Explaining the development of income inequality

Question

I'm a syndicated writer working on an explainer about income inequality and I realized I didn't really understand how it can possibly develop in an economy where all dollars are spent. That is, let's take a hypothetical: I understand how it's possible where one person creates a product that everyone else purchases (creating a concentration of wealth). But, then, that person invests or saves the money, which ultimately gets circulated back into the economy. If total money is zero-sum (all saved money is spent, all received money is spent), how does any one actor in the system end up with more money than others?

As I see it, the only mechanisms by which income inequality could increase within a group of people is if the system included globalization, where wealthy people spend money outside of the system (i.e. sending the money to other countries which were previously poor)

I'm open to answers that include a closed hypothetical economy (with 3 actors) or some other explanation. Thank you and let me know if I can clarify this question.

Update: Some have suggested its a duplicate of "how wealth is created". This is different because im asking about income (money supply and distribution), not the distribution of outputs. I get how some people might produce more. I dont understand how money concentrates in a system where all savings is invested or spent.

Answer 1

First off, dollars are not the sole determination of wealth. People can be wealthy by having a large house and a nice car and still have \$0 in the bank. Dollars hold wealth only because they can be exchanged for goods or services that actually do have value.

With that being said, let us take a look at what you have asked:

I understand how it's possible where one person creates a product that everyone else purchases (creating a concentration of wealth). But, then, that person invests or saves the money, which ultimately gets circulated back into the economy. If total money is zero-sum (all saved money is spent, all received money is spent), how does any one actor in the system end up with more money than others?

The two phrases that I have emphasized above, hold the answer to your question. In fact, you have almost answered your question in the first phrase.

The only reason that wealth has concentrated in Person A (who creates a product that everyone else purchases) is because everyone else has determined that they would rather have that product than the money that they have. The benefits of having that product outweigh the benefits of keeping the money. Many economists would argue that everyone is better off because the seller has improved his life by getting more money and the buyers have improved their lives by getting the better product.

Now, what does Person A do with the money? Person A does the exact same thing that everyone else did originally: he looks for products that he would rather have than money.
In the marketplace, Person B, Person C, and Person D are all selling unique products of their own. Person A sees value in purchasing the products from Person B and Person D, but values his money more than the product from Person C. So, Person A purchases from Persons B and D but not from Person C. This means that the money flows from Person A to Person B and Person D.

This cycle will continue to repeat indefinitely.
As long as Persons A, B, and D continue to produce products that people value more than money, they will continue to gain wealth.
On the flip side, as long as Person C does not produce a product that people value more than money, he will not gain wealth.

Answer 2

I'm pretty sure this answer is not definitive on the subject of income inequality, but I think it can address a couple of broad points in the original question.

In 'income inequality', 'income' refers to a flow concept. Either a number of monetary units per unit time (eg USD 12,000 per year) or a 'quantity' of commodities and services that the money can command over some period of time. The 'inequality' part has to do with some underlying distribution and its particular shape and/or general properties.

Incomes are generated as a remuneration to the factors of production that participated in output creation over a certain period of time (production too is a flow concept). If someone accepts that factors of production are paid their marginal value products (and production is linearly homogeneous) then that same person should also accept that the sum of incomes generated is equal to the sum of values (of output, commodities) produced. In this setting, differences in marginal productivity of factors should be sufficient in explaining differences in incomes (along with initial endowments). Actually, this is the canonical representation of how distribution works out.

In this setting, "...all dollars are spent". In fact, "...all saved money is spent, all received money is spent". 'Income inequality' is not about accounting identities (a caveat is that in the canonical representation there is no such thing as "money" and such a representation is more in par with the second view presented above with regards to what is denoted by 'income).

The other point is about what 'increases' or 'decreases' income inequality. Obviously, the specific definition of how to measure inequality will affect the scale over which changes are measured. There are different measures of inequality and which one is operational each time matters.

Also, 'globalization' is a term that contains myriads of processes and effects and as such obviously has an impact on 'inequality'. It's the specific degree and appropriate channels through which its effects are expressed, that matter for the changes in 'inequality'.

It seems to be suggested in the body of the question that free movement of capital across countries-courtesy of 'globalization'-increases inequality at home because money 'leak out' of the domestic circuit. On the other hand, it seems to be suggested that inequality decreases in the countries that receive the capital injections.

If that were the case and under suitable assumptions, inequality in the world as a whole would remain constant.

Answer 3

It’s difficult to think any economy would have zero surplus. If it did, and all funds were spent as soon as they were received there’d be zero savings or surplus goods. In a primitive economy (which suits your example as applying this to modern society isn’t reasonable) there’d be a lot of barter and the usage of money would mostly be superfluous. In a developed economy, for businesses to know how much to produce or services to offer they need some type of surplus and require savings and investment.

How does inequality get created in a closed economy? Your thought experiment that everybody spends what they receive straight away would in theory mean there would be zero inequality but there would be those who produce and provide more goods and services than others or the government would tax more than it spends giving rise to inequality. Eliminating inequality totally is not realistic in any way. Only if you want to set up a moneyless economy but even then goods and services still have utility and their value is intrinsic. Exchange of these goods would mostly be done by barter unless everybody’s needs were met such as under an abundance economy or techno communism, etc.