RIYADH – The issue of rising income inequality loomed large at this year’s World Economic Forum in Davos. As is well known, the United States’ economy has grown significantly over the past three decades, but the median family’s income has not. The top 1% (indeed, the top .01%) have captured most of the gains, something that societies are unlikely to tolerate for long.
Many fear that this is a global phenomenon with similar causes everywhere, a key claim in Thomas Piketty’s celebrated book Capital in Twenty-First Century. But this proposition may be dangerously misleading.
It is crucial to distinguish inequality in productivity among firms from unequal distribution of income within firms. The traditional battle between labor and capital has been about the latter, with workers and owners fighting over their share of the pie. But there is surprisingly deep inequality in firms’ productivity, which means that the size of the pie varies radically. This is especially true in developing countries, where it is common to find differences in productivity of a factor of ten at the provincial or state level and many times higher at the municipal level.
These two very different sources of inequality are often conflated, which prevents clear thinking on either one. Both are related to a similar feature of modern production: the fact that it requires many complementary inputs. This includes not only raw materials and machines, which can be shipped around, but also many specialized labor skills, infrastructure, and rules, which cannot be moved easily and hence need to be spatially collocated. A shortage of any of these inputs can have disastrous effects on productivity.