The fundamentals Chapter 13

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The fundamentalsChapter 13

• Inequality and economic growth

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Plan

• Measuring Inequality
• Level of economic development and inequality
  Some facts
• Explaining inequality
• The effect of inequality on growth
• Intergenerational mobility

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1. Measuring Inequality

• Two useful methods
• Divide population in equal size groups and then
  measure average income for each group (or of
  total income earned).
• Divide income in equal-size intervals and measure
  population size for each interval. (Gini
  coefficient)

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Method 1
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Method 2
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The Lorenz curve and the Gini coefficient

• The two previous methods are difficult to use for
  making comparisons.
• The Lorenz curve
• Plots cumulative of households income against
  cumulative of households.
• Perfect equality implies a straight 45 line.
• Greatest inequality implies a straight horizontal
  line at 0 income (one household receives all
  income).

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The Gini coefficient

• The Gini coefficient measures the ratio of two
  areas Area between Lorenz curve and perfect
  equality line divided by area below perfect
  equality line.
• 0.466 for the USA

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2. Some facts about inequality and development

• The Kuznets Hypothesis As a country develops,
  inequality initially increases but falls later
  on.
• Is it empirically supported?

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The Kuznets curve across time
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The Kuznets curve across space
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The Kuznets curve

• No strong evidence from Fig 13.5.
• More advanced econometric studies (i.e.
  controlling for other factors) suggest the
  presence of a Kuznets curve. Turning point
  around 5,000.
• Issue still unresolved.

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The effect of growth on poverty

• Is economic growth good for the poorest of a
  country?
• The Kuznets curve does not help to answer
• At the initial stages of development, if higher
  average income is accompanied by higher
  inequality, the poorest could be made better or
  worse off.
• We need to dig deeper.
• Dollar and Kray (2002)
• Average income of poorest quintile
• against average income for country.
• Covers 1956-1999
• 137 countries
• Three observations per country on average

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The effect of growth on poverty

• An example from Dollar and Kray (2002)
• Mexico 1989
• Average income of poorest quintile 1,932
• Average income for country 8,883
• South Korea 1988
• Average income of poorest quintile 3,812
• Average income for country 8,948
• Taiwan 1975
• Average income of poorest quintile 1,925
• Average income for country 4,854
• Mexico is much more unequal than South Korea and
  Taiwan. (Typical for Latin American countries.)
• Concerning growth, our question is
• Where would you rather be poor,
• in a rich or in a poor country?

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The effect of growth on poverty

• A further result from Dollar and Kray (2002)
• Many policies that affect growth do not seem to
  affect income distribution, i.e. the share of
  total income going to the lowest quintile remains
  more or less constant.
• Examples of policies considered include
• Openness ( on growth)
• The rule of law ( on growth)
• Inflation (- on growth)
• Government consumption (- on growth)

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3. Explaining inequality

• Why is there inequality?
• Why does it vary over time and between countries?

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Why is there inequality?

• People have different income levels because they
  have different characteristics
• Human capital
• Physical capital ownership
• Basic talent
• Skills
• Geographical location
• Also luck
• All else equal, a more unequal distribution of
  characteristics results in higher income
  inequality.
• But this is not the end of the story.

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Remunerating a characteristic

• The extent of income differences depends on how
  society remunerates the different
  characteristics.
• An example Education

• All else equal, the higher the yearly retrun,
  the higher the inequality.

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The resulting income distribution

• Income distribution depends on the mix of
• Characteristic distribution
• The reward given to each characteristic.

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A change in education returns

• Suppose that over time, returns to education
  increase from 5 to 10 per year.

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A change in education distribution

• Suppose that over time, education becomes more
  evenly distributed.

