Feb 12 2008

A macroeconomic mystery – the gap between America’s “rich” and “poor”

You Are What You Spend – New York Times

Fact:
The richest 20% of Americans earn 15 times the income of the bottom 20%.

Fact: The richest 20% of Americans only consumer 4 times as much as the poorest 20%.

Question:
Why don’t the richest 20% consume 15 times as much as the poorest 20%?
Consumption Gap
The author of this NYT opinion piece claims that the gap between America’s rich and poor is not as stark as the income figures suggest. While before tax income of the top 20% is around $150,000, the poorest 20% earn only around $10,000. Clearly these numbers indicate an enormous income gap in America.

However, when it comes to consumption, the poor consume an average of $18,000 on everything from food to housing to entertainment to transportation. The richest 20%, on the other hand, consume an average of only $70,000, less than half their before-tax income.

So the question is, is standard of living based on our income, or on our consumption? If it’s income, then there’s certainly a huge gap in standard of living between the rich and poor. But if we believe it’s consumption, then the gap is narrowed dramatically. The author claims the latter:

To understand why consumption is a better guideline of economic prosperity than income, it helps to consider how our lives have changed. Nearly all American families now have refrigerators, stoves, color TVs, telephones and radios. Air-conditioners, cars, VCRs or DVD players, microwave ovens, washing machines, clothes dryers and cellphones have reached more than 80 percent of households.

It turns out that in the last 50 years, a combination of rising wages for the lowest classes and falling prices for many household products has lead to a narrowing in the “consumption gap” in America:

In time, ownership spread through the levels of income distribution as rising wages and falling prices made them affordable in the currency that matters most — the amount of time one had to put in at work to gain the necessary purchasing power.

At the average wage, a VCR fell from 365 hours in 1972 to a mere two hours today. A cellphone dropped from 456 hours in 1984 to four hours. A personal computer, jazzed up with thousands of times the computing power of the 1984 I.B.M., declined from 435 hours to 25 hours. Even cars are taking a smaller toll on our bank accounts: in the past decade, the work-time price of a mid-size Ford sedan declined by 6 percent.

And to whom do we owe our thanks for the lower prices of all these great products? No, not the hard-working Americans whose labor went into their production, rather our trading partners, like… yep you guessed it, China!

There are several reasons that the costs of goods have dropped so drastically, but perhaps the biggest is increased international trade. Imports lower prices directly. Cheaper inputs cut domestic companies’ costs. International competition forces producers everywhere to become more efficient and hold down prices. Nations do what they do best and trade for the rest.

This was a great editorial written by an economist working for the Federal Reserve Bank of Dallas. Click on the graph above and have a look; you’ll be surprised at the revelations behind the numbers. Maybe it’s true, the gap between the richest and poorest Americans may not be as bad as the income numbers show!

Hat tip to AP Econ teacher Mr. Rood for the link.

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

16 responses so far

16 Responses to “A macroeconomic mystery – the gap between America’s “rich” and “poor””

  1. Mollieon 13 Feb 2008 at 9:26 am

    The richest 20% in the country don't consumer 15 times that of the poorest 20% in the counrty is because it is simply not feasible; being 15 times richer than another person does not mean that you will consumer 15 times as much food or 15 times more gas driving to your respective job. Then what about their grand houses and luxurious cars? There is, for the most part, not a 15x difference in price between the automobiles of the poor and rich, and though housing can sometimes be closer to that 15x difference, it, alone, cannot make up for the [lack of such great] difference in the other areas earlier mentioned.

  2. Howard Jingon 13 Feb 2008 at 10:36 am

    I agree with Molly in that sometimes it is not wise to spend fifteen times the amount of money as someone even if you are fifteen times richer than them. I would assume that somewhere along the line you would start getting hit by the law of diminishing marginal returns and experience massive amounts of ennui.

