2.12 The market’s inability to achieve equity

Learning objectives

• Distinguish between income and wealth, and between equality and equity.

• Explain how a free market distributes income through the rewards paid to the factors of production.

• Draw and explain a circular flow diagram showing why a free market produces unequal incomes.

• Explain why wages differ between workers, using labour market diagrams.

• Explain why the ownership of land, capital and skills is unequal, and why inequality of wealth tends to compound.

• Calculate factor incomes, labour shares and the growth of wealth from given data.

• Discuss whether an unequal market outcome should be seen as a market failure.

Introduction

A free market can be very good at deciding what to produce and how to produce it, yet it gives no guarantee that the result is fair. In 2025 the richest 10% of the world’s adults received just over half of global income and owned about three-quarters of global wealth, while the poorer half of the world owned about 2%.

Such gaps have their roots in the way a market economy pays people: households earn incomes from the factors of production they own, so unequal ownership leads to unequal incomes, and unequal incomes lead, over time, to even more unequal ownership. The topic links two key concepts that often pull in different directions, efficiency and equity, and it explains why intervention in the distribution of income is so often debated.

Equity, equality and the “for whom” question

Every economy must answer three basic questions: what to produce, how to produce it and for whom. In a free market economy, the price mechanism answers the first two through prices that signal scarcity and create incentives. The third question, who gets the output, is answered by incomes: a household can buy goods and services only if it has the income or wealth to pay for them.

The market therefore distributes output in line with purchasing power, which depends on what each household owns and on the prices those possessions earn. Nothing in the price mechanism looks at need, effort or fairness. Whether the resulting distribution is acceptable is a separate question, which the price mechanism cannot answer.

Equality is not the same as equity

Equality means that outcomes are the same or similar, for example every household having the same income. Equity means fairness, which is a normative idea: people disagree about what a fair distribution looks like. Most people accept some differences in income as fair, for instance when they reflect different hours worked or years spent training, while regarding very large differences, or differences caused by luck of birth, as unfair.

Because equity is about fairness, statements about it belong to normative economics. The claim “the top 10% receive 53% of global income” is positive: it can be checked against data. The claim “that share is too high” is normative: it depends on values. Economists can show how a market distributes income and what the consequences are, but the judgment about how much inequality is acceptable involves values as well as evidence.

Efficiency and equity are different tests

Allocative efficiency is reached when resources produce the combination of goods and services that society values most, where marginal benefit equals marginal cost. A competitive market can achieve this, but the result depends on the distribution of income it starts from. Demand curves measure willingness and ability to pay, so the wants of a household with a high income count for more in the market than the needs of a household with a low income.

This means that an outcome can be allocatively efficient and still be inequitable. A market for luxury yachts may work efficiently while families nearby cannot afford housing. For this reason economists treat efficiency and equity as two separate tests of a market outcome, and a market that passes the first may fail the second.

Income and wealth

Inequality can be measured in two different things, income and wealth. They are linked, but they behave differently, and much of the explanation for why markets produce inequality depends on the difference between them.

Income is a flow: an amount received over a period of time, such as a salary of $40,000 a year or rent of $1,200 a month. Wealth is a stock: the value of the assets a household owns at a point in time, such as a house, savings, shares and land, minus its debts. Wealth produces income (shares pay dividends, savings earn interest, property earns rent), and income that is saved adds to wealth.

The way a total is shared between households is called a distribution. The distribution of income describes how a country’s total income is divided between its households in a year; the distribution of wealth describes how the total stock of assets is divided between them at a point in time.

Wealth is almost always much more unequally distributed than income. Most households have some income, from work or from government transfers, but many households own few assets, and some have debts larger than their assets, so their net wealth is close to zero or negative. In the United States in mid-2026 the poorer half of households owned 2.3% of household net worth, while the richest 1% owned 32.5%.

Sources: Board of Governors of the Federal Reserve System, Distributional Financial Accounts, via FRED (2026).

