Why Is Wealth Distributed So Unequally?

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<> on October 11, 2011 in New York City.

The first man who, having enclosed a piece of ground, bethought himself of saying This is mine, and found people simple enough to believe him, was the real founder of civil society. From how many crimes, wars and murders, from how many horrors and misfortunes might not any one have saved mankind, by pulling up the stakes, or filling up the ditch, and crying to his fellows, “Beware of listening to this impostor; you are undone if you once forget that the fruits of the earth belong to us all, and the earth itself to nobody.” – JJR

Is rousseau right? When did people begin to become unequal and why is wealth distributed the way that it is?

Rousseau examines society as social and financial institutions evolved. He notes that in mans hypothetical state of nature everyone was happy and equal. Although people had always been unequal in terms of strength, talents etc, once society changed from living in small groups without money or property, to societies which utilize property and money, inequality skyrocketed (see On the Origin of Inequality).

This makes sense, but why isn’t money distributed more evenly, rather then being concentrated in the hands of a few people?

The reason is because wealth follows a Pareto distribution. This is also known as the 80/20 principle – and in this case the top 20% hold 80% of the wealth. Pareto distributions are seen in many different areas. For example: fixing 20% of all computer bugs at Microsoft fixes 80% of all problems, 20% of pods contain 80% of all peas etc. Pareto distributions occur because of properties of the distributed variable are exponential in nature. The reason fixing roughly 20% of computer bugs fixed 80% of the problems is because when people use computers they do some tasks exponentially more then others.

This distribution is different from a normal distribution where most of the values are concentrated around the mean. Human height is a good example of a normal distribution – as most people will be around the same height. You won’t see human height follow a pareto distribution because it would mean that most people would be short – and some people would be 20 or 30 times taller then the rest.

Thats great, but…

Why does wealth distribution follow a Pareto distribution rather then a normal distribution?

AND

What are the underlying properties of society that make wealth distribution exponential?

After much thought, discussion, and research, I have come up with a number of reasons. It seems that the strongest and most influential of which is that “money makes money”. Simply having money can lead to exponentially more money, while having less money will always lead to having less of an opportunity to get more. Lets examine why this is:

  1.  If your parents are rich, you have a greater chance of being rich. Not only is wealth inherited, but rich people are more likely to have better habits, better health, more knowledge, better values, and more time then poor people. They are able to pass along all of these things to their children so that they are at an advantage from a young age. So if you have had money in your past – it can continue on into your future.
  2. The more money you have, the less barriers to entry you have. As your wealth increases, it becomes easier and easier to set up businesses or act on opportunities requiring high capital investments. It enables you to be one of the few people who can capitalize on the opportunity and thus gives you a greater opportunity to generate more wealth then those with less more.
  3. Compound Interest.

 Investing your money means you can take advantage of compound interest – its exponential. The more you have, the more you get.
  4. Having more money optimizes your risk tolerance. See my article on Risk Tolerance. Essentially, as your wealth increases, your risk tolerance changes accordingly allowing you to generate greater amounts of money from what you have. (although the amount is not exponential – it still plays a role in leading to the exponential property of simply having money).
  5. Having more money means more time, energy, and health and knowledge. As your wealth increases you can afford services and objects which will save you time, save you money, make you healthier, and give you more energy. Ex. buying things in bulk saves you money. You can afford health insurance. You can buy a first class ticket which will allow you to sleep and maximize your energy when the flight is over. Additionally, you will have the time to invest in yourself. You can go to university, college and learn whatever you need to be successful. All of these thing will allow you to generate exponentially more wealth then someone without access to them.
  6. The more money you have the more likely you are to know people who have more money.  They say that life is often about who you know. However it may not be that if you have money you know rich people, but rather is you know rich people you have money. In either case, knowing wealthy and successful people puts you at an advantage to earn even more money.

The conclusion that I have come to is that just having money will allow you to generate exponentially more money in the type of economic system which exists today. However it may not be the only reason wealth follows a Pareto distribution – there may be a combination of factors. Here are some other alternatives:

 

Alternative Reasons:

  1. Sometimes Niches Don’t matter. 

When searching for a product to buy you want to find the absolute best product. As it turns out – there often is a best product for you to buy. There is often a company who provides a better product at a better price. This company will get an exponential amount of business because they are the best – regardless of niche.
  2. Limited capacity and popularity.

 There is only so much room in the human brain. We can only remember a certain number of names, a certain number of products, and a certain number of solutions to our problems. Because of this limited capacity, we can only like, do, use and listen to a certain amount of things at once. We are likely know the most popular things simply because there is not enough room for us to know all of them. Thus only a small number of things can be popular and thus will make exponentially more money then their competitors.

 

Notes:

Wealth distribution roughly follows a pareto distribution in all countries. However, wealth distribution does not HAVE to follow a pareto distribution and some countries have wealth more equally distributed then others.

The power laws is also scale invariant. This could mean that no matter how rich a country gets (or how technologically advanced) that wealth will always be distribution according to a paretos law. However I believe that the economy as a dynamic system is much more complicated then that and that scale invariance only applies up to a point. It could be that, as we become richer, our laws and our economy will change leading to wealth following a different distribution.

See Can Everyone Be Rich to see what a world could look like if this were the case:

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