Transcript Chapter 7

Chapter 7

Majority of the world’s population has access to
very limited resources

With low incomes distributed unequally,
consequences for poverty and undernutrition
can be immense

Inequality can also affect aggregate savings
rates and the capacity to work

Access to credit and education can be
constrained
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The relationship between inequality and
 per-capita income: the inverted U-hypothesis
 savings
 political redistribution
 credit markets
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What is the relationship between inequality and per-capita
income? (Kuznets, 1955)
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Development seems to be an uneven and sequential process:
 All groups do not benefit simultaneously; development favors certain
groups, while others must “catch up”
 Economic progress (rise in per capita income) is initially accompanied
by rising inequality, but over time disparities go away
 A plot of inequality against per-capita income looks like an “inverted
U”

A simple test can take the form of the following
regression: si  A  by  cy 2  D  error
 si is the income share of the i-th quintile
 y is the log of per-capita GNP
 D is a dummy variable for socialist countries

Too much variation in the data across countries
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Other functional forms can also fit the inverted U-hypothesis: we
need a theory of inequality to tell us what to test
1
si  A  by  c  D  error
y
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Cross-sectional studies assume that the income-inequality
relationship is same across countries: unsatisfactory
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The Latin Effect: highest inequality levels are in middle-income
countries. Most of these are in Latin America. So is the inverted-U
due to the Latin Effect?
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Once structural differences across countries are controlled for,
inverted-U vanishes (Deninger and Squire, 1996)

There can be three types of income growth:
 Uniform growth: accumulation of wealth, annual raises, productivity
changes over time, etc.
 Uneven growth: specific sectors take-off (software, bio-tech, etc),
creating demand for certain types of skills only  inequality
increasing
 Compensatory growth: eventually incomes diffuse into the greater
economy, creating demand for other goods (houses, cars, vacations,
etc), education, and skills  inequality reducing

If uneven changes occur at low income levels, and compensatory
changes at high income levels, we can give the inverted Uhypothesis some theoretical foundation

Consider the following two scenarios:
 Individual A earns $55,000 per year, while individual B earns
$5,000 per year
 Individuals A and B each earn $30,000 per year

In the above example,
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Total income is the same for both scenarios ($60,000 per year)
Average income is same for both scenarios ($30,000 per year)
But distribution of income is obviously different
Consumption and savings patterns will also be different
What matters for inequality is the marginal savings rate
 The amount saved from an additional dollar of income
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The relationship between inequality and
savings depends on the relationship between
savings and income
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Relevant question: what is the relationship
between savings and income?
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Low levels of income:
 Subsistence needs are high and there is not much to
save
 Savings rate could be low or even negative

Middle income levels:
 Savings rates are high, as middle class people are
guided by aspirations of upward mobility
 Save for future generations

High levels of income:
 Conspicuous consumption is high, so marginal savings
rates are low
 “Need” for additional savings are also low
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If the government follows policies to reduce
inequality, how does it affect savings and
growth?

In an extremely poor country, “redistributive”
policies may reduce savings and growth
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In a rich country, “redistributive” policies may
increase the savings rate and growth
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So, should poor countries tolerate inequality in
the interests of growth?
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The idea: high levels of inequality create political
demands for redistribution
 How does this affect growth?
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Redistribution can take two forms:
 Redistribute existing wealth among the population
▪ Land Reform, confiscatory taxes
 Redistribute increments of new wealth among the
population
▪ Tax on increments to wealth, income, profits, etc.
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Redistributing existing wealth is very difficult,
both politically and economically
 Information needed on who holds most of the wealth
and in what form
 Government officials sometimes hold most of the
economy’s wealth
 Large landowners or the very wealthy often act as
vote banks (political donations, influence over
communities, etc)
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Most governments therefore choose to
redistribute increments of wealth and income
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On problem with empirical exercises between
inequality and growth is that of causality
 Both are determined endogenously in the
development process
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One way to deal with this:
 Use data on some initial measure of inequality
and subsequent years of growth
 What is a good measure of initial inequality:
wealth, income, or land?
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Social norms and legal institutions ensure
that markets work (act of buying and selling)
However, when transactions are spread over
time (borrowing and re-paying debt), social
mechanisms are far weaker
Markets cannot function unless there is
 a clear statement of a social contract
 a well-defined mechanism for punishing
deviations from the “norm”
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Access to credit markets is important for all kinds of
economic activity
 Investment, education, health, etc.