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A framework for understanding

• The above provides a good framework to think
  about inequality.
• In a developing economy, a lot of changes occur
  simultaneously
• Changes in the distribution of all sorts of
  qualities among people.
• Changes in the relative payments to all those
  qualities.
• A serious analysis must account for that.
• Difficulty Some qualities are not easy to
  measure (patience, entrepreneurship, )

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Back to Kuznets

• So why would inequality initially increase with
  growth?
• Imagine an initially poor country that opens
  itself to the rest of the world. The arrival of
  new technologies may cause
• Higher returns to education
• Higher returns to physical capital
• The privilege tend to have more of those in
  poorer countries.
• Over time, the distribution of those qualities
  may become more equal.
• Question What about freer competition?

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Evolution of inequality in the USA
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Evolution of inequality in the USA

• Why then is inequality increasing in the USA?
  Three candidates
• New technology High returns for being able to
  master information technologies. Not everyone
  can. Eventually, this effect should decreae as
  all children learns about IT.
• Trade With globalisation, the wages of
  low-skilled workers tend to allign with those of
  LDCs.
• Remuneration of superstars Enormous premium
  for being the best

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4. The effect of inequality on growth

• The theory Four channels to consider
• Accumulation of physical capital
• The accumulation of human capital
• Government redistribution
• Socio-political instability
• Empirical evidence Does inequality affect growth?

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i) The accumulation of physical capital

• We have seen that a higher savings rate leads to
  higher growth.
• Richer people tend to have a higher savings rate.
• This suggests that higher inequality may actually
  increase growth.

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ii) The accumulation of human capital

• The opposite of physical capital A more unequal
  distribution of income tends to lower investments
  in human capital. Why?
• Why?
• At the individual level, it is safe to assume
  that returns to physical capital are constant.
• But they decrease quite fast for human capital.
• That is because human capital can only be used by
  the one who owns it.

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ii) Human capital

• No individual wants to invest more than I in
  human capital.
• The rich will invest the balance in physical K.
• The poor invest all in human capital lt I.
• A more equal income redistribution increases
  growth because human K has a higher return than
  physical K.

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iii) Government redistribution

• One (rough) way to look at redistribution by
  government is by taxing all income at the same
  rate and making lump-sum transfers.
• This way, those whose income is below the mean
  receive more than they pay in taxes, and
  conversely for those above the mean. The
  inequality of disposable income is thus lower
  compared to pre-tax income.
• The farther ones income is from the mean, the
  higher the benefit from this type of taxation.
  Moreover, those with lower income will demand a
  higher tax rate.

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Redistribution and the median voter

• For all countries, the median income level is
  below the mean. (Income distribution is skewed to
  the left.) The majority will thus favour this
  type of redistributive taxation, all else equal.
• The farther the median voter is from the mean,
  the larger the pressure to increase the
  redistributive tax rate.
• Inequality tends to increase the distance between
  mean and median income.
• All else equal, higher taxation tends to lower
  efficiency as it lowers incentives to work and
  increases incentives to evade taxes (unproductive
  activities).
• Combining 1, 2 and 3, higher inequality tends to
  reduce efficiency and thus economic growth.
• This could mean that some of those whose income
  is below the mean are made worse off by
  redistribution The size of the pie versus the
  share of the pie.

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iv) Socio-political instability

• What if the majority does not
• get heard by the rulers?
• Demand for redistribution will take the shape of
  political instability, crime, large cost of
  protecting property rights, etc.
• All else equal, higher inequality results in more
  ineffciency through those types of unproductive
  activities.

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Does inequality affect growth? Some evidence

• Earlier, we have looked at how growth and
  inequality appear to be connected through the
  Kuzents hypothesis.
• The question now is whether and how inequality
  causes growth according to the data.
• The quick answer is that we dont really know
  because
• Lack of data
• Effect depends on stage and/or type of development

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Does inequality affect growth? Some evidence

• About types of development
• In countries whose growth depends mostly on
  physical capital accumulation, inequality may
  increase growth.
• In countries growing on human capital
  accumulation, the opposite may hold.

