Lect 2 rev - determinants and consequences of inequality copy


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  • Even if one just looks at average incomes, it’s apparent that the majority of the world’s population has little access to resources
  • Income inequality: Gini coefficient; range: 0, 100. Source: University of Texas Inequality Project - UTIP (version EHII 2.3), Galbraith, J.K. and Kum, H. (2004). ‘Estimating the Inequality of Household Incomes: A Statistical Approach to the Creation of a Dense and Consistent Global Data Set’, UTIP working paper No.22 , May, available at: http://utip.gov.utexas.edu . They are estimates of gross household income inequality , computed from a regression relationship between the Deininger & Squire (1996) inequality measures and the UTIP-UNIDO pay inequality measures, controlling for the source characteristics in the D&S data and for other relevant variables. In particular, the estimated Gini is simply: EG = α + β*T + γ *X, where EG stands for estimated household income inequality. T represents the measured dispersion of manufacturing pay, and X is a matrix of conditioning variables including dummies for the three types of data source (gross or net income/expenditure; household versus per capita; income versus expenditure), and other relevant economic variables. These are (a) the ratio of manufacturing employment to population, (b) the share of urban population (urban), and (c) population growth rate.
  • In the initial phase, inequality widens; later, as everybody else catches up, inequality falls Kuznets made several important assumptions influencing his conclusions: (1) per capita income is always higher in the nonagricultural sector; (2) population in the agricultural sector declines over time; and (3) inequality in the agricultural sector may be as wide, but not wider than in the nonagricultural sector. If the nature of sectoral imbalances leads to widening inequality as population shifts from rural to urban production, what causes the reversal of this trend? Kuznets’s answer was rooted in (a) compositional effects; and (b) institutional transformations resulting from the political and sociological dynamics of the production process. But Kuznets also emphasized some institutional features of an urban economy. Kuznets (1955: 17) argued that “the major offset to the widening inequality . . . must have been a rise in the income share of the lower groups within the nonagricultural sector of the population.” This is accomplished through the institutional and political changes inherent in “the dynamism of a growing and free economic society.” In other words, the dislocating effects of the industrial revolution eventually give way to social and political organization among lower strata, ultimately leading these groups into greater absolute and relative economic shares.
  • Kuznets’s central purpose was to establish the character and causes of secular trends in the size distribution of income, and specifically to question whether income inequality increases or decreases during the process of economic growth. Data limitations imposed the use of an inequality measure calculated as ratio of the richest 20% over bottom 60% income share The comparison included only India, Sri Lanka and Puerto Rico (LDCs), as well as USA and UK (DCs)
  • S i is the income share of the i -th quintile, y is the log of per capita GNP When using country-specific dummies, the Kuznets curve vanishes; GNP coefficients sings are wrong and insignificant Structural differences across countries or regions might create the illusion of an inverted-U (ii) imperfect measurement of inequality;
  • Galor and Zeira, 1993; Banerjee and Newman, 1993
  • Ray 1998, chapter 7 Markets preserve or widen inequality, and have no intrinsic mechanisms to correct economic inequality Historical inequalities perpetuate themselves if luxury good in capital intensive. “Trickle down” hypotheses are thus unsound. But if luxury good is labour-intensive, historical inequalities are self-correcting: inequality raises the demand for L relative to K, which leads to higher wages and a reduction of inequality in the future.
  • In addition to its impact on earning power, schooling is seen as a social equalizer. A large body of empirical research has been conducted on the effect of education on income inequality. For example, Knight and Sabot (1983) observe that there are two effects of educational expansion on income inequality: the composition effect , raising the earnings of those who are more educated, tends to increase income inequality, and the wage compression effect , which follows the expansion of the educated labor supply relative to demand, tends to decrease income inequality. Checchi (2004) finds that average years of education have a strong negative effect on income inequality. Thomas et al., 2000; Checchi, 2004
  • Democracy variables have been found to be negatively correlated with income inequality; see Li et al. (1998) and Lundberg and Squire (2003). (iii) mechanism has been emphasised by Rodrik (1999), who finds that democratic countries tend to pay higher wages and have a larger labour share. Read Morrison C., (2006), “Institutions, Factor Endowment and Inequality in Ghana, Kenya and Senegal”, in de Janvry A. and Kanbur R. (eds.), Poverty, Inequality and Development: Essays in Honour of Erik Thorbecke , Springer Jolly R., (2006), “Inequality in Historical Perspective”, UNU-WIDER Research Paper No. 32 , March Angeles L., (2007), “Income Inequality and Colonialism”, European Economic Review, forthcoming Robinson J. and Sokoloff K.L., (2004), “Historical Roots of Inequality in Latin America and the Caribbean”, in De Ferranti D., Perry G., Ferreira F.H.G., Walton M. (eds.), (2004), Inequality in Latin America and the Caribbean: Breaking with History? , World Bank
  • Read Morrison C., (2006), “Institutions, Factor Endowment and Inequality in Ghana, Kenya and Senegal”, in de Janvry A. and Kanbur R. (eds.), Poverty, Inequality and Development: Essays in Honour of Erik Thorbecke , Springer Jolly R., (2006), “Inequality in Historical Perspective”, UNU-WIDER Research Paper No. 32 , March Angeles L., (2007), “Income Inequality and Colonialism”, European Economic Review, forthcoming Robinson J. and Sokoloff K.L., (2004), “Historical Roots of Inequality in Latin America and the Caribbean”, in De Ferranti D., Perry G., Ferreira F.H.G., Walton M. (eds.), (2004), Inequality in Latin America and the Caribbean: Breaking with History? , World Bank
