Factor & Personal Distribution of Income

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

This lesson will introduce you to the ways economists measure the distribution of income in a country. The distribution of personal income among individuals and factor income among groups in the economy will be explored.

Personal Income Distribution

Edward is the chief economics officer for the nation of Nad, and he's concerned about the distribution of income in his country, which is growing more unequal. Edward knows that when income inequality becomes worse, people in democratic countries like Nad like to elect new political leaders. In short, too much inequality is bad for the job security of politicians!

Edward needs to come up with ways to study the problem: one is to create an income distribution table. Often, these tables will split the population into fifths. The bottom fifth is the bottom 20% of households, the second fifth is the next 20%, and so on to the top fifth that is the top 20%. Then, next to each fifth is the share of the total income in the economy earned by each fifth. The income distribution table for Nad looks like this:

Income distribution table for Nad: notice that the bottom fifth and second fifth (bottom 40%) earn only 13% of the cumulative income.
Distribution 1

Looks disturbing, Edward thinks to himself. The two bottom segments represent 40% of the voters and they are getting a very small slice of the big pie.

The Gini Index

Another measure of income inequality is the Gini index. The Gini index is a mathematical measure that ranges from 0 to 1. A Gini index of 0 indicates perfect income equality. In other words, everyone in the economy has the same income. An index of 1 would indicate a large inequality of income. The world Gini index was estimated to be about 0.52 in 2016. Edward is intrigued, and looks up the Gini index for Nad. He sees that it is 0.49, which means slightly less inequality than average, but it has ticked up from 0.47 the year before.

Edward is thinking about that bottom 40% again and their now increasing inequality. He brings this to the attention of the newly elected president. Edward recommends providing those people with jobs building roads and infrastructure. The country of Nad needs something to bring up the income of the bottom 40%, or the new president may not be in office for long!

The Factors of Production

Before Edward can look at the distribution of income in another way, he needs to understand the four factors of production. These factors comprise all of the inputs necessary to produce goods and services:

  1. Land, which represents all of the natural resources needed to produce goods and services.
  2. Labor, which represents all of the work that laborers and contractors perform at every level of the organization.
  3. Capital, which is all of the tools, machinery and technology.
  4. Entrepreneurship, which is combining the other factors in order to make a profit.

Put these factors together and you can make anything! For example, an entrepreneur conceived a new social website a few years ago that has taken the country of Nad by storm. She started building it herself, but soon needed to hire a few professional coders and writers (labor) to make the website operational and put good content on it. The coders and writers work on computer workstations (capital). The entrepreneur also needed servers (more capital) to allow thousands of users easy access to her website. The servers contain lots of metal (land), and she had to buy some property and build a warehouse to house the server farm (more land and capital). Through her entrepreneurship, she was able to combine the other three factors, and what is left over goes to the entrepreneur as profit.

Factor Income

Edward can use the factors of production to look at factor income, which is income based on the factors of production. For example, every time a new member pays the $50 fee to join Nad's new social website, it creates income for the people who own factors that produced the website. Some portion of that $50 will go to pay the workers, some will go to pay for the servers and work stations, some will go to pay for the server farm, and some will go to the entrepreneur as profit. The money that the chatty citizens of Nad spend becomes income for other citizens of Nad who own the factors. That is one of the big circles of economics!

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