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Inequality Isn't Poverty

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D espite an economic boom that appears to be unparalleled in U.S. history, the market that spawned the economic growth is under attack. Several studies, including a recent joint study by the Center on Budget and Policy Priorities and the Economic Policy Institute, strongly declare that inequality is on the rise. Though the results of these studies are hardly universally accepted, they have led to criticism of our recent economic prosperity and of market economies in general.

Though the issue of inequality is multifaceted, I intend to address two facets only. Some of the criticism of the market is based on a confusion of language and almost all of the criticism is based partly on a misunderstanding of an exchange economy.

The words poverty and inequality are so often linked that it might be thought that they are synonyms. They are not. Poverty means indigence. Inequality means disparity. There is surely an inequality or disparity between the wealthy and the middle class. This does not mean there is poverty or indigence.

In a recent article in the New York Times, Michael M. Weinstein describes poverty as a form of inequality. In the joint study I referred to above, in a section that explains why inequality is a problem, the authors state that "since the late 1970s, the incomes of the poor have actually fallen or stagnated in most states." The clear implication is that poverty increased because of increasing inequality, though the authors shy from making an unequivocal statement either confirming or denying this conclusion.

Though it may be that inequality is increasing, poverty is declining. The Census Bureau reports that from 1997 to 1998 poverty declined both as a percentage of the population and in absolute numbers. The poverty rate dropped to 12.7% from 13.3%, to 34.5 million people in poverty from 35.6 million; the number of poor people declined by more than 3%. The percentage of poor children declined to 18.9% from 19.9%, to 13.5 million children from 14.1 million; the number of poor children declined by more than 4.25%.

Since poverty and inequality can apparently move in opposite directions, a failure to clearly distinguish between the two may lead to serious policy errors. Attempts to alleviate inequality may have the unintended consequence of increasing poverty.

Besides the confusion of language, much of the criticism of market economies is based on a misunderstanding of an exchange economy.

In a number of articles, in both professional journals of economics and in popular publications, it is earnestly asserted that in market economies there are winners and losers. The winners are the rich and the losers are the poor. The rich get richer by taking from the poor.

According to Vernon M. Briggs Jr., in the June 1998 Journal of Economic Issues: "Indeed, the competitive principles inherent in capitalist economies mean, by virtual definition, that there will be 'winners' and 'losers.' " In a recent article in the New York Times, Richard Rorty declares that "the rich have been getting steadily richer and the poor poorer." Later in the same article he refers to our "increasing willingness to let the rich take more and more from the poor."

These conclusions are based on a fundamental misunderstanding of markets. In game theory, there are three broad categories of games: negative-sum games, zero-sum games and positive-sum games.

A negative-sum game is a game in which the winnings are less than the losings. An example would be a state-run lottery where the winners do not receive all the money paid in by the contestants. Some of it goes to the government. A government program to redistribute income is another example of a negative-sum game. The government takes money from some people to give to others but it does not dispense what it takes in. It keeps some money to pay its expenses.

There is a zero-sum game in which all of the winnings come from the losing players. Poker is an example. If I win, you lose. Many critics of a market economy view it as a game of poker, or a zero-sum game. The rich get richer only because the poor get poorer.

But the market is not a zero-sum game; it is a positive-sum game in which the winnings are larger than the losings.

Markets are positive-sum games based on voluntary trade. In a free market, no one will engage in an exchange unless he or she benefits from the exchange. Thus, if an exchange is consummated, at least prima facie, the exchange is mutually beneficial. If I win, you win too.

Great riches do not necessitate poverty. At least they do not do so in a market society.

Finally, some if not many of the critics of a market order (as well as some of its defenders) see wages, prices and profits as rewards for a past activity. Wages, prices or profits are seen as a reward for risk-taking, going to college or performing diligent work. This view of remunerations is an error, and perhaps a profound error.

Remunerations are not, at least not functionally, a reward for a past activity. Remunerations are a signal of what someone should be doing now or in the future. They are a communications system.

As some wages and prices go up, they indicate what people want. Thus, wages, prices and profits provide a signal of what one should do in the future to benefit others. However, these rising wages also provide an incentive for individuals to change their activities and provide the desired services because by doing so they will increase their income.

Once again, this is a description of a positive-sum game that hundreds of years ago Adam Smith described as the invisible hand. To paraphrase Smith, each person is led as if by an invisible hand to promote an end that is no part of his design. By engaging in self-serving activities, we actually benefit other people.

Wages are not rewards, they are signals. If they are treated as rewards, their function will undoubtedly be vitiated and the market order will be impaired. If remunerations are viewed as rewards, there will be an attempt to redistribute income to satisfy someone's sense of an appropriate reward for a past activity. Remember those debates over "comparable worth" and "incomes policy"?

Indeed, the authors of the joint study state: "The strong economic growth of recent years results from the contributions of people in all walks of life, from laborers to corporate executives. It is a problem when everyone does not share in the resulting prosperity." Thus, presumably, the authors of this study, or at least someone, will have to determine the relative shares due to each individual and distribute those shares as rewards for past contributions. If such an effort is successful, the market order will not survive.

Poverty, not inequality, is the problem. The surest way to minimize poverty, if not terminate it, is through a system of markets that increase wealth, even if these markets happen to generate wealth unequally.

It is preferable to be unequal in wealth than to be equal in poverty.

CALVIN M. HOY is associate professor of economics at County College of Morris in Randolph, New Jersey.