  • Lee C-S., Nielsen F., and Alderson A.S., 2007, “Income Inequality, Global Economy and the State”, Social Forces, 86(1): 77-111, September This is because foreign capital penetration in this sector creates only a small well-paid labor force and because ownership of natural resources is typically concentrated. Other instances: Agricultural sector: foreign capital investment in the agricultural sector producing internationally traded commodities destroys traditional production processes and leads to unemployment and overurbanisation through its capital-intensive means of organization (i.e. labor shedding, land enclosure). Manufacturing sector: foreign investment in the manufacturing sector producing for the world market may lead to higher levels of income inequality because profits in this sector are increased by the maintenance of a large low-wage labor force (Bornschier and Chase-Dunn, 1985)
  • Lect 2 rev - determinants and consequences of inequality copy

    1. 1. 1Determinants and consequences of InequalityAim: Explaining the evolution of inequality across countriesand over time• What are the major factors affecting income inequality?• And why is income inequality important for developingeconomies?• If, in low-incomes economies, income is also distributedunequally, poverty and undernutrition are rife• The capacity to work and save are affected, bearingconsequences for national incomeOutline• 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
    2. 2. 2Inequality trends
    3. 3. 31.Kuznets’ hypothesis• Development is fundamentally an uneven process: it pullsup certain groups first and leave the other groups to catchup later• Hypothesis: economic progress, measured by income percapita, is initially accompanied by rising inequality, but thesedisparities disappear as the benefits of developmentpermeate more widely, i.e. Inequality follows an inverted-Upattern• The observed trajectory of inequality was the effect of acompositional effect resulting from population shifts fromrural to urban areas.• Inequality widens in the early stages of growth as aconsequence of demographic shifts in national populationsfrom rural/agricultural to urban/industrialized production.
    4. 4. 4Kuznets curve: empirical evidence
    5. 5. 5Kuznets’ hypothesis: empirical evidence• Two approaches: (i) tracking individual countries over time;(ii) examine variations in inequality across countries that areat 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 variationin inequality, while other omitted factors could get in theway;• Kuznets’ hypothesis constituted a useful starting point toinvestigate the role of factors behind the inequality-incomerelationship, but the inequality-income relationship is not asimple one
    6. 6. 62.Credit market imperfection (and wealth)• In principle, rich and poor can invest in capital• But the presence of credit constraints arising frominformation asymmetries limits the ability of individuals tomake productive investments in physical or human capital.In these circumstances, ownership of a collateral assetscan provide access to formal credit markets and cheapercredit.• Since the rich are more likely to own collaterable assets,the cost of investing to the poor typically exceeds that tothe rich• Thus the poor have less incentive to invest in capital andface higher costs of financing investments
    7. 7. 3. Inequality begets inequality• Initial inequality leads to the same or a greater level of inequalityIdea: demand composition matter• Income determines the composition of consumption (luxury vs.mass consumptions goods).• The pattern of consumption expenditure affects the distribution ofincome via demand composition of inputs (see figure).• Unequal economies register a proportionately larger demand forluxury 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 massconsumption good).• Hence, the greater demand for the luxury good translates intogreater demand for K, which raises the return to K and therebymaintains or magnifies initial inequality.7
    8. 8. 3. Inequality begets inequality 28
    9. 9. 94.Education• The average level of education is often taken to be amajor determinant of inequality.• 1streason: A greater supply of skilled labour tends toreduce the skill premium and hence reduces inequality inthe distribution of labour incomes, Li et al. (EJ 1998).• 2ndreason: For a given return to education, a more equaldistribution of years of schooling would result in lessinequality.• Education expansion is likely to increase proportionallythe education of all agents, and hence could in principlemake the distribution of years of education less unequal.• The empirical evidence indicates that countries with ahigher average educational attainment have a lower Giniindex of years of education
    10. 10. 105.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 incomeshare or protects their wealth.• A rich elite can influence economic policy through the votingmechanisms, through its economic power (bribes), orthrough direct political control (most political leaders aremembers of this group)• Elites increase their incomes as: (i) they seize assets andthus increase their endowments; (ii) acquire monopolypower by isolating their own enterprises from domestic andforeign competition; (iii) or because of monopsony powerthey affect the way in which the labour factor is rewarded.• Democratisation  increase in political accountability andextent of education  loosing privileges for the former elite.
    11. 11. 6. Colonial History matters• Structural, historical inequality: originates from conquest,colonization, slavery and land distribution by the state orcolonial power• Agricultural endowments  structural inequality  badinstitutions and low human capital investment persistence of inequality• Latin America economies: plantations, minerals andforced labour• North America: homogeneous population of Europeans,small family farms• Soil suitability: sugarcane vs. wheat11
    12. 12. 7. Dependence on foreign capital• The structure of the economy matters.• Penetration of and dependence of foreign capital increases incomeinequality by creating a dualistic occupational structure indeveloping economies, with a highly paid elite (in the internationalsector) and large groups of marginalised workers (left out of theinternational sector).• For instance, in an economy with a large extractive sector (minerals,oil), foreign investment benefits only a small portion of the nationalpopulation and thereby increases income inequality.• A role for the state? Governments, to attract and maintain foreigninvestment, implement policies that decrease the power of labor andinhibit vertical mobility. These include tax concessions, guaranteesof profit repatriation, and labor laws unfavorable to workers.• State capacity to control and regulate foreign capital penetration andactivities within its borders or to use tax and social policies as themoderating factor to curb the raise of inequality. 12