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
 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: 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
 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
 Cross-sectional studies assume that the income-inequality
relationship is same across countries: unsatisfactory
 The Latin Effect:
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:
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 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
 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:

 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.
 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
I (1  r )  W (1  r )  F   q  mw
 Re-arranging the above expression,
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
 F    q  mw
W I
1 r
 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