Presentation on theme: "Chapter 7. Majority of the world’s population has access to very limited resources With low incomes distributed unequally, consequences for poverty."— Presentation transcript:
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
The relationship between inequality and per-capita income: the inverted U-hypothesis savings political redistribution credit markets
What is the relationship between inequality and per-capita income? (Kuznets, 1955) 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: 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 Other functional forms can also fit the inverted U-hypothesis: we need a theory of inequality to tell us what to test Cross-sectional studies assume that the income-inequality relationship is same across countries: unsatisfactory TheLatin Effect 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? 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 Uniform growth: accumulation of wealth, annual raises, productivity changes over time, etc. Uneven growth: Uneven growth: specific sectors take-off (software, bio-tech, etc), creating demand for certain types of skills only inequality increasing Compensatory growth: 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 U- hypothesis 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, 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 marginal savings rate What matters for inequality is the marginal savings rate The amount saved from an additional dollar of income
The relationship between inequality and savings depends on the relationship between savings and income Relevant question: what is the relationship between savings and income?
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
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 In a rich country, “redistributive” policies may increase the savings rate and growth So, should poor countries tolerate inequality in the interests of growth?
The idea: high levels of inequality create political demands for redistribution How does this affect growth? Redistribution can take two forms: existing Redistribute existing wealth among the population ▪ Land Reform, confiscatory taxes increments Redistribute increments of new wealth among the population ▪ Tax on increments to wealth, income, profits, etc.
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) Most governments therefore choose to redistribute increments of wealth and income
On problem with empirical exercises between inequality and growth is that of causality Both are determined endogenously in the development process 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?
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”
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 A missing or imperfect credit market for the poor is a fundamental characteristic of unequal societies, and the macroeconomic implications can be severe
There is an economy with three possible occupations: subsistence worker, industrial worker, and entrepreneur 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 The entrepreneur sets up a business that hires industrial workers, but requires start-up capital
How much loan can the entrepreneur get to start the business? More importantly, can the entrepreneur get a loan at all? What are the conditions that would determine this outcome?
Suppose that the startup cost of the business is given by I. The business consists of hiring m workers at a wage w, to produce output q Profits equal q-wm If the loan is repaid with an interest rate r, then net profit is (q-wm)-(1+r)I Suppose that the entrepreneur has an initial level of wealth W, which he/she can put up as collateral to get the loan
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 Will the entrepreneur re-pay the loan?
The loan will be re-paid if Re-arranging the above expression, 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
Smaller are the values of F and, the more stringent is the requirement for initial wealth In the case where F = 0 and = 0, credit markets break down, and the business has to be financed completely by initial wealth If wages are low, then the minimum wealth requirement falls
Assume that there is an initial distribution of wealth in the economy 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
Entrepreneurs create a demand for labor Workers create a supply of labor These joint decisions determine the equilibrium wage rate A new stream of profits are generated for entrepreneurs, given the equilibrium wage rate This determines the distribution of wealth and income in the next period…and the process keeps repeating itself
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
If there are a lot of people in the subsistence sector, then equilibrium wages are low Profits for the (few) entrepreneurs are high Subsistence and industrial workers are unable to accumulate wealth (due to low wages) Inequality becomes history-dependent and persistent over time
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? 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