    Moreover, while the bottom twenty percent of Americans spend around $18,000 a year, they only make $10,000 a year. This means that every passing year, they are increasing their debt by $8,000 (pre-tax). In contrast, the top twenty percent of Americans are earning $150,000 a year and spending $70,000 of it. Every year they are saving $80,000 (pre-tax). They can SAVE more money in a year than many families MAKE in a year.

    The lowest fifth of Americans spends more money than they earn. If the highest fifth of Americans were to spend fifteen times the amount of money as the bottom fifth, they too would be spending more money than they earn. Perhaps the rich feel like staying rich, rather than being neck deep in debt.

  3. Jessica C.on 13 Feb 2008 at 6:45 pm

    I agree with Mollie that the top 20% don't spend 15x the amount that the bottom 20% spend because they simply don't have to. Basically, if we think about it, the rich and the poor buy the necessities. The only difference is that the rich have the money to buy the luxury goods and they can buy the things that they want AND need. However, these rich people won't spend all their money simply because they have it; they still act rationally. On the other hand, some rich people probably like saving their money and they just buy the necessities.

    There is also a HUGE gap between the rich and the poor in China and America. "Poor" people in America still have the money to buy TVS, cars, and fridges. As for the poor people in China, they literally only have the necessities. Some people barely have electricity! Does anyone want to tell me why the poor are so poor in China? Is it simply because that the cost of living is lower, or because there are SO MANY people in China, or is there another reason…

  4. Annie Sungon 13 Feb 2008 at 6:50 pm

    Before today, I was not aware that so many families rack up annual debts in order to stay alive on low incomes. It's true that it's unreasonable for a high-income person to spend 15 times more than a low-income person – they are all people regardless of income and the law of diminishing marginal utility will stop their spending at some point, before it goes into purchasing meaningless junk that doesn't make them happy. Looking at the bars on the top of the graphs, the income of many families are not enough to sustain their basic survival needs – food, housing, public services, transportation, and medical care being the main deposits of income. This is in comparison to the $16,000+ high-income families spend on transportation alone (flashy cars, I'm assuming), which is a higher amount than what low-income families spend on five categories combined. However, considering that prices of household appliances have been drastically dropping in the past few decades, the standard of living for the lower 5th should be, while not perfect yet, better than before.

  5. Jo Loon 13 Feb 2008 at 7:38 pm

    I'm not surprised that the upper 20% Americans earn 15 times more than the lower 20%. This seems right because out of all of the millionaires and billionaires in the world, most of them work and thus reside within the borders of the United States. Trade is a good thing, which causes most prices of goods and services to decline, but trade also has its disadvantages. Trading with oil rich nations has become a problem over the last few decades because those countries know they have a lot of what everybody wants. Because oil is one of the most sought after good on the market these countries are able to exploit the desire for this good and raise the prices.

  6. Michael Dailyon 13 Feb 2008 at 9:28 pm

    I think the reason behind the rich not spending 15 times more than the poor is the simply to do with the fact that the rich do not need 15 times more stuff. Obviously the rich can spend a good amount more than the poor, but they don't need to squander all of their money on luxury goods. In fact that may be why half of those rich people are in that top 20%: because they were wise with their money. And I also agree with what some other people have said in the sense that the "poor" Americans are not really that poor. America offers decent pay even to manual labors compared to the rest of the world, I mean why else would there be so many illegal Mexican immigrants in the US. As probably the most advanced economic country in the world it does not surprise me that the gap between the rich and the poor is not too large in terms of consumption.

  7. Hansen Guon 14 Feb 2008 at 1:02 am

    I'm with Michael. I think it is interesting to look at this from the point of view of consumption of products that improve the standard of living. If we look at it this way, then yes, most families do have TVs, VCRs, cellphones, etc. The statistic that the top 20% do not consume 15 times more is like Mollie has stated, not feasible. The top surely do not need that much. Thus, it makes more sense to me to judge the gap in living standards and consumption.