How a free market distributes income

In a market economy, incomes come mainly from selling the services of the four factors of production in factor markets. Firms need land, labour, capital and entrepreneurship to produce, and they pay for each one. These payments are factor incomes: wages and salaries for labour, rent for land, interest for capital and profit for entrepreneurship.

Each household’s income therefore depends on two things: how much of each factor it owns and the price each factor earns in its market. A household that owns only its own labour, and whose skills are in plentiful supply, receives one modest wage. A household that owns skills in short supply, a rented flat, a portfolio of shares and a business receives several incomes at once, some of them large. Income from owning assets is capital income.

The market does not set out to make the distribution unequal. It simply rewards ownership of factors at the prices set by demand and supply. Because the ownership of factors is very unequal, and because some factors earn much higher prices than others, the incomes that result are unequal too.

The circular flow model and inequality

The circular flow of income model shows the flows between households and firms. In its simplest form, households supply the factors of production to firms in factor markets, and firms pay them factor incomes. Households spend these incomes on goods and services in product markets, and the spending becomes the firms’ revenue. Money flows one way round the circle and real factors, goods and services flow the other way.

The simple model treats “households” as one group. Splitting them into groups by what they own turns it into an explanation of inequality. The diagram divides households into two types: Household A, which owns only its labour, and Household B, which owns its labour plus capital, land and shares in firms.

The diagram shows three steps in the argument. First, the incomes flowing back from firms to households differ: A receives one income stream, wages, while B receives four. Second, B’s larger income allows it to spend more on goods and services and still save, while A may need to spend everything it earns. Third, B’s saving buys more assets (the loop below its box), so B’s ownership of capital and land grows, and next year its interest, rent and profit are larger still.

The circular flow is therefore not a circle in which everyone stays in the same place. Each round of the flow can widen the gap between households that own capital and those that do not. This is the core reason why a free market tends to produce an unequal distribution of income and an even more unequal distribution of wealth.

Why wages differ

For most households, wages are the main source of income, so differences in pay between workers are a major source of inequality in their own right. In a free market, the wage for a type of work is a price set by the demand for and supply of that labour.

Demand for labour is a derived demand

Firms do not want workers for their own sake; they hire them to produce goods and services that can be sold. The demand for labour is therefore a derived demand. Workers whose output is valuable, because they are highly productive or because the product they help to make sells at a high price, face strong demand for their labour. Workers in a declining industry, or whose tasks can be done cheaply by machines, face weak demand.

Demand for labour also depends on its productivity. A worker with more human capital, the skills, knowledge and health that make labour productive, produces more per hour, so firms are willing to pay more for each hour of that worker’s time.

Supply of labour: scarce and abundant skills

The supply of a type of labour depends on how many people are able and willing to do the work. Jobs that need long training, rare talent or expensive qualifications have a small and inelastic supply, because new workers cannot enter quickly. Jobs that most people can learn in a few days have a large and elastic supply.

The two diagrams show how demand and supply combine. In the market for scarce, high-skill labour, such as specialist surgeons or experienced software engineers, demand is strong and supply is small and inelastic, so the equilibrium wage W₁ is high. In the market for abundant, low-skill labour, such as warehouse packing, demand is weaker and supply is large and elastic, so the equilibrium wage W₂ is low. The gap between W₁ and W₂ is a wage differential.

Wage differentials are not in themselves a sign that the market is failing. They act as signals and incentives: high pay for scarce skills encourages people to train for them, which in time increases supply and narrows the gap. This is the incentive function of prices at work in the labour market. The equity concern arises when people cannot respond to the signal, for example because they cannot afford the training or because the gap is caused by factors unrelated to skill.

Superstar markets

In some markets, modern technology allows the very best performers to serve a whole national or global audience at once. One footballer’s matches are broadcast to audiences around the world, one author’s book can be sold everywhere, and one chief executive’s decisions affect a firm worth billions. Buyers want the best, and the second best is a poor substitute, so most of the income goes to a few people at the top. This is the superstar effect.

The supply of one superstar’s talent is fixed: there is only one of each person. Their labour supply is therefore perfectly inelastic, and any increase in demand raises their pay without changing the quantity of their services.

