Markets Cause Inequality (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Free Markets & Capitalism Cause Inequality
Capitalism describes when factors of production such as capital are privately owned and workers are paid wages by the owners of the capital
Economies such as the United States and Singapore are classified as having some of the most capitalist economies in the world
A free market occurs when the price mechanism determines the allocation of resources without any government intervention
The free market can lead to unequal distribution of income and wealth
Income can be classified as;
Household income – income of individuals
Income can be acquired in the form of wages and salaries, rent, interest and profit
National income – income of the whole economy
How Capitalism can Cause Inequality
1. Inheritance
Income and wealth can be passed from one generation to another
If individuals and families have access to high levels of income and wealth, then they will have access to better quality goods/services such as education and healthcare
This can also create inequality of outcomes such as access to good schooling
2. Access to Capital
Wealthier individuals will be able to purchase factors of production such as land and capital to set up businesses
Business assets generate income in the form of profit and dividends
This allows these individuals to generate more wealth and income
A principle of capitalism is that individuals are motivated by the profit incentive
Using the Circular Flow to Explain the Reasons for the Inequality
The circular flow of income helps us understand how income is generated, distributed, and spent in an economy
Inequality in income arises from differences in earning capacity, ownership of productive assets, and the distribution of income sources
Understanding these dynamics can inform policy interventions aimed at addressing income inequality and promoting more equitable outcomes
The circular flow of income in an open economy
By analysing the circular flow of income, we can identify factors that contribute to income inequality
1. Households as earners and consumers
In the circular flow model, households are the primary source of labor and other factors of production
They provide labor to businesses in exchange for wages, salaries, interest and rent
Households also consume goods and services produced by businesses, thereby spending their income
Not all households have equal access to job opportunities or income-earning assets, leading to differences in their earning capacities
2. Businesses as employers and producers
Businesses employ the labor and other inputs provided by households to produce goods and services
In return, they pay wages, salaries, interest and rent to households
Businesses generate revenue from the sale of their products/services
Part of the profits are used to cover costs and the rest is profit
3. Income distribution
The income earned by households includes wages (and salaries), profits, interest, and rent
Income inequality arises from differences in the distribution of these sources of income
Higher-skilled jobs tend to command higher wages, leading to income disparities between different occupations
Ownership of capital assets (such as stocks, real estate, or businesses) can generate significant income for some households, while others may rely solely on wages
4. Saving, investment, and wealth accumulation
Households have the option to save a portion of their income
Households which are able to save can invest n various assets such as stocks, bonds, or real estate
Over time, the accumulation of wealth through investment can lead to further income inequality
Using the Circular Flow to Explain How Governments Reduce Income Inequality
The circular flow of income model can help us understand how governments can intervene to reduce income inequality within an economy
Specific policies and their effectiveness in reducing inequality can vary across countries and contexts
Governments need to consider a range of factors, including economic conditions, political considerations, and societal preferences when designing and implementing measures to address income inequality
The government is able to intervene in the circular flow in several ways so as to reduce income inequality
1. Redistribution through taxation
Governments can use progressive taxation policies to reduce income inequality
The additional tax revenue generated from the wealthy can be used to fund social welfare programs or invest in public goods and services that benefit lower-income groups
By redistributing income through taxation, governments can narrow the income gap between the rich and the poor
2. Minimum wage policies
Governments can establish minimum wage regulations
By ensuring that workers earn a certain minimum income level, fairer wages are paid and workers in some industries receive higher wages than they would have
This helps to reduce income inequality
3. Education and skills development
Governments can invest in education and skills development programs to enhance human capital and improve income opportunities for individuals from disadvantaged backgrounds
By ensuring equal access to quality education or vocational training, governments can equip individuals with the skills and knowledge necessary to secure higher-paying jobs
This will increase their earning potential
4. Labor market regulations
Governments can implement labor market regulations to protect workers' rights, promote fair employment practices, and reduce income disparities
These regulations may include laws on working conditions, overtime pay, anti-discrimination measures, and collective bargaining rights
This can help create a more level playing field for workers and reduce income inequality stemming from unchecked capitalism
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