Inequality and Development

Why inequality is important?

• Normative reasons
• Functional reasons
– Inequality affects the way economy works
• More important in developing countries
– Effects of inequality on aggregate economic
performance are stronger
 Endowments of goods,
inputs and shares

Borrow and exchange

lend

Demand and
supply equated
Education
Wealth

Endowments of goods,
inputs and shares

Today’s distribution gets repeated tomorrow

Economic growth and inequality related
Does inequality get reduced over time?
 Inverted U hypothesis
• Simon Smith Kuznets (1901-1985)
• American economist
• Nonel Prize in Economics - 1971
• Kuznets- 1955
• Measure of inequality
– Ratio of income of richest 20% of population to that of
poorest 60% of the population
• India – 1.96
• Srilanka - 1.67
• United States – 1.29
• United Kingdom – 1.25
 Sequential process of Economic
Developent
• Economic development is fundamentally
sequential
• Pull up certain groups first and leave other groups
to catch up later
• Initial phase- inequality widens
• Later, everybody else catches up
– Development permeate more widely
• Inequality falls
• Grow first, distribute later
• Trickle down
 Inequality and growth

inequality

Per capita income

 Thomas Piketty
• Capital in the Twenty-First Century by Thomas Piketty (Cambridge,
Massachusetts: Harvard University Press), 2014
• Kuznets curve highly misleading
– limited by the short range of data Kuznets looked into
– misleading about historical trends when seen in the larger perspective
• Instead it shows that the wealth-income ratio and the associated
inequality was high in industrially advanced countries until about
the first world war, then declined and stabilised in the period 1910-
70
• income gap in recent years between even the top 0.1% and the
remainder of the top 10% has been far wider than that between
the top 10% and average income earners
 Reasons for inequality
• Spectacular increase in inequality
• One possible explanation of this is that the skills and
productivity of top managers rose suddenly in relation
to those of other workers
• Another explanation, seems more plausible and turns
out to be much more consistent with the evidence, is
that these topmanagers by and large have the power
to set their own remuneration, in some cases without
limit and in many cases without any clear relation to
their individual productivity, which in any case is very
difficult to estimate in a large organization
• inequality inherent in the booming capital incomes concentrated at the
very top
• return of high capital/income ratios over the past few decades can be
explained in large part by the return to a regime of relatively slow
growth
• Large capital owners gain more than small capital owners
– income from wealth is more concentrated than wealth itself
• capital reproduces itself faster than output increases
r = long run rate of return on capital
g = long run rate of growth / steady state growth
r > g , excepting for the period 1910-50

 inherited wealth will dominate wealth amassed from a lifetime’s labor by a

wide margin
 the process by which wealth is accumulated and distributed contains
powerful forces pushing toward divergence
 Forces of divergence is more powerful than forces of convergence
 Solution
• Global wealth tax?
• In India, in 2002-03 the top 1% in India held
about 16% of wealth
• India abolished the inheritance tax (estate
duty) in 1985.
Tunnel Effect
 Tunnel Effect
• Hirschman and Rothschild
• Tolerance for inequality in income distribution
• Social and political upheaval
• Individual’s response to such an improvement
will depend on his beliefs as to what it implies
to his own prospects
• Increase in individual’s utility resulting from
an improvement in other’s economic status
– Tunnel effect
 Acceptance of Tunnel Effect
• Acceptance of improved condition of others
– Perceived link between growing fortunes of others and
growth of own welfare
– Greater the segregation in society weaker the link
– Anger and frustration
• Development strategy has to be devised by
keeping in mind the social and political context
• Weaker the tunnel effect (lower tolerance of
inequality)
– ‘Grow first and distribute later’ does not work
– Institutional issues??
 Types of income growth
• Even and placid process
– People accumulate wealth
– Acquire skills
– Exhibits steady gains in work productivity
– 2-3% annual raises for everyone
• Uneven process
1. Some sector takes off
• Increase in demand for specialized skills
• Growth
• Inequality
2. “compensatory” changes
• Incomes spreads throughout the economy as demand for
all sorts of other goods and service rise
• More people acquire specialized skills
• Income grains evenly throughout society
 Development in “dual economy”
• Economically backward and progressive sectors
coexist
• Development process of advanced sector propel
backward sector
• Technical progress biased against unskilled labour
and drive down relative wage
• Slower process of “compensatory” changes of
labour through education (financed by higher
wage)
• But labour surplus economy, wages do not rise
• Laws absent or ineffective to protect labour
• Complexity of path
• How traditional sector will grow?
• Does growth in traditional sector depend on
growth of modern sector?
• Role of traditional sector in growth?
• Where is the limit for growth?
 Rural-Urban Structural Transformation

