Unit 5 The rules of the game: Who gets what and why

5.11 The distribution of income: Endowments, technology, and institutions

We have modelled a simple two-person interaction to introduce the main ideas about how the institutional arrangements, or rules of the game, affect the distribution of income. In this section, we provide a general framework that helps explain why different individuals receive different incomes in broader contexts.

Income and endowments

A person’s endowments are the things they have that enable them to receive income. They include physical wealth (for example: land, housing, machinery); financial wealth (for example: savings, stocks/shares, bonds); intellectual property (for example: patents, copyrights); knowledge, skills, abilities, and experience that affect labour income; citizenship and rights to work. They can include characteristics such as nationality, gender, race, and social class, if these affect their income.
human capital
The stock of knowledge, skills, behavioural attributes, and personal characteristics that determine the labour productivity or labour earnings of an individual. Investment in human capital, through education, training, and socialization can increase the stock. Human capital is part of an individual’s endowment. See also: endowment.

An individual’s income depends on things that allow them to receive income. These endowments can be things they own, have, or are. They include the following:

  • Financial wealth: their savings or stocks or bonds that they own, on which they receive interest or dividends.
  • The physical assets they own: for example, land or the buildings and machinery of a company on which they may receive profits or rental payments, and which they can use as collateral.
  • Intellectual property such as copyrights or patents.
  • Knowledge, skills, and other personal attributes that affect their value to an employer and hence their labour earnings (sometimes termed their human capital).
  • Their race, gender, age, and other aspects that may affect wages, access to credit, or other exchanges.
  • Their citizenship and whether they have a visa, which determine whether they can legally work in a particular country and therefore their labour earnings.

An individual’s income depends on:

  • their set of endowments
  • the income derived from each endowment, which depends on technological, institutional, and political arrangements.

Example 1: Ella

Ella is an experienced medical technician, with endowments:

  • the ability to work for 1,750 hours per year as a medical technician
  • the right to a child benefit to assist in caring for her child.

Since she has only been able to find a part-time job as a medical technician, Ella’s income is: (875 hours × €30) + (1 child grant × €2,000) = €28,250.

Example 2: Kamal

Kamal has inherited a sum from his late father sufficient to start a small business, having previously managed a similar firm for €120,000 per year. His endowments are:

  • ownership of the buildings, equipment, trade name, and other assets of his business, worth €8 million
  • the skills and experience to manage a small business.

His income from the ownership of the business is €480,000: that is, the revenue minus the costs of all inputs. Costs include the management cost, which is €120,000 (either the cost of employing another manager, or the opportunity cost of managing the business himself). His income from human capital is $120,000 (whether he continues in his previous job, or manages his own business). Kamal’s total income is €480,000 + €120,000 = €600,000.

By studying why people’s endowments differ, and what determines the income associated with each one, we can understand income inequality. In particular, both institutions and technologies help to explain them. The arrows in Figure 5.23 point from the causes to the effects.

This flowchart shows that technology, and institutions and policies affect each other. They both affect differences in endowments and economic inequality, which is also affected by differences in endowments.

Figure 5.23 The causal relationships between technology, institutions and policies, endowments, and income inequality (or other disparities like wealth inequality).

The examples of Ella and Kamal illustrate some effects of institutions and policies on endowments. Inherited wealth gave Kamal a valuable asset, while subsidized higher education helped Ella qualify as a medical technician, and the government subsidy for child benefit provided additional support.

Inequality will be greater where inheritances are not heavily taxed and where educational policies allow the wealthy to acquire more and better education for their children. If marriage customs mean that people pick a spouse with a similar level of wealth to them—called ‘positive assortative matching’—this will contribute to inequalities in endowments. Elite private universities can contribute to positive assortment if, like exclusive social clubs, they provide meeting and matching opportunities for the sons and daughters of the wealthy.

To learn more about winner-take-all competition, refer to capstone Unit 21 of The Economy 1.0.