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Does inequality affect growth? Some evidence

• Because of lack of data, reserchers have turned
  to the effects of inequality on some of the
  theoretical channels just considered.
• Higher inequality tends to reduce human capital
  accumulation and increase fertility rates. This
  should contribute to reduce growth.
• A higher Gini coefficient tends to increase
  socio-political instability. (See next graphic.)
  This should reduce growth.
• Higher inequality tends to be associated with
  lower tax rates. (But that could be due to lack
  of democracy.)

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Inequality in Latin America and North America
compared

• Engerman and Sokoloff (2002) argue that
  differences in inequality are due to initial
  factor endowments, a fundamental cause.
• Latin America (and Southern USA)
• Large plantations Sugar, coffee (robusta),
  cotton,
• Mining
• Uses abundant local labor and slaves for exports.
• North America
• No large plantations
• Marginal economies (not for exports)
• Small family farms by european settlers.
• More egalitarian production and ownership of
  land.
• Demand for protection of private property and
  rule of law for all.
• Contrast Nicaragua and Costa Rica

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5) Intergenerational mobility

• IM The change of economic status of a family
  from one generation to the next.
• Two countries may have the same income inequality
  but very different IM.
• A high IM means that the children of poor
  families have about the same chances of ending up
  well off as the children of rich families, or
  conversely.
• IM is a measure of
• equality of opportunities

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The transition matrix

• Gives the probabilities of moving from one income
  group to another.

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Some determinants of economic mobility

• Access to education and health care
• Powerful interests blocking change by limiting
  entry from potential competitors
• Assortative mating What affects the decision to
  marry down? Is it important in Canada?
• Racial discrimination.

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Economic mobility and growth

• Some theories
• Positive effect since it suggests that the best
  is chosen for any job, regardless of
  socio-economic origin. Also free entry into
  markets.
• Class conflict is likely to be lower when people
  know that productive effort pays off. Less
  unproductive activities such as crime and
  political unrest.

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Conclusion

• We have seen
• How inequality is measured
• The Gini coefficient
• Some facts about the correlation between level of
  economic development and inequality
• The Kuznets curve
• The proximate sources of inequality
• Distribution of characteristics
• Rewards to the characteristics
• Theory and evidence on the effect of inequality
  on growth
• An example of a possible fundamental cause of
  inequality.
• Intergenerational mobility

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Conclusion for the course

• Questions asked
• Why are some countries rich and others poor?
• Why are Canadians so much better off today than
  one hundred year ago?
• Approach Explaining economic growth in the long
  run through
• Proximate causes
• Fundamental causes

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Conclusion for the course

• We have taken a detailed look at the proximate
  determinants of growth and income levels
• Physical capital
• Population growth
• Human capital
• Productivity
• Technology
• Efficiency
• Economic openness
• We have considered one suspected fundamental
  determinant of economic growth
• Inequality

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Conclusion for the course

• Work left for understanding why some countries
  are rich and others are poor
• Look at other fundamental determinants
• Read other chapters of Weil
• Study political-economy
• Institutions and Law and Economics
• Understand better the effects of the proximate
  determinants
• Advanced courses in macro-economics
• Advaced courses in the economics of information
  and uncertainty

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Between now and final exam

• List of assignments submitted at the tutorials.
• Tutorial this week is canceled
• One next week on this weeks assignment and other
  questions.
• One shortly before the final exam.
• Always better to submit questions by email to
  Sophie
• Format for final
• Similar to mid-terms but longer (3 hours)
• 10 multiple choice on material seen after the
  second mid-term.
• 3-4 problems covering the whole course.
• Answers need discussion, interpretations,
  explanations. (This is not a math course)

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Between now and final exam

• Know technical material, graphical and
  algebraic
• Solow model with population growth and human
  capital
• The Malthus model
• Returns to education
• Technological progress in the Solow model
• The development trap in the Solow model
• decomposing productivity into technology and
  efficiency
• Perfect capital mobility in the Solow model
• National accounts with foreign trade and
  investments
• Development accounting
• growth accounting