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1

Asymmetric Information

When one party of a transaction has more or better information than the other party
When sellers have more information than the buyers —> surplus-generating trades may not occur —> this is the market value
Could be transaction that would make both sides better, but asymmetric info prevents it from happening, as we will explain

2

Adverse selection

hidden fixed characteristics at the time of contracting

Fixed in the sense that they don’t change but you hide it (I.e. they don’t know about some characteristic that you have when you make the transaction (but they may learn it))
Ex: insurance - people with hidden characteristics buy it - someone who knows that they are sick could buy it - they know it but other side doesn’t
Ex: other side doesn’t know things like how bad a driver you are, how likely you are to get sick, or how smart/hard-working you are when you engage in a transaction with them


3

Moral hazard

hidden actions following contracting

Ex: insurance - after you buy insurance, you behave recklessly (I.e. buy car insurance and then drive more reckless)
Stuff that happens after you buy it,. such as questions about your investment strategy after getting funding or how hard you will work after receiving a loan


4

Lime/Lemon/Candy overview

2 groups of people - group 1 (citrus farmer) has a brown paper bag which has either a lemon or a lime (they don’t know); group 2 (juice producer) group has a mini-candy. Equal number of limes and lemons

group with the fruit (group 1) values a lime at 60 cents, a lemon at 30 cents, and a mini-candy at 50 cents
Group with the candy (group 2) values a lime at 70 cents, lemon at 40, and mini-candy at 50

So, for everyone a lime is better than a lemon; juice producer (group 2) values lime and lemon more than citrus farmer does

5

No-Info Case

Here, neither side has information about what is inside the bag - don’t know if lime or lemon
So, need to calculate expected value from a trade to see if worth it
To the farmer (group 1), EV (bag) = .50(.60)+.50(.30) = .45
To the juice producer (group 2), EV (bag) = .50(.70) + .50(.40) = .55
So, since the group without the bag values the bag more than the group with the bag, there can be trade for the mini candy (at 50 cents). Group 1 (sellers) will receive 50-45 = 5 cents and the buyers will receive 55-50=5 cents profit too.
If there were money, rather than just the mini-candies, could be trade between 45 and 55 cents, as this is the ZOPA - where everyone could benefit from a trade

6

Asymmetric Information Case

Now, same case, but the group with the bag (group 1) can see if it is a lemon or a lime
If price is a mini-candy (50 cents) - Since group 1 values limes more than candy, they will only want to trade the lemon. Group 2 won’t pay 50 cents for the lemon - need to lower the price. Market will unravel as no sale of limes. But, exchange for lemons between 30 and 40 cents could still occur.
Lime won’t sell for 60 cents, as group 1 can’t prove it is a lime, could be lying. Juice producer won’t pay 60 cents for this when expected value is 55 cents. Need a guarantee (if knew everything, then lime between 60 and 70 cents and lemon between 30 and 40) or no info - asymmetric information leads to a market failure in lack of trade when there should be trade here

7

Used Car argument overview

Adverse selection - consider a used car model, where the seller knows more about the car than the buyer.
Consider the buyer - ask why he is selling the car? Quality is worse than the price he’ll sell at. Buyer never wants to buy!

8

Akerlof Model Setup

Two groups of people
M is the stuff that people buy besides cars
xi is the quality of car i
Group 1:
Owns n cars; total income Y1
Total utility = U1 = M + from i=1 to n, the sum of xi
This means utility is what they can buy besides cars + the sum of the qualities of the cars they buy. One unit of utility for 1 unit of quality of the car
Group 2:
Owns 0 cars, total income Y2
Total utility = U2 = M + the sum from i=1 to n, 3/2* xi
This is saying the utility is what they can buy besides cars + 1.5 utility units for 1 unit of quality of car they buy. 50% more utility per quality than group 1

9

Group 1's cars

n cars, think of n as large
Quality is uniformly distributed with values between 0 and 2
Price of M (Other uses of income besides cars) is 1; price of cars is p
Note: single price for all cars bc buyers can’t tell difference in quality
μ is the average quality of cars on market for sale

10

Group 1 D&S

If μ > p —> D1 = Y1/p
If the quality is greater than the price, then they spend all their money on cars
If μ

D1 = 0
If quality is less than price, then spend no money on cars, all on the other stuff
Average quality of cars on the market:
Start with recognizing that the quality of cars is uniformly distributed between 0 and 2. Imagine a number line with this distribution
Then realize that there is a price p between 0 and 2 - only car quality between 0 and p will come onto the market
So, the average quality will be the midway point between 0 and p = p/2 (note this 2 is different from the 2 being the upper range, but rather is showing it is the midway point between 0 and p)
So, average quality of cars on the market = μ = p/2


