1. Chapter 7

2.  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

3.  The relationship between inequality and  per-capita income: the inverted U-hypothesis  savings  political redistribution  credit markets

4.  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”

7.  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

8.  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)

9.  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

10.  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

12.  The relationship between inequality and savings depends on the relationship between savings and income  Relevant question: what is the relationship between savings and income?

13.  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

15.  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?

17.  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.

18.  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

20.  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?

22.  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”

23.  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

25.  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

26.  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?

27.  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

28.  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?

29.  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

30.  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

31.  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

32.  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

33.  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

34.  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

35.  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