Written by Noah Rich
America, for better or worse, is at one of its most unequal points in history. While billionaires like Elon Musk have enough to consider buying multi-billion dollar companies like Twitter, over 21% of America’s children remain in poverty (Isaac and Hirsch; Horowitz et al.). This is striking, especially in light of how much progress- in theory- we have made as a society. There has never been more wealth, innovation, and ways to connect those who want to help to those who need help. Why could this gap possibly remain?
Before I begin to offer one facet of an answer to this question, I want to establish that I am not an expert. That being said, I do have some evidence, from relatively recent research on risk, that I hope adds nuance to your understanding of this contradiction.
However, before I get there, it is essential to understand some of the theoretical drivers of risky behavior.
Imagine you had a 50% chance of winning or losing some set amount of money. Would you take the bet if it involved $10? What about if the bet was upped to $100, or $10,000? Would you still take the bet? Well, according to a statistician, changing the monetary amount of this bet doesn’t change its value: as each gives you a fair 50% chance of winning or losing an equivalent amount of money, they all have an expected value of $0 (Black et al.).
Your decision to take each bet might be impacted by something called risk aversion. As economists describe, one who is risk-averse “dislikes every lottery with an expected payoff of zero” (Eeckhoudt et al.). In other words, those who are risk-averse are only willing to take bets if they think they are more likely to win than lose OR gain nothing at all. However, if you would have taken some of the bets- like the smaller ones- and not others- like the larger ones- your decision making is not fully explained by risk aversion. After all, if you were completely risk-averse you would not take any of these “fair” bets. Instead, your risk aversion might be tempered by an idea called diminishing marginal utility.
According to psychologists, this is the idea that “each additional unit of gain leads to an ever-smaller increase in subjective value” (Berkman et al.). Let’s say you were at an all-you-can-eat burger buffet. If your sense of satisfaction was not diminishing, then the benefit you would get from each individual burger would be about the same – your first burger would feel as good to eat as your hundredth. However, by the theory of diminishing marginal utility, your first burger would feel much better than the hundredth because it held more subjective value than the hundredth. It felt better (or at least did not feel quite as bad).
Going back to the hypothetical bets above, this idea could also apply: by framing the bet as a binary between a loss of something you already had against a potential future gain, I explicitly set up the bets so that the loss would seem to hold a different subjective value than the win, even though they had the same dollar amounts. Money you already have is going to be more valuable to you than potential additional money. As such, even though all the bets were fair, it might have felt like each bet had a different level of risk.
These two ideas explain why you, as an individual, might be willing to make a smaller “fair” bet over a larger “fair” bet. Why you might be willing to risk $10 on a bet but not $10,000. However- and this is what is key for the purposes of this article- what if you were a billionaire? What if 10,000 dollars felt more like $10 would to you or me? As I will explain below, that distinction is what might drive part of the large wealth divide we have in society today.
In 2019, researchers at the German Institute for Economic Research found that “high-wage subjects take higher risks than low-wage participants do if they are aware of the inequality in wages” (Schmidt et al.). In other words, they found that knowing you are wealthier than others changes your willingness to take a risk. Your subjective understanding of the benefit, utility, of your wealth, and thus your sense of risk aversion, is impacted by your understanding of your own wealth. Why does this matter for income inequality in our age? Well, as I will demonstrate below, large and risky financial investments often lead to novel innovations that help many rich become richer than they otherwise would be. And to make large and risky financial investments, you must first have wealth and be willing to take a risk.
One form of expensive and risky investment is venture capital. Venture capital is a “high-touch form of financing that is used primarily by young, innovative, and highly risky companies” (Strebulaev and Gornall). Most companies that receive this type of funding fail- but when they are successful, it can be on a massive scale. This type of investment is what touches big-name technology companies like Apple and Google (Strebulaev and Gornall). It is the kind of financing that both helps fuel the large-scale advancement our society has made in recent years and has helped fuel the concentration of wealth in places like Silicon Valley (Florida).
To be clear, I am not trying to suggest that companies such as those in the tech sector only benefit rich people. As research by organizations like the OECD suggest, research and development funding- as venture capital can finance- has a “positive impact” on “productivity and economic growth” (Appelt). And indeed, productivity increases tend to be linked with increases in standard of living.
It is important to understand that this chain of logic between risk aversion, subjective perception of wealth, and income inequality is not cold, hard, nor set in stone. This article is not an in-depth scientific paper. However, if we can understand that the perception of wealth, in addition to real wealth, has an impact on economic development, that is knowledge that can be harnessed. Maybe, this adds a new tool that can contribute to improving our economic system, minimizing the elements that beget human suffering- such as inequality- and maximizing the elements that promote human flourishing- like innovation. To be clear, I am not proposing a new solution here. Instead, I offer a framework that might be useful in making the world a better place.
Works Cited
Appelt, Sylvia. The Impact of R&D Investment on Economic Performance: A Review of the Econometric Evidence. 2015, p. 59.
Berkman, E. T., et al. Diminishing Marginal Utility – an Overview | ScienceDirect Topics. https://www.sciencedirect.com/topics/psychology/diminishing-marginal-utility. Accessed 6 July 2022.
Eeckhoudt, Louis, et al. Economic and Financial Decisions under Risk, Princeton University Press, pp. 3–25.
“Fair Odds.” Oxford Reference, https://doi.org/10.1093/oi/authority.20110803095808629. Accessed 6 July 2022.
Florida, Richard. “The Extreme Geographic Inequality of High-Tech Venture Capital.” Bloomberg.Com, 27 Mar. 2018. www.bloomberg.com, https://www.bloomberg.com/news/articles/2018-03-27/the-extreme-geographic-inequality-of-high-tech-venture-capital.
Horowitz, Juliana Menasce, et al. “1. Trends in Income and Wealth Inequality.” Pew Research Center’s Social & Demographic Trends Project, 9 Jan. 2020, https://www.pewresearch.org/social-trends/2020/01/09/trends-in-income-and-wealth-inequality/.
Isaac, Mike, and Lauren Hirsch. “With Deal for Twitter, Musk Lands a Prize and Pledges Fewer Limits.” The New York Times, 25 Apr. 2022. NYTimes.com, https://www.nytimes.com/2022/04/25/technology/musk-twitter-sale.html.
Schmidt, Ulrich, et al. “Income Inequality and Risk Taking: The Impact of Social Comparison Information.” Theory and Decision, vol. 87, no. 3, Oct. 2019, pp. 283–97. DOI.org (Crossref), https://doi.org/10.1007/s11238-019-09713-8.
Strebulaev, Ilya, and Will Gornall. “How Much Does Venture Capital Drive the U.S. Economy?” Stanford Graduate School of Business, https://www.gsb.stanford.edu/insights/how-much-does-venture-capital-drive-us-economy. Accessed 6 July 2022.