Wealth Inequality and the Production Function

by George Hatjoullis

Wealth inequality as a subject is sadly absent from mainstream economic theory. It is regarded as an ethical issue and one to be settled by political choice. Economics manages to develop a complete theory of choice without saying much about wealth inequality. Indeed the theory of choice takes the form it does (in my view) in order to avoid the subject of wealth inequality. Much of this is understood and forms the basis of many critique of economic theory. What is less well understood is that the absence also has implications for production theory.

Economics likes to treat production as essentially an engineering issue. A (closed) economy has so many people, and so much capital, land, natural resource, and a given state of technology. One can conceive of a surface that delineates the maximum amount of every combination of goods that it is possible to produce. The economics problem is then set as to how to ensure the economy operates at this surface. To operate within would be suboptimal, states every textbook, as if using up every natural resource as fast as we can is a good thing! In a world of man-made climate change these textbooks could do with some revision methinks. However, this is not the central issue of this blog.

The engineering solution to the maximum (not optimal) production surface ignores wealth distribution. It assumes maximum production levels are independent of wealth distribution. The only textbook in which I recall this was acknowledged is Theoretical Welfare Economics by J. deV. Graaf. This was first published in 1957 and reprinted in 1971, when I bought a copy as an undergraduate. Unusually I also read it and noted this observation about wealth distribution and production surfaces. It is not difficult to see the point. Better fed people with medical care are likely to be more productive. The principle that wealth distribution must affect maximum production is not difficult to establish. Hence there is no single maximal production surface. There is one for every possible wealth distribution. It is not hard to see why economists assumed this problem away. It is a shame that they did as it must have some profound lessons for developing economies.

A related concept to maximal production surfaces is potential output. This is likely to be within the physical limit of production (for a given wealth distribution) and is defined as the point of GDP growth when inflation begins to accelerate. If production surfaces are wealth distribution dependent then it is most likely so is potential output. This is a profound observation. It has always been understood that wealth distribution affects aggregate demand and hence the economy’s location relative to potential output. If it also affects the level of potential output, the problem of macro demand management becomes more complex but also much more interesting. If it is possible to raise the level of potential output and demand for this output simply by varying the distribution of wealth, then redistributive policies become macro economic tools and not simply ethical or political judgements. One can definitely see why conventional economic theory ignored wealth distribution.

This said it is as well to add that pursuing maximal growth may not be socially optimal. The issue of man-made climate change is one consideration but also the welfare benefits from more work and more consumption should also be reviewed. Maybe less is more…