The diagram shows demand rising from D₁ to D₂ as broadcasting rights or global sales expand. Because supply is vertical, the fee rises from P₁ to P₂ with no change in quantity. The same reasoning applies to the pay of chief executives of very large firms. In the 2025/26 financial year, the median chief executive of a FTSE 100 company in the UK was paid £5.06 million, 130 times the pay of the median UK full-time worker.

Sources: High Pay Centre, annual review of FTSE 100 CEO pay (2026).

Bargaining power

Wages also depend on bargaining power. Workers who can easily move to another employer, or who belong to a labour union that negotiates for them, can push wages closer to the value of what they produce. Workers with few alternatives, such as those in a town with one large employer, those on insecure contracts, or those whose status as employees is disputed, have weak bargaining power and may be paid less.

Gig economy work shows the issue. Ride-hailing drivers in the UK were treated by Uber as self-employed partners, with no right to a minimum wage or paid holiday. In February 2021 the UK Supreme Court ruled that they were “workers” and so entitled to the national minimum wage and paid holiday, which changed the balance of bargaining power through law rather than through the market.

Sources: Uber BV v Aslam [2021] UKSC 5, UK Supreme Court (2021).

Firms with market power can also widen inequality. A firm that earns abnormal profit because it faces little competition pays that profit to its owners, who are mostly wealthy households. Its customers pay higher prices, which takes a larger share of income from poorer households. Market power therefore shifts income from consumers and workers towards the owners of capital.

Discrimination and immobility

Two further features of real labour markets keep some wages low for reasons unrelated to productivity. Discrimination means that some workers are paid less or hired less because of their gender, ethnicity, age or another characteristic, rather than their skills. Immobility of labour means that workers cannot easily move to where pay is higher, because of housing costs, family ties, lack of information or qualifications that are not recognised elsewhere. Both stop the market from equalising pay for similar work, and both are also major causes of inequality and poverty in the economy as a whole.

The labour share of income

The incomes produced in an economy can be divided into two broad parts: income paid to labour (wages, salaries and employers’ contributions such as pensions) and income paid to capital (interest, rent and profit). The fraction that goes to labour is the labour share of income.

The labour share matters for inequality because labour income is spread across many households, while capital income goes mostly to the minority who own significant assets. When the labour share falls, a larger part of national income flows to capital owners, and the distribution of income usually becomes more unequal even if wages are rising.

The chart shows the labour share in the United States since 1950. It moved between about 60% and 65% for half a century and then fell after 2000, reaching 56.8% in 2023. Economists debate the causes. Explanations include technology that replaces routine tasks, the growth of very large and highly profitable firms, the decline of labour unions, and global competition from economies with lower wages. Whatever the cause, a falling labour share means that ownership of capital has become more important in deciding who receives income.

Why the ownership of factors is unequal

If every household owned the same mix of factors, a free market would produce similar incomes even with unequal factor prices. Inequality arises because ownership is far from equal. Each factor is distributed unequally for different reasons.

Land and property

Land is fixed in supply, and its ownership often reflects history: conquest, colonial rule, past laws and inheritance, rather than a market process starting from equal positions. In South Africa, a government land audit in 2017 found that white owners held about 72% of the farms and agricultural land owned by individuals, while black African owners, from a group that makes up about 80% of the population, held about 4%: a direct legacy of laws that once restricted where black South Africans could own land. Households that own land and housing receive rent, and benefit when land prices rise; households that rent pay that income to others.

Sources: Department of Rural Development and Land Reform, South Africa, Land Audit Report Phase II: Private Land Ownership by Race, Gender and Nationality (November 2017).

Capital and financial assets

Owning shares, bonds or a business requires savings, and saving is much easier for households with high incomes. A household that spends all its income on food, housing and transport cannot buy assets. Ownership of capital is therefore concentrated among households that already have high incomes or inherited wealth, and the income from capital flows back to the same households.

