Equality, equity, income and wealth

A free market economy is an economic system where demand and supply largely determine prices and allocate resources, with limited government intervention. It coordinates production and exchange, but there is no guarantee that people will consider the resulting distribution of resources fair.

Equality describes a situation where people receive the same amount or are treated in the same way. Equity is a normative principle under which resources or opportunities are distributed in a way judged to be fair. These ideas are different. Equal outcomes may be seen as unfair, while an unequal outcome may be considered equitable if it reflects differences in effort, responsibility or need. Fairness rests on value judgements, so no single distribution is objectively correct.

Income is a flow of earnings received over a period of time, including wages, rent, interest and profit. Wealth is the stock of assets owned at a particular point in time after deducting liabilities. A household might have a modest current income but substantial accumulated wealth. Another could earn a high current income yet have little net wealth.

How the circular flow produces unequal incomes

The circular flow of income is a model that shows how resources, goods and services, and money payments move between economic decision-makers. In the simplified model, households supply factors of production to firms through factor markets. Firms then use those factors to produce goods and services, which households buy through product markets.

Each of the four factors generates a different form of income:

• labour earns wages;
• land earns rent;
• capital earns interest;
• entrepreneurship earns profit.

Households differ in both the quantity and quality of the factors they own. Some have scarce skills and can command high wages. Others provide labour that the market values less highly, or they may be unable to work. Households that own land, financial assets or businesses receive rent, interest or profit in addition to wages. By contrast, others rely almost entirely on labour income.

Through the circular flow, income is distributed according to the factors households own and their market value, rather than according to household needs. The diagram shows a causal process: unequal factor ownership creates unequal factor incomes; these unequal incomes then produce differences in purchasing power and expenditure.

Consider one household that owns a profitable business and financial capital, while another supplies only relatively low-paid labour. Firms may pay both households the market income generated by their factors. However, the first household receives profit and interest as well as any wages, allowing it to purchase a larger share of the economy's output. Voluntary exchanges may make the market outcome efficient in a narrow sense, but that outcome can still be inequitable.

From income inequality to wealth inequality

Inequalities in income and wealth can reinforce each other. High-income households are usually better placed to save and buy property, shares or other assets. In turn, these assets may generate rent, interest, dividends or capital gains. Wealth may also pass between generations, giving some households greater opportunities and earning capacity from the outset.

A low-income household, on the other hand, may need to spend almost all its income on current necessities, leaving little capacity to build up assets. Having limited wealth can restrict access to education, training, credit or the funds needed to start a business. As repeated rounds of the circular flow take place, the initial inequality in factor ownership may therefore persist or widen.

Purchasing power and economic well-being

Demand is the quantity of a good or service that consumers are willing and able to buy at different prices during a given period, other things being equal. The word able matters. A low-income household may have a strong need for food, housing or healthcare but lack the purchasing power required to express that need as effective demand.

Firms in a free market mainly respond to consumers who can pay. Production and consumption therefore reflect purchasing power rather than need alone. Higher-income households can command more goods and services, whereas lower-income households may lack adequate access to essentials. For this reason, the free market's distribution of income and wealth may be judged inequitable.

This does not imply that every market exchange necessarily creates unfairness. The price mechanism simply has no built-in rule requiring equal ownership of productive resources, equal incomes or a minimum standard of living. Whether the resulting inequality is acceptable—and whether it justifies government intervention—is ultimately a normative judgement.