9.2 Income and wealth (2024)

investment: Investment is expenditure undertaken in order to generate a return in future: for example, buying financial assets that will generate income in future, or a house that will provide accommodation, or capital goods to be used by a firm to produce output. In the national accounts, investment expenditure refers more specifically to fixed investment (gross fixed capital formation) together with inventory investment. See also: fixed investment, inventory investment.
wealth: The stock of things owned, or value of that stock. Wealth may generate income, or contribute to the owner’s wellbeing in some other way. It includes the market value of a home, car, any land, buildings, machinery, or other capital goods that a person may own, and any financial assets such as shares or bonds. To calculate wealth, debts are subtracted—for example, the mortgage owed to the bank. Debts owed to the person are added.
share: Shares are financial assets that can be bought and sold, giving their owners (the shareholders) shared ownership of the assets of a firm, and therefore a right to receive a corresponding share of the firm’s profit.
human capital: The stock of knowledge, skills, behavioural attributes, and personal characteristics that determine the labour productivity or labour earnings of an individual. Investment in human capital, through education, training, and socialization can increase the stock. Human capital is part of an individual’s endowment. See also: endowment.
income, disposable income: Income, also known as disposable income, is the amount of profit, interest, rent, labour earnings, and other payments (including transfers from the government) received, net of taxes paid, measured over a period of time such as a year. Your income is the maximum amount that you could consume per period and leave your wealth unchanged.

Understanding borrowing, lending, and investment requires some terms—like wealth and income—that are in common use but are used in a precise way in economics.

Wealth

Wealth is the value of things that you own that contribute to your well-being in some way, called assets. Households invest in assets, including houses, works of art, and financial assets like shares, to ‘save’ or ‘accumulate’ wealth. The assets can either provide an income, for example the rents, profits, interest, or dividends from physical and financial assets you own, or provide other valued services, for example the transport and accommodation made possible by your vehicle and home. If you own intellectual property (such as patents, trademarks, and copyrights) these are also part of your wealth. A work of art is an asset that may appreciate in value, and at the same time, provide pleasure on the wall of your sitting room. Debts require you to make payments to others, and therefore count as negative wealth.

The term wealth is also sometimes used in a broader sense to include your health, skills, and ability to earn an income (your human capital). But we will use the narrower definition of material wealth in this unit, since we focus on forms of wealth that can potentially be turned into spending on goods and services.

Income

Your income is the maximum amount that you could spend over a given period of time without reducing your wealth, for example by selling some of what you own or by borrowing (remember taking on a debt by borrowing reduces your wealth). This includes what you receive as:

earnings (wages or salaries from labour)
profits, interest, dividends, and rents from assets that you own
any increase or decrease in the value of those assets (called capital gains and losses)
transfers from the government minus taxes paid.

In this unit, we simplify by not considering taxes as a deduction from one’s income, or transfers from the government as an addition.

earnings: Wages, salaries, and other income from labour.
flow: A quantity measured per unit of time, such as weekly income, or annual carbon emissions. See also: stock.
stock: A quantity measured at a point in time, such as a firm’s stock of capital goods, or the amount of carbon dioxide in the atmosphere. Its units do not depend on time. See also: flow.
depreciation: The loss in value of a form of wealth that occurs either through use (wear and tear) or the passage of time (obsolescence).
saving: When consumption expenditure is less than net income, saving takes place and wealth rises. See also: wealth.
bond: A financial asset where the government (or a company) borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).

Since it is measured over a period of time (such as weekly or yearly), income is a flow. Wealth is a stock, meaning that it has no time dimension. At any moment of time it is just there.

To highlight the difference between wealth and income, think of filling a bathtub, as in Figure 9.1. Wealth is the amount (stock) of water in the tub, while income is the flow of water into the tub. The inflow is measured by litres (or gallons) per minute; the stock of water is measured by litres (or gallons) at a particular moment in time.

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Figure 9.1 Wealth, income, depreciation, and consumption: the bathtub analogy.

Income either adds to wealth (in which case it is termed saving) or is used for consumption spending.

Some wealth takes physical forms, such as a car or office equipment. The value of physical wealth tends to decline, either due to use or simply the passage of time. This reduction in the value of a stock of wealth over time is called depreciation. Using the bathtub analogy, depreciation is the amount of evaporation of the water. In economics, an example of depreciation is the fall in the value of a car with mileage and with age. Like income, depreciation is a flow (for example, you could measure it in dollars per year for a car or computer), but a negative one.