Human capital

Skills are a factor that a person owns, but acquiring them costs money and time. Children from richer households tend to have better access to good schools, private tuition, university education and the contacts that lead to well-paid jobs. Children from poorer households may leave education early to earn, or may not be able to borrow to pay for training, because they have no assets to offer as security. Unequal access to education therefore turns inequality of income in one generation into inequality of skills, and so of wages, in the next. This is one source of inequality of opportunity.

Entrepreneurship

Starting a business usually needs capital, and borrowing is easier and cheaper for people who already own assets that can be used as collateral. Entrepreneurs who succeed can earn very large profits and build up large shares in their firms. Entrepreneurship is the factor that most clearly rewards talent and risk, but access to the finance needed to use it is itself unequal.

Inheritance and the luck of birth

Finally, a large part of wealth is not earned by its owner at all. Inheritance passes land, housing, financial assets and businesses from one generation to the next. Children of wealthy parents begin adult life owning assets that earn income; children of poor parents begin with only their labour.

The scale of inherited wealth can be large. In the year to mid-2023, 53 people became billionaires by inheriting a total of $150.8 billion, more than the $140.7 billion of wealth held by the 84 people who became billionaires through their own businesses in the same period.

Sources: UBS, Billionaire Ambitions Report (2023).

Why inequality tends to compound

The most important feature of market inequality is that it is self-reinforcing. Wealth produces capital income; capital income allows more saving; saving buys more wealth. Households with little wealth have no capital income and little room to save, so they stay where they are. Over time the gap between the two widens.

The loop in the diagram has four links. Wealth earns income from interest, rent and profit. That income, added to wages, is far more than a wealthy household needs to spend, so it saves a large part of it. The saving is reinvested in assets, so wealth grows each year, and when the owner dies or gives assets to children, the wealth passes on to the next generation, which starts the loop again from a higher level.

Three reasons the gap widens

1. Saving rates rise with income. Households with high incomes can save a large share of it; households with low incomes must spend nearly everything on necessities. Only the first group can turn income into new wealth.

2. Returns are often higher for larger fortunes. Wealthy households can afford financial advice, can spread risk across many assets and can wait for long-term gains, so they tend to earn higher average returns than a small savings account. Their wealth therefore grows faster in percentage terms as well as in absolute terms.

3. Inheritance carries the advantage across generations. Each generation begins where the previous one ended, so a head start is passed on rather than lost.

The French economist Thomas Piketty argued in Capital in the Twenty-First Century (2013) that when the rate of return on capital is higher than the growth rate of the economy, wealth grows faster than incomes from work, so the share of wealth held by the richest tends to rise. The argument is debated: returns on capital fall when capital becomes plentiful, fortunes are split between heirs and reduced by taxes, and many large fortunes are newly made. The basic mechanism, that wealth earns income which can be reinvested, is widely accepted.

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A market responds to purchasing power, not to need

Inequality of income would matter less if markets supplied goods in line with need, but the price mechanism rations goods to those who are willing and able to pay the market price. The rationing function of price is efficient in one sense, because goods go to those who value them most in money terms, but money valuations depend on how much money people have.

The diagram shows a market in equilibrium at Pe and Qe. Every point on the demand curve above Pe represents a buyer willing and able to pay at least the market price, and these buyers obtain the good. Points on the demand curve below Pe represent buyers who would value the good but cannot pay that much. For goods such as housing, health care, education and nutritious food, the people priced out may have the greatest need.

When incomes are very unequal, the market also directs resources towards what high-income households want. Firms produce luxury housing, private jets and premium services because that is where purchasing power is concentrated, while goods that low-income households need may be underproduced. Firms are responding to price signals as the theory predicts, but those signals reflect an unequal distribution of income.

Is market inequality a market failure?

Market failure usually means that a market misallocates resources: it produces too much or too little of a good compared with the social optimum, as with externalities, public goods, asymmetric information and market power. Inequity is a different kind of failure. A market can allocate resources efficiently, given the distribution of income, and still produce a distribution that society judges unfair. This is why inequity is described as the market’s inability to achieve equity rather than as a misallocation of resources.

