1. 1
Determinants and consequences of Inequality
Aim: 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

2. 2
Inequality trends

3. 3
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.

4. 4
Kuznets curve: empirical evidence

5. 5
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

6. 6
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

7. 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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8. 3. Inequality begets inequality 2
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9. 9
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

10. 10
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.

11. 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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12. 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. 12