The Second Welfare Theorem & Income Inequality

I stumbled over a great interview of the Institute of New Economic Thinking (2015) with Nobel laureate Joseph Stiglitz today, which has the bold title It’s Time to Get Radical on Inequality. The interview touches upon a range of issues related to income inequality but I want to focus on his answer to the question: To what extent has bad economic theory contributed to the rise of income inequality?

Stiglitz goes back to Econ101 for his answer and makes a great point on what some core economic ideas got wrong regarding income inequality. In particular, he emphasizes the Second Welfare Theorem. Stiglitz argues that the Economics profession took the Second Welfare Theorem literally to separate distribution from efficiency in the economy and leave the former for others to determine. While Economics focused on how to maximise the economic pie, the responsibility in deciding how to divide this pie was passed on to the political process.

I recall this concept from my Econ101 class together with the Edgeworth Box for the two consumer case. The Edgeworth Box highlights that – as long as the two people in the simplified economy are on the contract curve – it is an efficient outcome. That is what is most important. Thereafter, there is a role for others (government) to decide whether the initial efficient distribution is fair or whether wealth needs to be redistributed. However, the main goal is to achieve efficiency through efficient pricing mechanisms and competitive markets. The issue here, however, is that markets are “amoral” in a sense that the price mechanisms do maximize total welfare in the economy but they do not say anything about how prosperity ought to be divided among the population. The problem is that this would need to be a normative statement, based on the individuals’ perceptions what they regard as the ideal distribution of wealth in society. It could therefore not be descriptive, like the efficiency goal.

In addition to the fallacy to separate efficiency from distribution, there is a second bad economic idea, which contributed to the rise of income inequality; namely the myth of trickle-down economics. However, Stiglitz does point out that this is not backed by evidence and theory. Trickle-down economics is the conventional wisdom that a larger pie would necessarily benefit everyone in society opposed to that it could potentially benefit everyone. The key is that would and could are two very different concepts, but trickle-down economics takes economic growth as the guaranteed remedy for the poor.

How did (1) the decoupling of efficiency from wealth distribution and (2) trickle-down economics turn out? Stiglitz argues that both fallacies contributed to the rise of income inequality in the US. There is compelling evidence for surging inequality despite efficiency and economic growth. Median incomes and wages at the bottom of the income distribution have fallen over the past decades. Stiglitz points out that the economic system has failed to raise the standard of living for the larger share of the population.

A key lesson from this is that a mere focus on efficiency and output growth cannot cure income inequality; in fact the naivety in some parts of the Economics profession and conventional wisdom, that efficiency and GDP growth are sufficient conditions to raise living standards for everyone, both have contributed to the rise in income inequality to some extent.

That’s me for today! I hope this short post got you interested to read or hear more about income inequality and I really recommend you to catch up with the full interview on Youtube (approx. 18 minutes). I put the link to it at the end of the post!

Thanks for reading,

Jasse


New Economic Thinking (2015, 26 June). Joseph Stiglitz: It’s Time to Get Radical on Inequality . Retrieved from: https://www.youtube.com/watch?v=2NsTeeb-87w

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