Topic 6.5 Notes – Inequality

1. Income Inequality vs Wealth Inequality

Let’s separate the two clearly, because students mix these up all the time.

Income inequality

Income is money earned per year:

• Wages and salaries
• Interest
• Rent
• Profit

It’s a flow variable. It’s measured over time, usually annually.

Income inequality means annual earnings are distributed unevenly across people. It’s influenced by:

• Labor market outcomes
• Education and skills
• Technology
• Tax policy

Income levels and poverty rates vary widely across age, gender, race, education level, and countries. For example:

• College graduates earn more than high school graduates.
• The U.S. has higher income inequality than Scandinavian countries like Sweden and Norway, which use more redistribution.

Wealth inequality

Wealth is assets you own:

• Homes
• Stocks and bonds
• Businesses
• Savings

It’s a stock variable. It accumulates over time.

Wealth inequality is usually greater than income inequality because:

• Wealth compounds through investment returns.
• Wealth is inherited.

Someone can have low income this year but still be wealthy because of assets.

The core idea

Markets distribute income based on productivity, not fairness. That’s the foundation for the rest of this topic.

2. The Lorenz Curve and Gini Coefficient

The Lorenz Curve

The Lorenz curve is a graph of income (or wealth) distribution.

Look at the graph below as you read through how it works.

Lorenz curve and equality line

How to read it:

• X-axis: cumulative share of the population (from lowest to highest incomes)
• Y-axis: cumulative share of income earned

The straight 45° line labeled “Equal Wealth” represents perfect equality.
Example: the bottom 40% earn 40% of income.

The bowed curves represent actual distributions.
The more the curve bows away from the equality line, the greater the inequality. In the image, the red curve shows more inequality than the orange curve because it is farther from the equality line.

The Gini Coefficient

The Gini coefficient turns the Lorenz curve into a number.

• 0 = perfect equality
• 1 = perfect inequality

Higher Gini → more inequality.

You might see:

• U.S. has a higher Gini than many European countries.
• Latin American countries historically have had very high Gini coefficients.
• After World War II and during the Great Depression era reforms, U.S. inequality fell due to stronger unions and progressive taxation.

You will not calculate it on the AP exam. You interpret it.
If the Gini increases, inequality increased. That’s it.

3. Why Markets Generate Inequality

This connects back to factor markets.

Factor payments and marginal productivity

Each factor of production is paid its:

$$\text{Value of Marginal Product (VMP)} = \text{Marginal Product} \times \text{Output Price}$$

Workers with higher productivity earn higher wages.
Capital that produces more output earns higher returns.

If productivity differs, income differs.

Major sources of inequality

• Human capital
  Education, training, experience. The “college wage premium” is a classic example.
• Social capital
  Networks and connections that lead to job or business opportunities.
• Inheritance
  Wealth passed down across generations increases concentration.
• Discrimination
  Labor market discrimination lowers wages for certain groups.
• Access to financial markets
  Wealthy households invest in stocks and real estate. Returns compound over time.
• Mobility
  Low economic mobility means children tend to stay in the same income group as their parents.
• Bargaining power
  Labor unions can raise wages.
  Monopsony power lets firms suppress wages.

These are all fair game in an FRQ asking you to explain why inequality exists.

4. Tax Structures and Redistribution

Markets create a before-tax distribution. Governments change it with taxes and transfer payments.

Types of taxes

Progressive taxes expanded during the New Deal and after WWII, which reduced inequality in the mid-20th century U.S.

Transfer payments

Transfer payments are government payments not tied to production:

• Welfare
• Unemployment benefits
• Social Security

They increase income for lower-income households and shift the Lorenz curve closer to equality.