Wednesday, May 16, 2012

Prosperity creates poverty

“Capital is that part of wealth which is devoted to obtaining further wealth"- Alfred Marshall

Continuing from my previous post, where we saw that the same wealth distribution patterns across time and across cultures, you'd wonder what causes this. Is it a result of how we as people are, how we interact and how are economic systems function? Can we create a mathematical model that is based on human behavior as it relates to money and would it give us the same distribution?

People engaging with each other and exchanging something of value is very similar to particles bumping into each other and exchanging energy - a basic thermodynamic system that has been studied in a good amount of detail by physicists. You could run a simulation with a large number of people who all start of with the same amount of money. Then they engage with each other at random, exchanging a random amount of their money at each interaction. At the end of a number of iterations, the wealth distribution will be similar to distribution above - with the poorest 10% having 2% of the wealth and the richest 10% having 24% of the wealth. This is roughly what you'd see if you spread everyone evenly between the poorest and the richest person, that is without a huge amount of inequality.

To make the system behave more like normal people do, let's add another condition - that the richer person will never offer up for exchange more than what he could get from the poorer person. After you take this system through a number of iterations, the results are completely different - there are many poor people, with the wealth concentrated among the few rich.

Remarkably, a basic wealth maximization condition makes this system quite similar to the real world. Now that we have a sandbox that works quite like the real world, we can ask some questions, introduce certain changes and see what the results are.

Is the world really a zero sum game?
Can the poor actually carry out their wealth maximization objective?
Would forcibly removing the wealth maximization objective lead to prosperity?

Sunday, May 13, 2012

Is economic inequality inevitable?

"The Utopian scheme of leveling [wealth distribution] and a community of goods, are as visionary and impractical as those which vest all property in a crown. These ideas are arbitrary, despotic, and in our government, unconstitutional" - Samuel Adams

Study after study has shown that wealth and income distributions across countries and and cultures follow similar power law functions for the wealthy and log-normal distributions for the rest. In simple English: There are usually a few wealthy people and many poor.

In the US the wealthiest 5% have over 50% of the wealth (the wealthiest 1% have one third of the wealth while the poorest 40% hold just 4% of the wealth). In the UK, the wealthiest 5% have over 40% of the wealth and in India they have 38% of the wealth. This pattern holds even if you look within certain age groups or demographics. And it's been repeating itself through history.

Excavations in the ancient Egyptian city Akhetaten, which was populated for a short period during the 14th century BC, yielded a distribution of the house areas. Assuming that the house area is a measure of the wealth of its inhabitants, we find the same type of wealth distributions existed in the 14th century BC.

A study of the wealth and income distribution at the height of the Roman Empire in the 2nd century had the same type of distribution (and used wheat equivalents as the hypothetical currency).

Another study of the distribution of wealth in the medieval Hungarian aristocratic society around the year 1550 again found the same type of power-law based wealth distribution. The study assumed the wealth of a noble family was based on the amount of land and serf families that they owned.

In 1906, Italian economist, Vilfredo Pareto observed that 80% of the land in Italy was owned by the 20% of the population. He then carried out surveys on a variety of other countries and found to his surprise that a similar distribution applied. This is now known as the Pareto Principle or 80/20 rule. (Pareto supposedly also observed that 20% of the pea-pods in his garden contained 80% of the peas.)

This type of wealth distribution appears repeatedly throughout our history and continuous to occur even today - like an natural law that is invisible, but acting around each one of us right now.  While the Egyptian civilizations didn't survive, the Roman Empire fell and the medieval times ended, each left behind evidence that this natural law was active during their time. What makes this natural law work? What are the structural elements and interactions, the physics, behind it?

Can it be influenced or is it inevitable?