Whether the market distribution of income is a problem depends on how unequal it is, on why it is unequal, and on what follows from it. The table sets out the main arguments on each side.

The case that some inequality is useful

In a market economy, differences in pay are the signals that direct labour to where it is most valuable. If a data scientist and a cashier were paid the same, fewer people would spend years learning statistics and programming, and the economy would be less productive. Profit plays the same role for entrepreneurs: without the chance of a large reward, fewer people would risk their savings on new businesses, and there would be less innovation and fewer new products.

There is also a risk that policies to reduce inequality create new problems. Very high taxes on income may discourage work, saving and investment, and some highly mobile people and firms may move to countries with lower taxes. Economists sometimes describe redistribution as carrying water in a leaky bucket: some of what is taken from the rich is lost through administration and weaker incentives before it reaches the poor.

The case that market inequality is a serious failure

The incentive argument applies to inequality that reflects skill, effort and risk. It does not apply to inequality that reflects inheritance, the family a child is born into, or discrimination. These differences do not encourage anyone to work harder, and they mean that talented children from poor households may never develop their skills. In that case inequality wastes human capital and reduces the economy’s productive potential, so equity and efficiency point in the same direction.

Diminishing marginal utility gives a further argument. An extra $1,000 adds much more to the well-being of a household that cannot afford heating than to that of a millionaire. If the aim is to maximise total economic well-being, a given total income produces more well-being when it is less unequally shared, although this conclusion depends on the assumption that utility can be compared between people, which many economists reject.

High inequality can also undermine itself. When the poorer half of a population owns almost nothing, it has no buffer against job loss or illness, and recessions push many households into poverty quickly. Concentrated wealth can bring concentrated political influence, which may be used to protect existing advantages, for instance by lobbying against competition or against taxes on wealth.

A reasoned judgment

Most economists conclude that a free market, left alone, is likely to produce more inequality than most societies regard as equitable, because ownership of factors is unequal to begin with and because inequality of wealth compounds. At the same time, some inequality plays a useful role as an incentive. The real debate is therefore about how much inequality is acceptable and which kinds: inequality that reflects skill and effort is easier to defend than inequality that reflects birth and inheritance. This is why almost every government intervenes in the distribution of income, but to very different degrees. The judgment also shapes which policies make sense, since a policy aimed at inherited wealth differs from one aimed at low pay.

From the market to policy

Because the market itself has no mechanism to correct inequity, reducing inequality requires intervention. The main tools, studied in detail in macroeconomics as part of the economics of inequality and poverty, work at different points of the circular flow:

• Taxes take a larger share of income from high-income households (progressive taxes on income, taxes on wealth and inheritance), reducing the income and wealth that compound at the top.

• Transfer payments such as unemployment benefits, pensions and child benefits add income for households that own few factors.

• Government provision of education and health care gives every child access to human capital, whatever the family’s income, which tackles one root cause of unequal factor ownership.

• Labour market policies such as a minimum wage and laws on discrimination and workers’ rights raise the wages and bargaining power of low-paid workers.

Each tool has costs and limits, and each is evaluated in the study of inequality and poverty. The microeconomic point is that every one of them works by changing either the ownership of factors or the incomes they earn, which are exactly the causes of market inequality identified by the circular flow.

Case study: the concentration of global income and wealth

The World Inequality Report 2026, produced by the World Inequality Lab, combines national accounts, tax records and surveys from countries around the world to estimate how global income and wealth are shared between the world’s adults. Its estimates for 2025 show inequality on a very large scale, and an even larger inequality of wealth than of income.

What the data show

The richest 10% of the world’s adults, about 560 million people, received 53% of global income in 2025, while the poorest 50%, about 2.8 billion people, received 8%. Wealth is far more concentrated: the top 10% owned about three-quarters of global wealth and the top 1% alone about 37%, while the bottom half owned 2%. The report also finds that the richest 0.001% of adults, fewer than 60,000 people, increased their share of global wealth from almost 4% in 1995 to over 6%, and that billionaires’ wealth has grown by about 8% a year since the 1990s, nearly twice the rate for the bottom half.

