How inequality can lead to inefficient economic outcomes

The last few decades of advance in economic theory and empirical findings have raised questions about the general applicability of the very idea of equality-efficiency trade-off. In the rest of this essay, we shall enumerate and examine some of the relevant issues here.

When there is information asymmetry between the two sides in a given economic transaction, the above-mentioned trade-off may not hold. For example, creditors do not have enough information about the viability of a project brought to them by a potential borrower. You may have a project that you know is very much worthwhile from both private and social point of view, but the creditor may not be aware or convinced of it, and you do not have sufficient collateral to persuade the creditor to take the risk of lending to you. A rich man with an inferior project may get that loan, not you, because of the former’s larger assets, and hence, collateral value. Thus, inequality here promotes the less efficient outcome. Similarly, your low savings or collateral may not permit you to finance or borrow for investment in higher education for which you may otherwise have the talent and proficiency, whereas the less talented children of your rich neighbour go through college and university, while you drop out. This is a loss to society as well as yourself.

There is, of course, a great deal of socially unproductive risk-taking by the rich (with “collateral damage” for the poor), say, in financial or real-estate speculation. Even if we ignore this, it is important to keep in mind that not all dynamic innovations and productive risk-taking are by private fortune-seekers. In the US, much of the basic or foundational research and great innovations of recent times (like the internet, GPS, digital search engine, supercomputers, human genome project, magnetic resonance imaging, smart phone technology, hydraulic fracturing for shale gas, and a whole host of others) have been facilitated by or been the outcome of public investment funded to a large extent by taxpayer money. Scandinavian countries with a high-tax redistributive economy have not been lagging in innovations.

Click here to read the first part - Does inequality matter when poverty is falling? 

Even in the private sector assuring temporary monopoly and thus, great fortune for the innovator through the patent system has not been the only or the best way of encouraging innovations. Patents on a new technology often make things costly or obstructive for future innovators and thus may hamper further advances in technology. Open-source programmes are often more conducive to new developments of technology.

If inequality is generated by market power of big firms in product and labour markets, then there is a direct loss of efficiency (in output and employment) if that market power enables those firms in their attempt to maximise profits to restrict output (and labour hiring) below the amounts for a competitive firm.

Historically, the case where inequality and inefficiency have stubbornly persisted together relates to land, which is usually very unequally distributed. In traditional (and in some non-traditional) agriculture, the empirical evidence suggests that economies of scale in farm production are not inherently substantial (except in some plantation crops) and that the small farm is often the most efficient unit of production (if credit, insurance and marketing facilities are not inadequate). Yet the violent and tortuous history of land reform in many countries suggests that numerous road blocks on the way to a more efficient reallocation of land rights are put up by the powerful landed interests for many generations. Why don’t the large landlords instead voluntarily lease out or sell their land to small farmers and grab in the bargaining process much of the surplus arising from this efficient reallocation?

There clearly has been some leasing out of land, but problems of monitoring the tenant’s work and application of inputs, insecurity of tenure (discouraging long-term land improvements by the tenant), and the landlord’s fear that the tenant will acquire occupancy rights on the land have limited efficiency gains and the extent of tenancy. The land sales market is often rather thin (and in many developing countries the sales sometimes go the opposite way—from distressed small farmers to landlords and money-lenders). With low household savings and collaterals, the potentially more efficient small farmer is often incapable of affording the going market price of land.

Landlords on the other hand often resist land reforms particularly because the levelling effects reduce their social and political power and their ability to control and dominate even non-land transactions in the village. Large land holdings may give their owner special social status or political power in a lumpy way — for example, the status or political effect from owning 1,000 acres is larger than the combined status or political effect accruing to 50 new buyers owning 20 acres each. Thus the social or political rent of land ownership for the large landowner may not be compensated by the offer price of numerous small buyers. Under the circumstances, the former will not sell and inefficient (from the productivity point of view) land concentration persists.

Then there is the demand-side impact of inequality. There is a story of a Ford company executive in conversation with a union leader, pointing to the arrival of a bunch of robots in the factory and asking, “can you collect union dues from them?”, to which the union leader replied, “can you get them to buy Ford cars?”. Particularly, in times of depressed aggregate demand and idle capacity, inequality may hurt macroeconomic performance by making it difficult to stimulate enough mass consumer spending. Recent research suggests that a long-term rise in inequality can push the economy into a deep recession. There is also some evidence that inequality has encouraged excessive risk-taking in the financial sector, and along with household indebtedness, may have been responsible for the financial crisis that originated in the US in 2007-08.

Under inequality not merely the aggregate consumer demand may be deficient, but the pattern of consumer spending may also get distorted. Certain types of consumer spending on status goods (houses, cars, and other easily visible conspicuous consumption items) can, in the context of inequality and community norms of emulation and the resultant “expenditure cascade”, lead to a race to the bottom among neighbours and reference groups: clearly an inefficient outcome.

The writer is professor of Graduate School at University of California, Berkeley. His most recent two books are Awakening Giants, Feet of Clay: Assessing the Economic Rise of China and India, and Globalisation, Democracy and Corruption: An Indian Perspective; the article was first published in the international blog 3 Quarks Daily

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