What determines the degree to which an individual
may have access to credit markets?
 Amount of collateral
 How future is valued relative to the present
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A missing or imperfect credit market for the poor is a
fundamental characteristic of unequal societies, and
the macroeconomic implications can be severe
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There is an economy with three possible
occupations: subsistence worker, industrial
worker, and entrepreneur
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Subsistence and industrial workers do not need
any set-up capital
▪ Subsistence workers produce a fixed amount z with their
labor
▪ Industrial workers can earn a wage w
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The entrepreneur sets up a business that hires
industrial workers, but requires start-up capital
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How much loan can the entrepreneur get to
start the business?

More importantly, can the entrepreneur get a
loan at all?
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What are the conditions that would
determine this outcome?
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Suppose that the startup cost of the business is given
by I.
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The business consists of hiring m workers at a wage w,
to produce output q
 Profits equal q-wm
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If the loan is repaid with an interest rate r, then net
profit is (q-wm)-(1+r)I
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Suppose that the entrepreneur has an initial level of
wealth W, which he/she can put up as collateral to get
the loan
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Suppose that the expected cost of default on
the loan is a penalty F (example:
imprisonment) and a fraction  of the profits
from the business
  is a fraction because it may not be possible for
the lender to appropriate all profits
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Will the entrepreneur re-pay the loan?
The loan will be re-paid if
I (1  r )  W (1  r )  F  q  mw
 Re-arranging the above expression,
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F  q  mw
W I
1 r
 Right-hand side represents a threshold level of initial
wealth beyond which lenders would be willing to lend
 Individuals who start with an initial wealth less than this
threshold cannot become entrepreneurs, even if they
want to
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F  q  mw
W I
1 r
Smaller are the values of F and  , the more
stringent is the requirement for initial wealth
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In the case where F = 0 and  = 0, credit markets
break down, and the business has to be financed
completely by initial wealth
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If wages are low, then the minimum wealth
requirement falls
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Assume that there is an initial distribution of
wealth in the economy
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This initial distribution determines who can
be an entrepreneur and who cannot
 Individuals with initial wealth above the threshold
become entrepreneurs
 Individuals with initial wealth below the threshold
either join the subsistence sector or become
industrial workers
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Entrepreneurs create a demand for labor
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Workers create a supply of labor
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These joint decisions determine the equilibrium wage
rate
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A new stream of profits are generated for
entrepreneurs, given the equilibrium wage rate
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This determines the distribution of wealth and income
in the next period…and the process keeps repeating
itself
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If some workers in the industrial sector or subsistence
sector could become entrepreneurs, then this would
increase the demand for industrial workers and lower
inequality
 But this cannot happen because of lack of access to credit
markets
 This implies that lack of credit markets generate an
“inefficient” level of inequality
▪ Since there is a possibility to make some people better off without
making someone worse off
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If there are a lot of people in the subsistence
sector, then equilibrium wages are low
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Profits for the (few) entrepreneurs are high
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Subsistence and industrial workers are unable
to accumulate wealth (due to low wages)
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Inequality becomes history-dependent and
persistent over time
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What prevents non-entrepreneurs from
accumulating wealth so that, over time, the
borrowing threshold can be satisfied?
 Why can’t everyone become entrepreneurs in the
long run?
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Think of the “start-up” costs, I: these could
include experience, skills, certain levels of
education and human capital
 These costs can increase with development
 Lack of credit markets can also prevent individuals
from making human capital investments