Supply of cars of group 1
They will supply cars with quality between 0 and p —> fraction of cars supplied will be the ones between 0 and p divided by the total number of cars (2). So, supply of cars = (p-0)/(2-0) = p/2.
This is the fraction of cars supplied - need to multiple this by n to get the total number of cars
This depends that the upper range of quality of cars on the market is 2
So, total supply of cars of group 1 —> If p≤2, then S1 = p*n/2

11

Group 2’s Demand and Supply

Demand:
If 3μ/2 > p, then D2 = Y2/p
If 3μ/2 < p, then D2 = 0
Either spend all their money on cars or none. The pivot point is 3μ/2 —> larger pivot point because value cars more
Supply = 0 —> they don’t own any cars

12

Group 1+2 Demand

Get the aggregate demand - add up the demand functions for the two groups
If p Demand = (Y2+Y1)/p
Everyone wants to buy cars
If μ < p < 3μ/2 —> Demand = Y2/p
Here, only group 2 wants to buy cars, not group 1. Group 2 spend all their money on cars
If p > 3μ/2 —> Demand = 0
If price too high, nobody will demand any cars

13

Results of Akerlof Model

Remember that we know μ=p/2 from before, so we can plug this in to get the real demand
When we do this, only the third statement is true (because p isn’t less than μ or between μ and 1.5μ). Instead, p = 2μ, so the bottom equation is true
So, the total demand in the economy is 0
So, nobody will buy cars even though the group that owns cars should be selling cars as they generate less utility from a car than the group without car
So, no trade takes place despite buyers who value goods more than sellers
Average quality not worth justifying paying the price of p
—> When sellers have more information than buyers, surplus-generating trades may not occur. Only the bad types come onto the market, scare people off

14

Uzi, List, and Price Reading (Toward an Understanding of Why People Discriminate):

The disabled receives higher price quotes than the non-disabled receive
And the disparate treatment of the disabled is consistent with a model of statistical discrimination driven by search cost differences

15

Remedies for Market Failure Due to Adverse Selection:

Some market-based and some require regulation
Certification and Third Parties, Middle Men and Reputation, Asset Fire Sales (say fire at a warehouse, liquidate and sell for less - events that drive high quality goods on the market), government regulation requiring people to enter the market (health/car insurance), government regulation requiring more information to be made available, etc

16

Other Bad Market Outcomes from Adverse Selection:

Last class - surplus generating trades may not occur
Other costs of dishonesty -
Ex: time spend picking out stones from rice (efficiency lost)
Not just that not getting all the rice, but opportunity cost of losing time to do this
Statistical discrimination—> potential market response to adverse selection problem

17

Statistical Discrimination:

Statistical Discrimination: Idea that when lack of information, people may use information on group averages to make inferences about the group as a whole.
Group is defined by an easy-to-observe characteristic
Ex: May pay men and women differently —> don’t know how long each person will stay at the firm, but generally women stay less because have kid, so for all women, expect this and pay less
Ex: young men charged higher on car insurance bc more likely to crash
Ex: racial profiling at airports - could be more likely some races have guns
Profit maximizing but has the potential for negative consequences as can decrease the incentives to invest (why should women want to be in the workforce if paid less)
Distinct from taste-based discrimination
Taste-based is when you treat people differently because you like that group better. Preferences change more just because you don’t like them

18

Audit Study Methodology

Using trained actors to interact in real world markets
Advantage: Can try to hold constant all observable characteristics except the one key variable we are interested in
Compare outcomes in how the market treats them (prices offered, customers or applicants selected, etc)
Disadvantages:
Often not the real outcome of interest (may be that men get the job more often, but how about the middle step or vice versa)
Actors may know what the study is about (and this, unconsciously affects their behavior)
Ex: car salesman may notice half people in wheel chair and change how treated
Unobservable characteristics between groups not controlling for
Ex: send identical resumes and vary one characteristic like race signaled by the name. Examine call-back rates. Hold everything constant except the name

19

Audit Study on Discrimination Against the Disabled:

Reading from above where 6 disabled (in wheelchair) and 6 non-disabled people go to various body shops in Chicago to have their car bumpers fixed
Goal:
Look for evidence of discrimination against handicap people
Look for weather discrimination is taste-based or statistical
First experiment: “I’d like to fix my front bumper” then ask for a price quote
Testing for any discrimination - just looking to see if charged different amount
See that disabled are charged 593 while non-disabled charged 500 —> there is discrimination
Second experiment: Before asking for quote, say “I’m collecting a few quotes”
Testing for statistical discrimination based on search costs
Saying you are shopping around —> they assume person with wheelchair is looking around —> is difference in price based on these search costs.
Results: disabled group here for the least price - 461.4 and then non-disabled for 483.5
Overall conclusions:
Disabled given much higher quotes for repairing bumpers than non-disabled
Driven by statistical discrimination on basis of search costs rather than taste-based
This is found in other markets like mortgages (should always say shopping around so can get better price)

