 percent of households compared to the bottom 20 percent.{304}

  At one time, back in the 1890s, people in the top 10 percent in income worked fewer hours than people in the bottom 10 percent, but that situation has long since reversed.{305} We are no longer talking about the idle rich versus the toiling poor. Today we are usually talking about those who work regularly and those who, in most cases, do not work regularly or at all. Under these conditions, the more that pay for work increases the more income inequality increases. Among the top 6 percent of income earners in a survey published in the Harvard Business Review, 62 percent worked more than 50 hours a week and 35 percent worked more than 60 hours a week.{306}

  The sizes of families and households have differed not only from one income bracket to another at a given time, but also have differed over time. These differences are not incidental. They radically change the implications of trends in “income distribution” statistics. For example, real income per American household rose only 6 percent over the entire period from 1969 to 1996, but real per capita income rose 51 percent over that same period.{307} The discrepancy is due to the fact that the average size of families and households was declining during those years, so that smaller households—including some with only one person—were now earning about the same as larger households had earned a generation earlier. Looking at a still longer period, from 1967 to 2007, real median household income rose by 30 percent over that span, but real per capita income rose by 100 percent over that same span.{308} Declining numbers of persons per household were the key to these differences.

  Rising prosperity contributed to the decline in household size. As early as 1966, the U.S. Bureau of the Census reported that the number of households was increasing faster than the number of people and concluded: “The main reason for the more rapid rate of household formation is the increased tendency, particularly among unrelated individuals, to maintain their own homes or apartments rather than live with relatives or move into existing households as roomers, lodgers, and so forth.”{309} Yet these consequences of rising prosperity generate household income statistics that are widely used to suggest that there has been no real economic progress.

  A Washington Post writer, for example, declared “the incomes of most American households have remained stubbornly flat over the past three decades.”{310} It might be more accurate to say that some writers have remained stubbornly blind to economic facts. When two working people in one household today earn the same total amount of money that three working people were earning in one household in the past, that is a 50 percent increase in income per person—even when household income remains the same.

  Despite some confused or misleading discussions of “the rich” and “the poor,” based on people’s transient positions in the income stream, genuinely rich and genuinely poor people do exist—people who are going to be living in luxury or in poverty all their lives—but they are much rarer than gross income statistics would suggest. Just as most American “poor” do not stay poor, so most rich Americans were not born rich. Four-fifths of American millionaires earned their fortunes within their own lifetimes, having inherited nothing.{311} Moreover, the genuinely rich are rare, like the genuinely poor.

  Even if we take a million dollars in net worth as our criterion for being rich, only about 3.5 percent of American households are at that level.{312} This is in fact a fairly modest level, given that net worth counts everything from household goods and clothing to the total amount of money in an individual’s pension fund. If we count as genuinely poor that 5 percent of the population which remains in the bottom 20 percent over a period of years, then the genuinely rich and the genuinely poor—put together—add up to less than 10 percent of the American population. Nevertheless, some political rhetoric might suggest that most people are either “haves” or “have nots.”

  Trends over Time

  If our concern is with the economic well-being of flesh-and-blood human beings, as distinguished from statistical comparisons between income brackets, then we need to look at real income per capita, because people do not live on percentage shares. They live on real income. Among those Americans who were in the bottom 20 percent in 1975, 98 percent had higher real incomes in 1991—and two-thirds had higher real incomes in 1991 than the average American had back in 1975, when they were in the bottom 20 percent.{313}

  Even when narrowly focusing on income brackets, the fact that the share of the bottom 20 percent of households declined from 4 percent of all income in 1985 to 3.5 percent in 2001 did not prevent the real income of the households in this bracket from rising by thousands of dollars in absolute terms,{314} quite aside from the movement of actual people out of the bottom 20 percent between the two years.

  Radically different trends are found when looking at statistics based on comparisons of top and bottom income brackets over time, rather than following individual income-earners over the same span of time. For example, it is a widely publicized fact that census data show the percentage of the national income going to those in the bottom 20 percent bracket has been declining over the years, while the percentage going to those in the top 20 percent has been rising—and the amount going to those in the top one percent has been rising especially sharply. This has led to the familiar refrain that “the rich are getting richer and the poor are getting poorer”—a notion that provides the media with the kind of dramatic and alarming news stories that sell newspapers and attract television audiences, as well as being ideologically satisfying to some and politically useful to others. The real question, however, is: Is it true?

  A diametrically opposite pi
cture is found when comparing what happens to specific individuals over time. Unfortunately, most statistics, including those from the U.S. Bureau of the Census, do not follow particular individuals over time, even though the illusion that they do may be fostered by data on income categories over time. Among the few studies which have actually followed individual Americans over time, one from the University of Michigan and another from the Internal Revenue Service, show patterns similar to each other but radically different from the often-cited patterns in data from the Census Bureau and other sources. The University of Michigan study followed the same individuals from 1975 through 1991 and the Internal Revenue Service study followed individuals through their income tax returns from 1996 through 2005.

  The University of Michigan study found that, among working Americans who were in the bottom 20 percent in income in 1975, approximately 95 percent had risen out of that bracket by 1991—including 29 percent who had reached the top quintile by 1991, compared to only 5 percent who still remained in the bottom quintile. The largest absolute amount of increase in income between 1975 and 1991 was among those people who were initially in the bottom quintile in 1975 and the least absolute increase in income was among those who were initially in the top quintile in 1975.{315}