Scipio

I would rate utility theory alongside such innovations as elasticity as two of the more important economic ideas that bring the general optimization/equilibrium discipline in line with reality.

Here though, I'll try to keep it brief and simple. Premise: In the United States, and most of the world, the rich (say, the top 5%) get richer, and the lower classes (to throw out another number, the bottom 66%) gain less ground. This is one of the fundamental points of strain in a capitalist system. As long as some kind of balance is struck (the bottom segment gets some of the benefits of society's overall progress), peace and prosperity abide.

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Begin brief economics lesson:

What is risk aversion? It's simple, and here's a basic mathematical example, using expected values and common sense:

Job A: For each month, you have a .05 probability of getting $200,000 dollars, and a .95 probability of getting nothing.

Expected monthly income: $10,000
Expected annual income: $120,000

Job B: You have a 1.0 probablility of getting $5,000 each month.

Expected monthly income: $5000
Expected annual income: $60,000

If people are sufficiently risk averse, they'll take the second option, even though in the long run they'll make twice as much with the first one. Utility theory says that people don't try to maximize money, they try to maximize utility. A common utility function follows:

U = sqrt(W)

U=utility, W=wealth

Uexpected of Job A = 22.36 (sqrt(200k)*.05 + sqrt(0)*.95)
Uexpected of Job B = 70.71 (sqrt(5k)*1)

As our intuition might indicate, the second job is a lot more attractive to most people. Economics lesson over.

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Simple argument: People who have more wealth are better able to behave in a risk neutral way. They can capture higher expected values even if they take losses sometimes. Imagine that Job B is a typical, decent salaried white collar job, and that Job A is that of a stock trader. The worker will get a certain income to cover his needs. If someone already has enough wealth to survive, they can choose Job A and expect to make twice as much income. Because people in the majority (botton 66%) have to be risk averse merely to survive, they are at a significant competitive disadvantage compared to those who begin better off, simply because of their attitudes towards risk.

Policy implications: without some way to minimize this risk, relatively high income inequality is the equilibrium outcome. Because money has diminishing marginal value, there's a social interest in spreading the money around a bit more. It's also good for overall economic health as it promotes strong consumer demand. Centralization of production is still possible, but some ownership would shift to the somewhat wealthier middle class, who could invest in securities and equities. So how is risk aversion minimized? By rewarding risky (high expected value) behavior, and by minimizing the consquences of good risks (high expected value) that fail.

I'll leave the specific policies for a later time. Just thought I'd toss some of what I've learned in economics in.

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guy44

Interesting post. I'm going to talk baseball now because, well, I like baseball. Tell my if I've got your thinking down:

The Yankees are your top 5%. They can afford to engage in large risks because they always have more money. They can give bazillions to mediocre pitchers like Wright who've only had one good year - there's a small chance he'll have it again, but even if he doesn't, the Yankees have the money to go out and get another pitcher to take his place.

A team like the Padres has limited resources and, while not destitute, must avoid high-risk, high-reward strategies. They needed a centerfielder last year, but couldn't afford someone like Carlos Beltran, because he costs too much. Sure, adding him to the team has a small but real chance of making the Padres better than the other teams in the NL East, thus allowing them to make the playoffs and collect additional revenue to cover his cost...but that's too high a chance. The Mets, who have the money to ignore a worst-case scenario with Beltran, then signed him for way more than the Padres could ever hope to offer.

In summary, NY sucks.

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alansmithee

FYI, Yankees rule, they're just going through a rough spot.

More to the topic, I think the above baseball example could be sumamrized as such:

Those who have the most wealth are better able to absorb the impact of having a high-risk venture not pay off. This helps increase the income disparity, because as you gain wealth you are better able to take the high risk/high reward ventures. For instance, in the OP's example someone with a year's worth of living expenses in the bank will be better equipped to take the opportunity that will potentially pay 200k because he won't need to worry about monthly expenses as he already has those covered. So someone already with more capital is just able to build, and on and on.

Also, in real life many of the potential high-risk opportunities also require some starting capital which those in the lower income brackets don't have to spare.

So it isn't just that those who lack aren't properly analysing risk, but they are either less equipped to deal with the negative impacts from risk going bad or aren't able to make the initial investments necessary to take part in those risks.

jorgelito

Is it kind of like:

People with deeper pockets can last longer at the gaming tables or have a better chance of "winning big"? Because they can afford the higher risk for higher pay-off whereas the average joe can't "gamble" as high and reap the higher pay-off.

Manx

It takes money to make money.