20

Moral Hazard and Real Estate Agents:

Standard contract w RE agent to sell home is pay agent 3% of price of the house.
Could be moral hazard as may not be worth the extra effort to get just a little more return
Ex: say you can sell house for 450-550k. If sell for 450k, then agent gets 15k and you 485k. If sell for 550k, agent gets 16.5 and you get 533k. So difference is just 1.5k for the agent but 48.5k for the owner —> lot of work for the agent to get just 1.5k more
We will look at what experts recommend/implement for others vs when they buy their own houses
This study only looks at the sale side

Empirical Evidence:
Levitt and Syverson look at 98k sales in suburban Chicago (3,300 houses owned and sold by agents for themselves)
Using regression to look at price of estate agents and compare with what sell their own houses for
Y = b*AGENT_OWNED + cX + e
b is how differently they behave when sell for themselves vs someone else
AGENT_OWNED is either 0 or 1 depending on who owns it
X is a vector of all characteristics of houses
c is a constant and e is the error
—> Agents’ own houses sell for 3.7% more and are on market for 9.5 extra days (10% longer)
We hold constant all other factors and see that b=3.7% when measuring cost and b=9.5 when measuring days.
Still is possible we didn’t control for everything or perhaps owners don’t listen to the agent
But, overall the evidence is there that moral hazard affects the selling behavior of real estate agents
But, does it matter that you are losing 3.7% and paying the agent the 3%? Is that $ important?
An alternative payout structure could be to pay a larger percent above certain amounts, but the pivot point is questionable and risky for the agent

21

Synthesis Class 2

Last session: model demonstrating a market failure from asymmetric information (adverse selection)
Private market for unemployment insurance - not good market for this because of adverse selection - only people likely to be fired would buy
Consider idea that statistical discrimination is a possible response to problems of adverse selection —> when individuals have more private information about their own quality or willingness to pay than the firm (wheelchair study)
Empirical evidence on moral hazard in RE markets

22

Peer Monitoring and Enforcement Reading:

“Group liability should improve repayment rates by providing incentives for peers to screen, monitor, and enforce each other’s loans,” but group liability may create excessive pressure and discourage good clients from borrowing, hurting growth and sustainability. No increase in default and larger groups - so group liability not working to help repayment rates - banks can do “just as well as peers at monitoring and enforcing loans and generating high repayment rates.”

23

Asymmetric Information in Creditor/Borrower Relationships:

Principal-agent relationships (p v a):
Bank vs bank loan borrower, firm issuing bonds vs bond investor, moneylender vs household, microfinance institution vs borrower
Adverse selection:
Hard for the bank to tell who is good vs bad type of borrower
Can charge higher interest rate for people who less likely to repay - but hard to know who they are
Moral hazard:
After borrow, do things that bank won’t want them to like investing in a more risky investment
Consider a borrower who can invest in 2 things and limited liability so the bank can’t punish the borrower if less than 0 return. In US, require collateral to prevent this, but not the case in small markets - bank can’t collateralize
Option 1: less risky —> 50% chance to get 100, 50% to get 0
If get the $100, then borrower gets $40 and bank gets $60 (interest).
If get the $0, then both get 0
Expected payoff to borrower is $20; to bank is $30
Bank likes this
Option 2: more risky —> 5% chance to get $1000, 95% chance to get $0
If get the $1000, borrower gets $940 and bank still gets $60
If get 0, both get 0
Expected payoff to borrower is 47, to thank is 3
Loan not equity contract, so all the upside goes to the borrower
So, the borrower clearly prefers the more risky while bank prefers less risky. So, huge issue here with moral hazard, as borrower will invest in risky things likely

24

Loan Screening and Monitoring:

Screening and monitoring to prevent adverse selection and moral hazard
Screening - seeing if good person beforehand (to mitigate adverse selection)
Monitoring - check in on them regularly (to prevent moral hazard)
Problem of lending to the poor - as high costs to gather information, small loan size, and loan officer not making a lot of money (about $1200) - responsible for 100 clients, so max you can spend on information collection is $12 per client
Issues with collateral - not available (poor property rights institutions) and not enforceable (poor legal institutions)

25

Traditional Solution: Village Moneylender:

Someone that lives in the village and provides small loans —> leveraging information from the village
Study by Steel and found that 70-80% of moneylenders in Ghana have perfect repayment
79% interest rate average —> very high given good repayment rates, but village moneylender can solve problem because know people int he village
May solve problems of adverse selection and moral hazard as swing by more often to monitor since live in the village
But, may not be efficient as very high interest rate - need return > 79% to have this be profitable for borrower
If whole village has a problem and need money for everyone like a large shock happening, problem as won’t be able to fund. Really only works for individual shocks

26

Microfinance:

