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Determinants and consequences of InequalityAim: Explaining the evolution of inequality across countries

and over time• What are the major factors affecting income inequality?• And why is income inequality important for developing

economies?• If, in low-incomes economies, income is also distributed

unequally, poverty and undernutrition are rife• The capacity to work and save are affected, bearing

consequences for national income

Outline• Determinants of inequality: Kuznets’ hypothesis, Demand composition,

Education, Institutions, Credit market, Colonial history, Trade openness • Consequences of inequality: economic growth, political stability,

education and crime

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Inequality trends

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1.Kuznets’ hypothesis • Development is fundamentally an uneven process: it pulls

up certain groups first and leave the other groups to catch up later

• Hypothesis: economic progress, measured by income per capita, is initially accompanied by rising inequality, but these disparities disappear as the benefits of development permeate more widely, i.e. Inequality follows an inverted-U pattern

• The observed trajectory of inequality was the effect of a compositional effect resulting from population shifts from rural to urban areas.

• Inequality widens in the early stages of growth as a consequence of demographic shifts in national populations from rural/agricultural to urban/industrialized production.

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Kuznets curve: empirical evidence

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Kuznets’ hypothesis: empirical evidence• Two approaches: (i) tracking individual countries over time;

(ii) examine variations in inequality across countries that are at different stages in the development process (cross-section studies)

• Scepticism: • (i) the data exhibit too much variation to support an

‘ineluctable law’; i.e. income alone can explain little variation in inequality, while other omitted factors could get in the way;

• Kuznets’ hypothesis constituted a useful starting point to investigate the role of factors behind the inequality-income relationship, but the inequality-income relationship is not a simple one

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2.Credit market imperfection (and wealth)• In principle, rich and poor can invest in capital

• But the presence of credit constraints arising from information asymmetries limits the ability of individuals to make productive investments in physical or human capital. In these circumstances, ownership of a collateral assets can provide access to formal credit markets and cheaper credit.

• Since the rich are more likely to own collaterable assets, the cost of investing to the poor typically exceeds that to the rich

• Thus the poor have less incentive to invest in capital and face higher costs of financing investments

3. Inequality begets inequality• Initial inequality leads to the same or a greater level of inequality

Idea: demand composition matter• Income determines the composition of consumption (luxury vs. mass

consumptions goods).• The pattern of consumption expenditure affects the distribution of income

via demand composition of inputs (see figure).• Unequal economies register a proportionately larger demand for luxury

goods. • Agents own the same amount of L, but different amounts of K. Individuals

owning more K enjoy a larger income. • Assume luxury good is capital-intensive (relative to mass consumption

good). • Hence, the greater demand for the luxury good translates into greater

demand for K, which raises the return to K and thereby maintains or magnifies initial inequality.

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3. Inequality begets inequality 2

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4.Education• The average level of education is often taken to be a

major determinant of inequality.

• 1st reason: A greater supply of skilled labour tends to reduce the skill premium and hence reduces inequality in the distribution of labour incomes, Li et al. (EJ 1998).

• 2nd reason: For a given return to education, a more equal distribution of years of schooling would result in less inequality.

• Education expansion is likely to increase proportionally the education of all agents, and hence could in principle make the distribution of years of education less unequal.

• The empirical evidence indicates that countries with a higher average educational attainment have a lower Gini index of years of education

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5.Political and economic institutions• Role of democratisation or political liberties • Limited civil liberties allow the top income group (a minority)

to affect public policies in a way that increases their income share or protects their wealth.

• A rich elite can influence economic policy through the voting mechanisms, through its economic power (bribes), or through direct political control (most political leaders are members of this group)

• Elites increase their incomes as: (i) they seize assets and thus increase their endowments; (ii) acquire monopoly power by isolating their own enterprises from domestic and foreign competition; (iii) or because of monopsony power they affect the way in which the labour factor is rewarded.

• Democratisation increase in political accountability and extent of education loosing privileges for the former elite.

6. Colonial History matters

• Structural, historical inequality: originates from conquest, colonization, slavery and land distribution by the state or colonial power

• Agricultural endowments structural inequality bad institutions and low human capital investment persistence of inequality

• Latin America economies: plantations, minerals and forced labour

• North America: homogeneous population of Europeans, small family farms

• Soil suitability: sugarcane vs. wheat

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7. Dependence on foreign capital

• The structure of the economy matters. • Penetration of and dependence of foreign capital increases income

inequality by creating a dualistic occupational structure in developing economies, with a highly paid elite (in the international sector) and large groups of marginalised workers (left out of the international sector).

• For instance, in an economy with a large extractive sector (minerals, oil), foreign investment benefits only a small portion of the national population and thereby increases income inequality.

• A role for the state? Governments, to attract and maintain foreign investment, implement policies that decrease the power of labor and inhibit vertical mobility. These include tax concessions, guarantees of profit repatriation, and labor laws unfavorable to workers.

• State capacity to control and regulate foreign capital penetration and activities within its borders or to use tax and social policies as the moderating factor to curb the raise of inequality.

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