Inequalities and Investment Abhijit V. Banerjee
The ideal 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 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 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 a(m) = a(1) (a(1) a(0))/20
However if capital markets are imperfect 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 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? With credit Constraint WEALTH Without credit Constraint ABILITY
Why the distribution of wealth matters? 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 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: 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 Aleem (1990) on money-lenders in rural Pakistan 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 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). This mechanism takes us to 80% of the potential productivity
Reinforcing factors: Lack of insurance The ideal insurance market is one in which people bear no avoidable risks. Typically hurts the poor the most and discourages taking on additional risks. In a setting where a single village constitutes a separate insurance market: 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 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 Legal constraints on land transactions: 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 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 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 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 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 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 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 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 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 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 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? 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 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: 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? How can rich getting richer impact the poor? Rich and poor compete for capital 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 "Summary Report on Informal Credit Markets in India" 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%).