Consumption and saving

Water also flows out of the tub. The flow through the drain is called consumption, and it reduces wealth just as income increases it. Consumption refers to household spending on goods and services.

An individual (or household) saves when consumption is less than net income, so wealth increases. Wealth is the accumulation of past and current savings. Saving can take a number of forms, for example, putting money into bank deposits, or buying financial assets, such as shares (also known as stocks) in a company, or bonds issued by a government or a company in the financial markets. The choice about where and how to save depends on the relative returns that you can earn and on how easy it is to turn the savings back into money for consumption. Purchases of shares or bonds are often done on behalf of the individual by another organisation, most often the company that runs their personal pension fund who will have more expertise on what to buy and when. The decisions about how much money to save in each saving option will depend on what the expected return is, which will depend on the riskiness of the asset. Returns in asset markets are generally higher for assets that are considered higher-risk. Contributions to a personal pension fund are an example of the use of savings to buy financial assets.

government bond: A financial asset where the government borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).

When a government’s spending is greater than its tax revenue, it borrows by issuing bonds. A government bond is generally considered to be a safe asset because it is a promise from the government to pay some fixed amount to the holder of the bond on a given schedule over a fixed period of time, and because it is assumed that the government will not default on the payments.

When companies plan to spend more than their revenue (for example, on the purchase of machinery and equipment), they have a number of choices. They can borrow from banks (bank loans), borrow from the public by selling company bonds, or sell part of the company (shares). A company is more likely to default on its payments to bondholders than is the government. This higher risk of default means that it is generally more expensive for firms to borrow than it is for the government. The return that a bondholder searches for will be higher to compensate for the higher risk relative to government bonds—in other words, company bonds are riskier than government bonds.

Read Extension 9.2 for more details on the characteristics of bonds and shares.

Shares are literally a share in the ownership of a company. The holder owns some fraction of the company’s buildings, equipment, intellectual property, and other assets. As a part owner of the firm, the shareholder also owns a share of the profits of the firm. The value of a share fluctuates depending on how profitable the firm is and is expected to be in the future. Shares therefore differ from bonds in two important respects: there is no promised payment to the holder (it depends on how profitable the firm is), and there is no fixed maturity period for the ownership of a share (it may be held for a lifetime). For these reasons, shares are a riskier type of savings or class of asset than are company bonds, which in turn are riskier than government bonds due to the higher risk of default.

Question 9.1 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

Your material wealth is the largest amount that you can consume without borrowing; it includes the value of your house, car, financial savings, and human capital.
Income minus depreciation is the maximum amount that you can consume while still leaving your wealth unchanged.
Bonds are a way for companies and governments to borrow from the public.
Depreciation is the loss in your financial savings due to unfavourable movements in the market.

Human capital, such as your health, skills, and ability to earn an income, is immaterial wealth.
Income minus depreciation is the flow that corresponds to your stock of wealth, so if you consume it all, your wealth is unchanged.
Both companies and governments can borrow from the public by issuing bonds. The bond issuer promises to pay a given amount over time to the bondholder.
Depreciation is the loss in value through wear and tear or the passage of time.

Question 9.2 Choose the correct answer(s)

Freny Mistry has wealth of £800,000. To make this example more realistic, we introduce an income tax. There is no wealth tax in this economy. She has a market income of £60,000 per year, on which she is taxed 25%. Her wealth includes some equipment, which depreciates by £4,000 every year. Based on this information, read the following statements and choose the correct option(s).

Her after-tax income is £60,000.
Her net income (income after tax and depreciation) is £45,000.
The maximum amount of consumption expenditure possible for Freny Mistry is £41,000.
If she decides to spend 70% of her net income on consumption and the rest on investment, then her investment is £12,300.

Her after-tax income is her market income less tax, which is £60,000 × 0.75 = £45,000.
Her net income is her after-tax income minus depreciation, which is £45,000 – £4,000 = £41,000.
£41,000 is her net income. Consuming this amount does not alter her wealth. However, she can also consume all of her wealth, so her maximum possible consumption expenditure is £800,000 + £41,000 = £841,000.
A 70% portion of her net income is £28,700, leaving £12,300 to spend on investment.