The pattern inside one rich country is similar. In the United States, the share of household net worth owned by the richest 1% rose from 22.8% in 1989 to 32.5% in mid-2026, while the share owned by the poorer half fell from about 3.5% to a low of 0.4% in 2010–11, after the housing crash wiped out the home equity of many households, before recovering to 2.3%.

Which theory explains it

The data fit the mechanisms of the circular flow closely. The gap between income shares (53% for the top 10%) and wealth shares (75%) is what the theory predicts: incomes are unequal, but wealth is more unequal because high incomes allow saving and saving accumulates. The faster growth of the largest fortunes matches the compounding argument: large fortunes earn high returns, are largely reinvested, and are increasingly passed on through inheritance. The fall in the US labour share over the same decades shows the factor-income side of the story: a growing part of national income has been paid to owners of capital, who are concentrated at the top.

The sharp fall in the bottom half’s US wealth share after 2007 shows another feature of the theory. Households with few assets often hold them mainly as a home bought with a large mortgage. When house prices fell, their net wealth fell much more in percentage terms than that of richer households with diversified assets, whose share then recovered faster as share prices rose.

Limits of the evidence

Global wealth estimates are uncertain. Much wealth is held in forms that are hard to value, such as private businesses, or hidden in offshore accounts, and the World Inequality Lab has to combine sources of different quality across countries. Comparing incomes across countries also depends on exchange rates and price levels. Global figures combine inequality within countries with inequality between countries, and a large part of the global gap reflects the difference between rich and poor economies rather than market forces inside any one of them. The data show how unequal the outcome is; they cannot by themselves show how much of it is unfair, which remains a normative judgment.

Sources: World Inequality Lab, World Inequality Report 2026 (2025); Board of Governors of the Federal Reserve System, Distributional Financial Accounts, via FRED (2026); Penn World Table, University of Groningen, via FRED (2025).

Exam practice

This material is HL only, so it can appear in HL Paper 1 and HL Paper 3, but not in Paper 2. Questions on it are at the level of explanation and analysis (AO2): explain the mechanism and draw the circular flow diagram. Evaluation of inequality and of policies to reduce it is usually combined with the macroeconomic study of inequality and poverty, so a Paper 1 part (b) question may draw on both.

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Paper 1, part (a)

Paper 1, part (b)

Short Paper 3-style items

Short items can also ask for a labour market diagram to explain a wage differential, which follows the same rules as any demand and supply diagram.

Paper 3: calculation and policy

Summary

• Equity (fairness) is a normative idea and differs from equality (similar outcomes); efficiency and equity are separate tests of a market outcome.

• Income is a flow; wealth is a stock of assets net of debts. Wealth is much more unequally distributed than income.

• A free market pays households for the factors they own: wages, rent, interest and profit. Unequal ownership of factors produces unequal incomes, as the circular flow split by type of household shows.

• Wages differ because of derived demand, the scarcity of skills, superstar effects, bargaining power, discrimination and immobility.

• When the labour share of income falls, more income goes to capital owners and inequality usually rises.

• Inequality compounds: wealth earns income, high incomes allow saving, saving buys assets, and inheritance passes the advantage on.

• Markets ration by ability to pay, not by need, so an efficient market can still be inequitable; some inequality creates incentives, but inequality from birth and inheritance does not.

Self-check

• To do:

  I can distinguish between income and wealth, and between equality and equity.

• To do:

  I can explain how a free market distributes income through factor incomes.

• To do:

  I can draw a circular flow diagram with two types of household and use it to explain why incomes are unequal.

• To do:

  I can use labour market diagrams to explain wage differentials, including superstar markets.

• To do:

  I can calculate a labour share and the growth of wealth from given data.

• To do:

  I can explain why the ownership of land, capital and skills is unequal and why wealth inequality compounds.

• To do:

  I can explain why a market can be allocatively efficient but inequitable.

• To do:

  I can discuss whether market inequality is useful or harmful, with real evidence.