• Agriculture as supplier to industry

– Food
– Labour
• Industry as supplier to agriculture
– Inputs: tractors, pump sets, chemicals
– Final consumption goods
• Supports each other in earning and spending
foreign exchange
 Formal and Informal Sector
• Formal and informal urban sectors
– Entry in formal sector costly
• Laws (labour, corporate) and insurance
– Entry in informal sector relatively easier
• Labour laws not binding
• Tax laws relaxed / not implemented
• Informal sector
– Nonunionized, nonprofessional
– Lack of access to credit from formal institutions
• Modern and traditional sector?
• The dual economy
 The Lewis model
• Sir Arthur Lewis (1915-1991)
• Parents migrated from West Indies
• Studies and worked in United Kingdom
• Outlined fundamental resource flow
• Nobel Prize – 1979
• Traditional sector: agricultural sector
– Older techniques of production/ less capital
– Labour intensive
– Family labour Production
• Modern sector: industrial sector method
– New technology
– Use of capital organization
– Wage labour
 Family labour
• Family farm values
• Each members receives share of output
• Sharing rules shelter family members from
difficulties of finding employment elsewhere
– Mutual insurance
• Urban informal sector
– Neighborhood store run by joint family
 Movement of surplus labour
• Movement of labour from traditional to modern
sector
• Unlimited labour supply
• No opportunity cost of migration from traditional
to modern
– No loss of traditional sector output as labour supply is
reduced
• Surplus labour would be absorbed by the
modern sector to the extent capital is available
• Capital accumulation in modern sector becomes
engine of development
 Surplus labour
• Land fixed
• Diminishing returns to labour input
• Employs beyond marginal product equals “wage”
output

Evidence from agricultural

sector of India, Egypt,
Jamaica
Casual jobs in urban
Latin America large farms
and family farms
Why people do not
migrate/ hire out?
How is it possible that
MP=0 but “wage” is positive
Marginal product = 0
Surplus labour labour
Less labour, no change in output
 Answers
• Family labour
– Family norms and values
– “wage” is not real market wage but average product
• Migration
– Only if average product (“wage”) in traditional activity
equals (or <=) marginal product (wage) of other sector
• Marginal product is not 0 in traditional activity
• Different individuals specialized in different jobs
 New Concept of Surplus Labour
• Disguised unemployment
– Difference between existing labour input in
traditional activity and labour input that sets
marginal product equal to wage
• Surplus labourers not labour
 Surplus labour
4 hrs x 10 labourers = 40 lab hrs
8 hrs x 5 labourers = 40 lab hrs

output Disguised unemployment = 4 hrs x 5 lab = 20 hrs

labour
Disguised Surplus labour
unemployment
 How to maintain output?
• Remove labourers not labour
– Remaining labourers in traditional activity would
adjust their labour input once labourers are
removed
– Increase in work effort
– Total output same
• Full compensation of labour for the lost
worker
• Marginal cost of working on the farm constant

• Opportunity cost of labour rises as more and

more labour migrates
– No full compensation of work by surplus labourer
 Ranis and Fei

• Transfer of labour from agriculture to industry

• The simultaneous transfer of surplus food-
grain production, which sustains that part of
labour force engages in nonagricultural
activity
• Minimum cost of hiring labour to industry
• Supply curve of labour to industry
 Basic Structures
• Surplus labour
• Disguised unemployment
• Wage rate by income sharing
• Capitalist industrial sector
• Total labour force divided between agriculture
and industry
Average Agricultural
Surplus

W* Average surplus

Constant surplus
Declining surplus Declining surplus

Industrial labour
 Industrial wage

W**

Industrial labour
 Constraints on Growth

• Capital accumulation in industrial sector is engine

of growth
• More labour employed
• Increase in price of food
• Increase in industrial wage
• Pace of development driven by capital
accumulation but limited by the ability of
economy to produce a surplus food
• Expansion of industrial sector depends on
production conditions in agricultural sector
 Policy Issues: Agricultural Taxation
• Taxation keeps agricultural income low and wage
rate would fall
• If no tax, rise in agricultural income will need rise
in industrial wage to keep migration continued
• Small farmers
– would not prefer taxation
• Large farmer
– might prefer taxation if they employ significant amount
of labour and can evade tax
• Industrialist
– prefer taxation
• Industrial workers
– would not prefer taxation
 Policy Issues: Agricultural Pricing
Support price for agriculture

• Increase marketed surplus

• Subsidy to consumers
– Lower price for urban consumers
– Lower industrial wage
• High procurement price
– Increase in wage rate