Inequalities and Investment
Abhijit V. Banerjee
The ideal
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If all asset markets operate perfectly,
investment decisions should have very little
to do with the wealth or social status of the
decision maker.
If someone has an opportunity to make
money, then it really does not matter whether
she herself has the money or not---she can
always borrow what she needs, and if the
risk bothers her, she can always sell the risk.
A very simple economy
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Production function: with a minimum investment of K,
output is aK
a is the productivity of the investor: uniformly distriuted
between a(0) and a(1).
Wealth distribution G(w), mean W
In a perfectly functioning economy, the marginal a, a(m)
will be such that
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K(a(1) – a(m))/(a(1) – a(0)) = W
If W/K = 1/10 for India say (implying a minimum efficient
scale of $40000 in India), then
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a(m) = a(1) – (a(1) – a(0))/20
However if capital markets are
imperfect
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Say you can only borrow up to the value of your wealth (data
suggests much less)
Then to invest $40000 you will need $20000
What fraction of Indians have $20000?
According to Davies et al. (2006): no more than 10%
Therefore the marginal investor will be such that
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a(m) = a(1) – (a(1) – a(0))/2
For a(1) = 2 and a(0) = 1, this implies that the average
productivity of those invest goes down from 1.95 to 1.5
The growth rate goes down by ½.
Who becomes an entrepreneur?
WEALTH
With credit
Constraint
Without
credit
Constraint
ABILITY
Why the distribution of wealth
matters?
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If everyone in this economy had the same wealth,
and the capital market cleared, the allocation will be
exactly as if there was a perfect capital market.
The point is that lenders do not care very much
about the productivity of the borrowers: they care
about repayment. For them there is a trade-off
between the most productive borrower and the most
reliable borrower, who is often the one who has
more money.
What do we know about the ability to
borrow
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In a perfect credit market: there is a single
interest rate and everyone can borrow and
lend as they want at that rate.
In the developing world:
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Borrowing and lending rates are very different
Lending rates vary enormously across borrowers.
Upward sloping supply of credit
The rich can borrow more at lower rates than the
poor.
Some examples
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Aleem (1990) on money-lenders in rural Pakistan
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Average lending rate is 78.5%. The lenders take deposits at
32.5%. Bank deposit rate is 10%.
The standard deviation of the interest rate was 38.14%
compared to an average lending rate of 78.5%.
The median default rate is between 1.5 and 2% and the
maximum is 10%.
The “Summary report on informal credit markets in
India” (Dasgupta, 1989) reports that the interest
rates paid goes from 33% for those with assets
above Rs. 100000, but 120% for those between Rs.
5000-10000.
Potential mitigating factors
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Very small businesses are common, and therefore presumably
profitable
– Not particularly so, because they have to cover the cost of
running the business (Banerjee-Duflo)
Firms could grow to be very large and still be productive
– Traded firms in India have an average real return of 11% for
the period 1991-2004
– Much lower than the marginal interest rate paid by the
average small/medium firm (over 30% real per annum)
The most productive firms will grow and absorb most of the
capital stock (Caselli-Gennaoli).
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This mechanism takes us to 80% of the potential productivity
Reinforcing factors: Lack of
insurance
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The ideal insurance market is one in which people
bear no avoidable risks.
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In a setting where a single village constitutes a
separate insurance market:
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Typically hurts the poor the most and discourages taking on
additional risks.
That your income fluctuations should not change your
consumption, as long as aggregate consumption is
unchanged.
Almost always rejected, to a greater or lesser
extent.
Reinforcing factors: limitation of the
land market
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The ideal land market is one where anyone
can buy or lease as much land as they want
for as long as they want at a price that only
depends on the quality of the land (and the
length of the lease).
Moreover, the lease should be at a fixed rent,
so that the lessor is the residual claimant on
the product of the land.
The evidence on land markets
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Legal constraints on land transactions:
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Land ceilings, minimum size of plots
Lack of clear titles, customary rights
Sharecropping: tenant is not residual
claimant
Preponderance of short-term leases
Reinforcing factors: the peculiarities of
the family
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Decision rights are rarely in the hands of the
person who gets the human capital.
Parent’s incentives to invest in their children
either rely on their altruism or on their faith in
their children’s willingness to pay them back.
As a result, such investments acquire many
of the characteristics of a consumption goods
The rich typically end up investing more.
Evidence of under/over-investment
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The fact that so many people in India are
willing to pay interest rates of 60% or more
and therefore must have an even higher
marginal product.
The average marginal product is not much
more than 22% (ICOR 4.7)
Therefore some people must have marginal
products that are much lower.
More evidence under/over-investment
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Direct evidence on marginal product:
– Mckenzie and Woodruff (2003): In Mexico, for firms with
less than $200 invested, the rate of returns reaches 15%
per month, Estimated rates of return decline with
investment, but remain high (7% to 10% for firms with
investment between $200 and $500, and 5% for firms
between $500 and $1,000).
– Banerjee and Duflo (2004): for firms with plant and
machinery between Rs. 6.5 million to Rs. 30 million-returns to capital in these firms must be at least 70%.
– De Mel, Mckenzie and Woodruff study the results of an
experiment in which small firms in Sri Lanka were given a
random shot of capital: returns of 4-5% per month.
Evidence from agriculture
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In the forest-savannah in Southern Ghana the standard crop is
a cassave-maize inter-crop. Recently pineapple cultivation for
export to Europe has offered a new opportunity for farmers in
this area.
In 1997 an 1998 more than 200 households in four clusters in
this area, cultivating 1070 plots were surveyed every 6 weeks
for approximately two years by Goldstein-Udry (1999).