Technology matters, too. For example, the technology of digital platforms favours large-scale enterprises and ‘winner-takes-all’ competition between them. In this setting, a few people—the owners of winning firms—will end up with substantial endowments in the form of valuable financial or real assets, while the rest end up with little.

The income value of a particular endowment, say a programming skill or ownership of a 3D printer, likewise depends on technology, institutions, policies, and other factors such as supply and demand. Being physically strong was a valuable endowment in agriculture—until mechanization made it less important in determining earnings. The change in technology reduced the demand for physical skills, so their value (relative to other skills) fell. The value of owning land depends on how productive it is in growing marketable crops (technology and demand) and whether it is zoned for commercial or residential uses (institutions).

In the case of Kamal, competition from a new supplier in the market may reduce the return from his business assets. Perhaps Ella is unable to find full-time work due to cuts in government healthcare spending. Maybe licensing by a professional standards organization enhances the value of her skills, or gender discrimination by employers reduces it.

Using the model to review the inequality between Angela and Bruno

Let’s apply the cause-and-effect model to the interaction between Bruno and Angela. The inequality between them depended on:

  • Their endowments: Owning the land meant Bruno could decide whether Angela could work on it.
  • Angela’s productivity as a worker: This is determined by her endowment of skills and capacities, and the agricultural technology.
  • Angela’s reservation option: What Angela would get if she were (in Case 1) to attempt to escape from Bruno’s domination, or (in Cases 2 and 3) to refuse to work for him and seek employment or land to farm elsewhere. This is an important influence on her power to increase her income relative to Bruno’s. It is determined by her endowments and the institutions or policies in place.

Bruno owns the land and Angela only owns her time and capacity to work. Inequality in land ownership matters because it determines who has to work for whom, and who can earn income from allowing others to work with their capital goods or their land.

Endowments can also change reservation options. If Angela owned some land that she could work herself, Bruno would need to pay her at least enough to ensure that she would rather work for him than on her own land.

The income from their endowments was also affected by differences in institutions and policies. Under forced labour, the institutions enabled Bruno to coerce Angela to work. In Cases 2 and 3, labour laws and policies gave Angela a higher reservation option, increasing her utility and income, and decreasing Bruno’s.

How endowments, technology, institutions, and inequality interact over time

Endowments and the income they generate are constantly changing as people acquire more skills or as the value of an endowment—such as a piece of land or a rental apartment—changes. Figure 5.23 illustrates the causes of economic inequality. Figure 5.24 illustrates how inequality, in turn, can cause changes in institutions, technology, and in the endowments of the next generation.

For example, the children of richer parents may receive more and higher quality education, or greater inherited wealth. And economic inequality may influence institutions and policies: in most countries—even democracies—a wealthy person typically has more influence on what the government does than a poor person. A greater gap between the rich and the poor could increase the political advantage of the wealthy, resulting in policies favouring those with higher incomes.

This flowchart shows that in a certain period, technology, and institutions and policies affect each other. They both affect differences in endowments and economic inequality, which is also affected by differences in endowments. In the following period, economic inequality affects technology, institutions and policies, and differences in endowments. The causal relationships are the same as in the previous period.

Figure 5.24 Economic inequality over time. The red arrows show that economic inequality in one period has effects on technologies, institutions and policies, and differences in endowments in the future.

Question 5.8 Choose the correct answer(s)

Read the following statements about endowments and choose the correct option(s).

  • Endowments are facts about an individual that may affect his or her income.
  • Having or not having a degree does not constitute a difference in endowments if it is a matter of individual choice.
  • All individuals have the same reservation option irrespective of their endowments.
  • A visa (permission to work for a non-citizen) is not an element of an individual’s endowment because it cannot be sold.
  • Tradeability is not part of the definition of an endowment.
  • Whether one has a degree or not affects the income of the individuals. Therefore one with a degree and one without have different endowments.
  • Reservation options depend on the individuals’ endowments. For example, a firm owner’s reservation option is to hire another employee, while an employee’s reservation option is receiving an unemployment benefit if available.
  • Tradeability is not part of the definition of an endowment. An endowment is anything—including the right visa—that can affect an individual’s income.