Subsistence and Self-perpetuating Inequality

http://growthecon.wordpress.com/2014/07/09/subsistence-and-self-perpetuating-inequality/

July 9, 2014
Dietz Vollrath, an associate professor of economics at the University of Houston

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••• The Moral Economy of the Peasant by James C. Scott. He says you can understand a lot about the peasant mind-set by realizing they face subsistence constraints, and that this makes them incredibly risk averse.

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Combine this conception of subsistence and risk aversion with the commonly understood relationship of risk and reward. In finance and entrepreneurship, we generally believe that those willing to absorb higher risks are able to reap higher rewards. Entrepreneurs earned that money by taking a risk in starting a company. Aside from entrepreneurship, big fixed investments in education — quitting your job to go back to school — are very risky moves that in turn have high expected rewards.

Together, subsistence and the risk/reward correlation imply that inequality will be self-perpetuating. Poor people will not take on big risks (starting a business) because they cannot handle even a small probability of failure that takes them below subsistence. So they stay in low-wage jobs and don’t undertake investments that might make them better off.

[And the probability that a new business will fail is very high. There is also the fact that you can't invest money that you don't have. If you are poor, any decrease in income, even if temporary, can result in eviction, shut-off of utilities, repossession of your car, not being able to afford enough food to survive.]

Well-off people are able to tolerate bigger risks, and so also earn higher rewards. They start businesses, get more education, or move across country for a new job. If it doesn’t work out, they won’t starve, so it’s worth the risk. And because they undertake big risks, they tend to earn high rewards. The rich can expand their incomes and/or wealth at a faster rate than the poor, because of their higher risk tolerance. This naturally acts to expand inequality over time.

The crucial point is that there is no pathology to the poor refusing to take big risks. With subsistence constraints, the poor don’t remain poor because they are lazy or stupid, but because they are rationally avoiding big risks that might push them below subsistence.

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Won’t providing income support just incent all the poor people to stop working? Remember that most of the people screaming loudest about this – Casey Mulligan – are tenured professors who cannot be fired. Despite having no incentives whatsoever to continue working on research or provide more than perfunctory teaching, Mulligan continues to work. Why? Why does he not rationally show up to collect his check and then go home to eat Cheetos and watch Dr. Phil? If Casey Mulligan continues to work despite a guaranteed income, I’m fairly confident that the vast, vast majority of people will continue to work even if they are no longer at risk of falling into destitution.