Chance favors the concentration of wealth

A new model predicts that chance pushes wealth into the hands of a few.

By Deane Morrison  July 25, 2011   University of Minnesota

Most of the wealth in our society is invested in businesses or other ventures that may or may not pan out.   Thus, chance plays a role in where the wealth of a society will end up.

But does chance favor the concentration of wealth in the hands of a few, or does it tend to level the playing field? Three University of Minnesota researchers have built a simplified model that isolates the effects of chance and found that it consistently pushes wealth into the hands of a few, ever-richer people. Their study appears in the journal PLoS ONE (Public Library of Science 1).

“Predictions from this model about how wealth is distributed were more accurate than predictions from classic economic models,” says first author Joseph Fargione, an adjunct professor of ecology, evolution and behavior.

Chance pushes wealth into the hands of a few, a new University of Minnesota study shows.

Their results have implications for economic growth, the researchers say. Healthy economies support diverse entrepreneurial efforts, leading to high economic growth. But concentration of wealth reduces diversity, and with it the most likely growth rate for a country’s economy.

“The implication is that nations with diverse economies should tend to outcompete on the world stage those with large concentrations of wealth, such as monarchies, or established democracies that have allowed their wealth to concentrate,” says author Clarence Lehman, associate dean for research in the University’s College of Biological Sciences.

How it works

The researchers simulated the performance of a large number of investors who started out with equal amounts of capital and who realized returns annually over a number of years. But their wealth didn’t remain equal, because each year an entrepreneur’s return was a random draw taken from a pool of possible return rates. Thus, a high return did not guarantee continuing high returns, nor did early low returns mean continuing bad luck.

“The irony is that the economic diversity that helps ensure the presence of some successful enterprises and spurs economic growth could be lost if the success of these enterprises undermines economic diversity.”
—Joseph Fargione

Even though all investors had an equal chance of success, the simulations consistently resulted in dramatic concentration of wealth over time. The simple reason: Some individuals were lucky enough to realize multiple high growth rates, and once they got ahead with compounding capital returns, they tended to stay ahead.

The model predicted that the rate at which wealth concentrates depends on the variation among individual return rates. For example, when variation is high, it would take only 100 years for the top 1 percent to increase their share of total wealth from 40 percent—a recent level in the United States—to 90 percent.

“At the beginning of the 20th century, the top 1 percent held 60 percent of the U.S. wealth, a situation that prompted President Theodore Roosevelt to seek a progressive income tax and other reforms,” says Fargione.

But while the rate of wealth concentration was increased by high variation among individual investors’ returns, it bore no relation to the average economic growth.

“This leads to the surprising finding that wealth will concentrate due to chance alone in growing, stagnant or shrinking economies,” says author Steve Polasky, professor of applied economics in the College of Food, Agricultural and Natural Resource Sciences.

The simulation results showed wealth concentrating regardless of economic cycles of growth and recession and regardless of whether wealth is split between two offspring every generation. Also, simulations in which entrepreneurs who were successful at the beginning were given a greater chance of being successful in the future (as often happens in real life) led to an even faster concentration of wealth.

Steering away from the rocks

The researchers express concern that the extreme concentration of wealth, in addition to raising issues of fairness, could hurt economic growth. As wealth concentrates with a few individuals, the growth of the economy will depend more and more on the returns of those few, making the economy less resilient to disruptions in their investments.

“The irony is that the economic diversity that helps ensure the presence of some successful enterprises and spurs economic growth could be lost if the success of these enterprises undermines economic diversity,” says Fargione. “To retain the benefits of a diverse capitalist economy, we need economic policies that counter what seems to be the innate tendency for economies to concentrate wealth and become less diverse.”

The simulations showed that a tax (or other mandatory donation to the public good) on the largest inherited fortunes would short-circuit the over-concentration of wealth. But the researchers stress that their point is to advocate not a particular policy, but a policy that accomplishes the goal of protecting long-term economic stability.

Tags: College of Biological Sciences, College of Food, Agricultural and Natural Resource Sciences

WAMMToday is now on Facebook! Check the WAMMToday page for posts from this blog and more! “Like” our page today.