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Thursday, December 01, 2011

Kenneth Arrow: Economics and Inequality

I've written recently on several occasions about the mal-distribution of income over the last several decades, i.e. the fact that wages have lagged behind increases in labor productivity. Why has this happened? Kenneth Arrow explains how the fact that "the bulk of the gains from increased productivity went to a small group of upper-income recipients" is related to market failure in the finance industry, in particular the presence of asymmetric information (he also highlights additional explanations for rising inequality such as the "steady attack on the use of the tax system as a means of equalizing income"):

Economics and Inequality, by Kenneth Arrow , Boston Review: The specific problems of the current United States economy—the drastic increase in unemployment and sluggish increase in output—overlay a tendency of much longer duration, a drastic and rapid increase in the inequality of income. ... Profits from the finance sector, which historically have been about 10 percent of all profits, have risen to an extraordinary 40 percent. ...
The notion of a well-running market is applicable to manufactured goods; different items are produced to be alike and can be evaluated by consumers. But the products of ... finance ... are ... complex. The consumer cannot seriously evaluate them—a situation that economists call “asymmetric information.”
This casts light on the claim that the problem is one of personal ethics, of “greed.” After all, the search for improvement in technology, and consequently in the general standards of living, is motivated by greed. When the market system works properly, greed is tempered by competition. Hence, most of the gains from innovation and good service cannot be retained by the providers.
But in situations of asymmetric information, the forces of competition are weakened. The individual .. client of a financial firm does not have access to all the relevant information. Indeed, when the information is sufficiently complex, it may be impossible to provide adequate information.
In these circumstances, the concept of “greed” becomes more relevant. There arises an obligation to present the relevant information as fully as possible, an obligation that has been violated in the financial industry. ... A proper sense of responsibility has to be enforced by legislation... There has been some erosion in the law, for example under the Clinton administration, and in enforcement. The Dodd-Frank law is a step in the right direction, but the influence of the financial industry watered it down and created unnecessary complications.
It is, of course, not superfluous to argue that steepening the income tax progression, removing a number of blatant loopholes, such as the special treatment of capital gains, and reducing the exemption level for estates would add considerably to post-tax equality.

    Posted by on Thursday, December 1, 2011 at 12:33 AM in Economics, Income Distribution, Market Failure | Permalink  Comments (54)


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