  8. Erinon 14 Feb 2008 at 2:01 am

    I agree that the reason the richest 20% of Americans don't spend 15x more than the 20% simply because they don't need it. I can compare it to an example given to my econ. class by our teacher the other day. Say the price of salt drops 50%(and is predicted to stay that way for a very long period of time), does that mean people will buy 50% more salt than they normally do? No. They don't need salt, it is not a necessity, and they will continue consuming as much as they would if the price hadn't dropped. That is the same reason the richest 20% of Americans don't spend 15x more than the poorest 20%, it is not needed. Sure, they do spend more money than the pooest people, that is simply a given…the more money you have, the more you spend. But these rich people are rational, and that is probably part of the reason why they are rich, so they know how to differentiate between a necessity and a want, and spend their money accordingly.

  9. Tarynon 14 Feb 2008 at 6:50 am

    I also agree with what everyone has been saying: the reason the richest 20% of Americans do not spend 15x more than the poor 20% is because they do not need to consume more gas, more food, etc. But I do believe income is still a validity in assessing standard of living. Income is the factor that drives an American's decision on what to consume. A poorer person may choose to buy a junk car while a richer person will choose to buy a luxery vehicle, and a poor person may buy low grade gasoline while a rich person while buy high grade gasoline. So, in some ways the way to asses standard of living is by examining a person's lifestyle which includes income and consumption.

  10. Caleb Liaoon 14 Feb 2008 at 12:10 pm

    I agree that the reason the richest 20 percent of Americans don’t spend fifteen times more than the 20 percent because they do not need it.

    The rich don't consume that much more because they do not have the need for such goods. Plus, if the rich were to spend their money like that, they wouldn't be able to buy bigger things when they wanted to.

    It makes complete sense that the rich don't spend enough to keep the circular flow of the economy working, and although it sucks, its the way things are.

  11. Shana Lopezon 14 Feb 2008 at 1:51 pm

    To answer the question, "Why don’t the richest 20% consume 15 times as much as the poorest 20%?" I think there's been quite a number of similar answers that have good points, so I'll agree with the fact that the rich don't need to spend a lot of money if they don't want to.

    I have questions though, about the "poorest 20%", like the reason for their situations. A lot of people go into debt because they spend too much and over load on credit card bills (or something similar). Some of these poor could have even been in the "rich" range before their spending.

    Thinking about this, I don't have a problem with the rich not consuming 15x as much as the poor.

  12. howardon 14 Feb 2008 at 9:35 pm

    I think if the richest 20% do consume 15 times more it would be as poor as the poor. However, if it did consume 15 times more than the poor, the poor would be better off because there are more demands from the rich meaning more money in their pockets.

  13. Laurenon 14 Feb 2008 at 11:27 pm

    I would have to agree with the general consensus here. The richest 20% are not spending 15 times more than the poor 20% because necessities will be bought by everyone and mroe people won't buy luxuries because of a price change. It's like Erin said. If the price of cinnamon goes up, the amount of people who buy it won't go down simply because it is a luxury. People don't really need it, and it's not an item you need often, like salt.

  14. Jonathan Lauon 17 Feb 2008 at 5:50 pm

    Although the richest 20% of people in America earn 15 times the income of the poorest 20%, they obviously don't consume 15 times as them; it just would not be realistic. There are certain necessities that everyone needs, which constitutes for a large percentage of each group's consumption, but when it comes to luxury goods, the richest 20% of Americans don't spend THAT much more than the poorest 20%.

    It was interesting to see that the poorest 20% of Americans consume almost double the amount they make. How can they afford to buy more than they have in their pockets?

  15. Ericon 24 Feb 2008 at 2:50 pm

    I think the idea of using consumption as measure of standard of living is ludicrous. Under this model increasing one's debt in order to increase consumption (whether making ends meet or buying a big screen TV) makes one richer (as opposed to making the banks richer). And, conveniently, the rich are now seen as less well off because most of them don't blow all the money they earn (especially when they can invest and sit back while their savings compound)? Nothing short of economic propaganda and a laughable attempt IMO… or maybe the author (federal reserve bank economist) actually believes what he/she wrote?

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