Differences in types of debt and assets (wealth) of poor and rich households

This unit explains how a person’s situation—especially how much wealth they have—affects the borrowing and lending opportunities open to them. Their choice will depend on what is feasible and on their preferences. Before providing a model to shed light on this choice, we present information on the debts and assets of poor and rich households.

Question 9.3 Choose the correct answer(s)

Based on the two bar charts and two pie charts in Figure 9.2, read the following statements and choose the correct option(s).

The richest quartile has half of all residential debt, and mortgages make up more than half of total debt, so the richest quarter must have a disproportionately large share of total debt.
The least wealthy quartile has the largest share of education loan debt, but has a disproportionately small share of total debt.
The category of assets for which the poorest quartile has the highest share (relative to other categories) is the category that makes up the smallest share of total assets in the pie chart.
The third quartile holds a substantial share of equity in business and directly held stocks, but they do not own a substantial share of life insurance and retirement accounts.

The first fact is shown in the first bar chart and the second is shown in the first pie chart. Putting them together, we deduce that this statement must be true. In fact, the first row of the bar chart shows that the richest quartile has almost half of all debt.
The least wealthy quartile (as noted in the text—this group contains many young people) has more than half of educational loan debt. But educational loan debt—although the third largest category—makes up a relatively small share of total debt. Overall, the poorest quartile has far less than 25% of total debt.
The poorest quartile has a higher percentage share of vehicles than they do of any other asset category, and vehicles is the category with the smallest overall share of total assets.
The third quartile’s shares of equity in business and directly held stocks are very small. Their share of life insurance and retirement accounts is slightly higher, but still very small. Almost all of these assets belong to the highest quartile.

We have explained in the main part of this section that bonds and shares are financial assets that can be bought by households, as different forms in which to hold their savings. Here we describe in more detail the characteristics of these assets, and what determines their value.

Bonds

Governments and firms raise finance by issuing bonds which are then bought and sold in the bond markets. The government and firms are the borrowers and the households (or organizations like pension funds) are the lenders. The loan is provided for a fixed period, called the maturity of the bond.

There are two forms of payment that make up the return that a bondholder receives for lending the government or a firm money:

Face value, which is an amount paid when the bond matures
Coupons, which are fixed payments made at known periods until maturity (for example, every year or every three months).

The name ‘coupons’ is used because, in the past, bonds were physical pieces of paper, and when one of the fixed payments was redeemed, a coupon was clipped from the bond.

These are guaranteed returns, in contrast to shares where the shareholder does not know in advance what they will earn, as it depends on the firm’s profitability.

A bond is a financial asset:

Issuing or selling a bond is equivalent to borrowing.
A bond buyer is a lender or saver.
Governments and firms borrow by issuing bonds.
Households buy bonds as a form of saving.

Stocks

Firms also borrow from households by selling them shares (stock) in their company. The shares are bought and sold on the stock market. The proportion of company shares that an individual (or household) owns will determine the share of returns on the stock that they earn.

The value of the stock can go up or down, depending on how profitable the firm is expected to be in the future. Firms expected to generate greater net earnings will have higher valuations, and if expectations change, so will the value of the shares. Like bonds, their value will also depend on interest rates elsewhere in the economy, and on how risky the earnings are thought to be. If the value is expected to go up, then lenders will pay a higher price for the shares; and if the value goes down, lenders will only be willing to pay a low price.

The households that buy the shares are not guaranteed a specific return, in contrast to bonds. Shares are therefore more risky than bonds. There are several examples of different determinants of changes in the price of shares in Question E9.1.

Question E9.1 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

A company was founded and led by a well-respected business person. If the company’s founder unfortunately passes away very suddenly, with no clear successor, the company’s share price will fall.
A devastating pandemic causes lockdowns around the world. A company emerges as the leader in video communication. The share price of that company will rise rapidly at the start of the pandemic.
A company emerges as the leader in self-driving cars. When an official report is issued that details the surprisingly large number of accidents its cars have been involved in, the share price is most likely to remain stable.
A company’s share price would be expected to rise when it reports much higher sales and revenue, together with a decline in total cost, than had been expected.

If investors believe that the company will be less profitable in the near future without the well-respected founder at the helm, the share price will be lower.
The change in the situation—with widespread lockdowns—is likely to make the company much more profitable than had been expected previously.
If the large number of accidents is new information, and is interpreted to mean that the company will be less profitable than had been expected, this information will quickly be reflected in the share price, which would most likely fall.
The company has reported higher-than-expected profits, which would generally lead to an increase in the share price.