Income Distribution and the Demand Constraint

Abstract

This paper argues that the interaction between inequality and the demand patterns for goods is a potential source of persistent inequality. Income distribution, in the presence of non-homothetic preferences, affects the demand for goods and, due to differences in factor intensities across sectors, it alters the return to factors of production and the initial distribution of income. Low inequality leads to high demand for medium skilled intensive goods, providing a bridge over which low skill dynasties may transition to the high-skilled sector in the long run. Under high inequality however, the initial lack of demand for medium skilled labor breaches this bridge from poverty to prosperity and inequality persists. This paper examines the dynamic interaction between the income distribution in an economy and patterns of demand. It shows that such interaction is a potential source of persistence in initial inequality, that affects (human) capital accumulation and growth. These effects arise because of two factors. First, with non-homothetic preferences, the income distribution affects the pattern of demand for goods and services. Second, due to differences in factor intensities of goods, this demand pattern affects the distribution of factor returns as well. Low initial inequality, through greater demand for less skilled labor, creates a virtuous cycle that carries low income families from poverty to prosperity. Under high initial inequality however, a lack of such demand vitiates this virtuous cycle, resulting in low human capital accumulation and growth. Links between income inequality and growth have received much attention in the the- oretical literature in recent years. Benabou (1996) identifies two broad strands of this literature—one that links inequality and growth through political economy aspects of de- velopment and the other, through the role of capital market imperfections (CMI). Our set up here is closer to the latter approach, particularly to the work on inequality and human capital accumulation. Briefly, the CMI approach examines how the lack of easy access to credit can affect aggregate capital investment and economic growth under high inequality. It has been shown that even though poor families could be hindered by credit constraints in the short run, they could still catch up with richer families in the long run by gradually accumulating (human) capital over time. 1 Yet, such catch up will not happen if there are indivisibilities in the initial level of investment necessary to acquire any human capital. This is because poor families may never accumulate enough to meet such a threshold. 2