Pineapple production first order stochastically dominates the
traditional inter-crop and the average returns associated with
switching from the traditional maize and Cassava intercrops to
pineapple is estimated to be in excess of 1,200%!
Yet only 190 out of 1070 plots were used for pineapple. The
authors say that the "The virtually unanimous response to the
question "Why are you not farming pineapple?"provided by our
respondents was "I don't have the money
More evidence from agriculture
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Binswanger-Rosenzweig (1993) estimate the relation between
the profit-wealth ratio and a measure of underlying risk, namely
the standard deviation of the date of monsoon onset, for four
different size categories of farms. The data comes from the
Indian ICRISAT villages.
The first observation is that profit-wealth ratio is the highest for
the smallest farms, and when risk is comparatively low, the gap
is more than 3:1. Because wealth includes the value of the
land, the measure implicitly takes into account differences in
the quality of the land.
The second notable fact is that when risk goes up, the average
return goes down. Specifically, a one standard deviation
increase in the coefficient of variation of rainfall leads to a 35%
reduction in the profit of poor farmers, 15% reduction in the
profit of median farmers, and no reduction for rich farmers.
Evidence on human capital
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Basta at al. (1979) study an iron supplementation
experiment conducted among rubber tree tappers in
Indonesia.. Work productivity in the treatment group
increased by 20% ($132 per year), at a cost per workeryear of $0.50. Even taking into account the cost of the
incentive ($11 per year), the intervention suggests
extremely high rates of returns.
Some other interventions (Vitamin A, deworming) suggest
very high returns.
However measured returns on education tend not to be
very high especially we focus on instances where the
data quality is good: no more than 20%
Investment efficiency and the
distribution of wealth
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Lots of people run regressions of growth on
inequality.
Depending on the specification you can get pretty
much anything you want (Banerjee and Duflo, 2004)
Moreover causality issues are huge here: growth
causes inequality, inequality causes growth, tax
policy causes both..
Therefore better to study individual channels and
assess the direct evidence for them.
Effect on aggregate investment
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If some under-invest and other over-invest, why do we think
that aggregate investment suffers?
Because the over-investment is driven by a lowered interest
rate, which lowers savings.
Because in some cases there may be no compensating overinvestment: for example when the investment is on land, the
small farmer might under-invest because he is leasing land and
the big landlord might end up under-investing because he has
too much land to work.
If this is the case land reforms might cause growth
Banerjee-Gertler-Ghatak (2002) found that a tenancy reform in
West Bengal increased productivity by 62%
The effect on the scale of investment
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Even if aggregate investment is unchanged, investment may be
at the wrong scale.
If the production function has diminishing returns to investment
inequality increases misallocation.
If it has local increasing returns, the effect depends on the size
of mean investment relative to the optimal scale.
The evidence on returns to scale is mixed: Mackenzie and
Woodruff (2003), De Mel et al. and Mesnard and Ravallion
(2001) argue for diminishing returns, while Banerjee and Duflo
(2004) suggest non-convexities but at much larger scale.
Firms in the corporate sector in India earn relatively low returns
(11%). So there is some diminishing returns at the top.
The effect on the quality of investment
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A different type of inefficiency in investment arises when
there is both inequality and heterogeneity. Then a
wealthy but inept entrepreneur may run a much bigger
firm than his poor but highly talented competitor.
An interesting example of this phenomenon comes from a
study of the knitted garment industry in the Southern
Indian town of Tirupur (Banerjee-Munshi, 2004)
Gounder entrepreneurs, who are rich but have little
industry experience invest much more (3 times as much
at the start) than other entrepreneurs, who are selected
on the basis of industry background, but end up
producing less.
What does all this add up to?
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Beyond being rather complicated (which it is..)
The distribution of wealth is surely nowhere
close to what it needs to be to induce efficient
investment.
It is not true that the only problem is that the
poor are too poor. The rich are probably too rich.
It is not true that only the poor lack capital: some
of the most underserved investments may be in
the middle.
More take-aways
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It is not true that we do not need to worry about the
rich becoming richer as long as the poor are also
getting richer:
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Rich and poor compete for resources, including capital.
Making the rich richer makes it harder for the poor to
compete with them.
This competition might reduce efficiency: there may be a
large but inefficient investment that the rich nevertheless
prefer to lending to the poor (who invest efficiently
This gets reinforced if the fixed cost goes up when
the economy is richer (land, labor, etc.)
But redistribution is not just a normative or political
concern: it is also about efficient use of resourcs.
What does all this add up to?
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How can rich getting richer impact the poor? Rich and poor
compete for capital
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Toy economy with 2 technologies: a) low capital intensive needs
K, yields α and b) high capital investment requires K*, which is
K*>K and yields α*<α.
Poor have W1<K and rich have W2>K.
Suppose neither poor nor rich can afford to invest in K*, but all can
invest in K.
The capital market would clear with rich lending to the poor and
everyone investing in less capital intensive technology
However, eventually with time rich get rich enough to invest in K*
and they stop lending to the poor and start borrowing from them.
Poor can no longer reach up to K and as a result the turn into
lenders.
Another example
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"Summary Report on Informal Credit Markets in
India"
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For Finance Corporations: the maximum deposit rate
for loans of less than a year is 12%
The minimum lending rate on loans of less than year
is 48%: the maximum is 5% per day.
Default costs explain 4 per cent of the total interest
costs for finance companies.
In their rural sample those with assets in the range Rs.
5,000-10,000) pay the highest average rate (120%)
and the richest (with more than Rs. 100,000) pay the
least (24%).