For example, suppose I’m operating a noisy factory and there
are nearby residents who are bothered by the noise. Maybe it would cost me $10
million to shut down my factory, but only $1 million (total) for the residents
to sound-proof their homes, automobiles, and perhaps wear earplugs when they
are outdoors. For society as a whole to function well, we don’t want to destroy
$10 million in value when we can instead pay only $1 million. The noise-abatement
should be done by the residents. They are the least-cost avoiders. Even if a
judge rules that I am responsible for the liability, I can offer to pay the
cost of sound-proofing the local residences.
Or perhaps it’s reversed: maybe I can sound-proof my factory
for only $500k. I that case I am the least-cost avoider. Again, a judge could
get the ruling “wrong” and tell the residents that they have to just lump it. The
residents don’t have to sit there and take it, nor do they have to shell out
the $1 million. They can offer to pay me $500k if I’ll agree to install
sound-proofing. There are other solutions. Maybe the residents can simply move
away, or they can just deal with the noise. There are also potential problems. Maybe people
move close to noisy factories anticipating that they’ll have an opportunity to sue. We don't want to set up rules that encourage "lawsuit entrepreneurs." These are all things to consider when adjudicating externality problems,
whether it’s a judge or the affected parties negotiating with each other, or
perhaps a legislature setting rules and defaults. The point is you ultimately want the party who can solve
the problem at the lowest cost to be responsible for implementing its lowest-cost
solution.
Enter income inequality.
I’m not even sure what kind of social problem this is. It’s not really an “externality.”
There isn’t a harm done by one party to another. It’s just a structural feature
of society that some people find distasteful. A high-salary top executive is paid by an
employer who values that executive’s contribution more than the salary, otherwise
the employer wouldn’t hire that person. Both parties agree to the transaction,
so we can presume both parties benefit from it. Both parties are better off for
having each other. That is a net win for society. Third parties can take umbrage at these salaries for being "too high," but this is no more an externality than the moral revulsion and disgust felt by moralizing puritans (say, anti-gay or anti-pornography agitators). Sorry, but those very high incomes are easily justified by the underlying economics; they aren't some kind of mistake or "market failure" (a term that is increasingly used to mean "a feature of the world I don't like").
Nor are the low wages of low-earners "externalities" in any meaningful sense. Sure, we’d all love it if
everyone were more productive and could command a higher salary. But some
people simply don’t have the skills necessary to justify such a salary. Employers
offer, say, $8 an hour to flip burgers because placing someone in that position
adds at least $8 an hour to the company’s revenues. As much as we might bemoan
the low pay of these workers, they do willingly accept these jobs. It’s still a
win-win, even though it’s not quite as big a win as we’d hope (on either end of the transaction, BTW).
What we have here are voluntary pairwise transactions in which
both parties to the trade benefit. Nothing magical happens when you aggregate
them across the economy. Aggregating the distributional data and plotting it or
fitting a Pareto curve to it or calculating a Gini coefficient doesn’t conjure into existence a “problem” that
was not there in the original interactions. You could try to tell some story
about how the little guy is getting “screwed” by big, powerful players, but
this is usually a refusal to acknowledge the reality. Those low-wage and
low-salary workers have inherently low productivity. It’s not like their employers are making a
huge profit off their backs. (Who do you think loses their jobs first in an
economic downturn: low-wage workers or high-wage workers? Doesn’t the “low-wage
workers are underpaid” theory predict the opposite? Shouldn’t employer be loath
to let go workers on whom they’re reaping such a huge surplus? This stops being
a mystery if we acknowledge that there is no huge surplus and the low-paid
workers are probably being paid appropriately for their productivity.)
Forget all that for a second and let’s posit that “income
inequality” is some kind of externality. Who is the least-cost avoider? It’s surely not the high salary earners. Are they supposed to monitor the effort of
low-wage workers? Are they supposed to judge whether they are making a serious
enough attempt to acquire education and meaningful employment, and then to
perform adequately once on the job? Do high earners acquire a larger and larger
“monitor, judge, and redistribute” workload as they move up the distribution? The
“inequality” framing gets this wrong by trying to make high earners responsible
for the poverty of low earners. It’s not just that this indulges zero-sum
thinking (though that too is a pretty serious error); rather it’s that if
the low-wage workers perceive a problem with their income they usually have many
levers of control. There are many options for that person to increase their own income if the figure on their W-2 is too low. The individual income earner is the only person who can observe their own level of satisfaction/disappointment with their own salary. S/he's also the only person who can accurately judge the attractiveness of various options (as in "I could go back to school but it'd be so boring the wage premium isn't worth it" or "I could put in the extra effort at work, but meh I got a good enough thing going on right now.") The least-cost avoider is in most cases the low-wage worker.
He can say, “I’ll take another shot at acquiring education, and this time I’ll
take it seriously.” He can say, “I’ll show up to work on time and try to work
more effectively.” He can say, “I’ll choose a profession that offers more
upward mobility.” No other person can weigh the relative costs and benefits of these options for him (not without making heroic assumptions and generalizations).
Of course there are cases where these expectations on the
low earner are unreasonable. An abandoned (perhaps battered) wife with small
children probably needs external help. Or someone with a serious mental or
physical disability. It would be dense to say, “Why didn’t you choose the
medical profession?” to someone with, say, Downs Syndrome or a severe attention
deficit problem. But, at least in my observation, these are a minority of
cases. Many people in the “low earnings” group deliberately choose to remain
there and reject easy steps toward upward mobility. I observe many people who
were at some point in the same cohort as me: same high school, same college, same grad
school, started work at the same time with the same number of exams completed,
etc. Some of them lapped me because they were more ambitious, and I lapped many
of them because of my own ambition. It’s a mistake to summarize as “inequality”
the divergence of different people starting with the same level of opportunity.
And it’s a bigger mistake to place the burden of “fixing” the “mistake” on the
people who opted for higher earnings, as opposed to more leisure time or bigger
families.
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[Bad experiences have forced me to anticipate bad comments. I won't publish any comments along the lines of "Oh, so it's poor peoples' fault that they're poor!" If that's anyone's reaction, I'm afraid you misread the post and missed the point. My post is about income inequality, not poverty. Despite them being often confused or intentionally conflated, these are very different topics.]
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