The idea of giving poor people loans
Muhammed Yunus has the idea to rely on group liability and women, but the general idea of microfinance is more broad - can be for profit and individually - idea of providing small scale loans to poor people that formal banks won’t provide
Yunus’s idea:
Lend to groups rather than individuals so that you have group liability - other group members work to solve problems of moral hazard and adverse selection
Group can only get further credit if everyone pays back, often lends only to women (as women are more responsible with expenditures), and giving credit to women who normally wouldn’t get credit otherwise
Started in 1976 but has exploded - 137.5M loans issued in 2010 alone (average few hundred dollars)
Different from village moneylender in that lower rate for this and source of financing and shocks are different —> village money lender is more constrained and can’t respond to negative shocks from everyone in the village while this can

27

Microfinance and Asymmetric Information:

May address adverse selection (explains information about villagers) and moral hazard (help monitor other people)
Group members provide screening where people don’t want to enter a group with individuals who will default —> prevent adverse selection (only enter if good group)
You form your own group —> I won’t enter a group with someone I know is bad at re-paying loans. Goal is to pick so you filter these people out
Group members in the village provide monitoring —> prevent moral hazard

28

Study Design:

Work with Green Bank of Caraga, Philippines - looking at group vs individual liability
Note that individual liability here has some components of group liability as meet with loan officer in a group, but not liable for the others like you are in group liab
Experiment 1: 170 existing microfinance groups and randomly choose 85 to convert from group liability to individual liability —> testing just moral hazard as already selected the groups —> about monitoring after
Experiment 2: Examine new groups formed in treatment and control areas —> only adverse selection here —> individual enters group, see if you like their qualities
In the Green Bank, each loan cycle is 4 months and groups are 15-30 members. First level of liability is group of 5 members (liable for 4 others, but officer means with 3-6 total groups at same time)
Initial loan $18-90, 2.5% monthly interest (start small, can get larger loans if meet repayment).
Weekly meetings with officer to make repayments
Ex - use money to buy a cow - need product within a week to repay

29

Results:

Experiment 1 —> looking at the number of times clients had difficulty repaying on the X axis and density on the Y axis
Results are extremely similar for the control group and the treatment group - doesn’t matter if group or individual liability for repayments
Experiment 2 —> looking at number of times clients had trouble repaying on the X axis and density on the Y axis —> the opposite effect is seen here! Treatment group has less difficulty repaying. Group liability selects worse individuals
So, group liability doesn’t improve moral hazard or adverse selection, and screening worsened somewhat with group liability (experiment 2)
Green Bank had very low default to begin with, and possible that other monitoring they do is sufficient though - so not necessarily very generalizable

30

Other Evidence:

Six randomized evaluations of microcredit —> see slides 18-20 for details
Question is does offering microfinance loans make people’s lives better?
There is an increase in borrowing, but no consistent effect on consumption per capita
Yes, borrowing more, but not transforming their lives
Modest take-up rates of credit among perspective entrepreneurs
Lack of transformative effects on the average borrower
Other criticisms of microfinance:
2010 Bangladesh prime minister accused microcredit industry of “sucking blood from the poor”
Still high interest rates in Bangladesh (20-50%) and some are for profit with owners making millions during IPOs
Presence of multiple microfinance institutions (MFIs) in a location creates indebtedness traps
Rash of high-profile suicides of heavily indebted farmers in India - mass default results. Problem

31

Synthesis Class 3

Potential problems of moral hazard in executive compensation
Moral hazard and adverse selection problems in lending (especially to the poor)
Microfinance as a potential way to reduce the cost of monitoring and screening to make lending to the poor economically viable.
Evidence from a randomized field experiment suggests that group liability (instead of individual liability) didn’t solve the problems of either moral hazard or adverse selection
Other research on the impact of microfinance on economic outcomes is mixed. 


32

High/Scope Perry Preschool Study Reading:

Do a study where send some people to preschool and don’t send others —> see long-term positive affects on those who went to preschool

33

Inequality: Why we care

Outcome of interest:
Fairness - people like and value fairness
See this with the ultimatum game:
Two players, one makes an offer regarding how much to split the endowment and the other player can accept or reject the offer. If reject it, both get $0
Even though player 2 should really accept anything >0, he will only accept if perceived to be fair - rather take 0 than something unfair
In higher stakes game, player 1 seems to offer more wide range of offers - low stakes offer less and more is rejected in the low stakes game
Markets lead to more inequality than we prefer as a society (market failure)
Inherent in human nature when treated unfairly to not like it
Functional reasons:
Impact on growth rates
Though savings (want people to save, aspirations to do better), violence (too much inequality could result in more violence), political instability (if crazy high inequality, could over throw), and health/stress

People also value equality - especially the poor. But even rich people still don’t like inequality

34

Inequality vs. Inequity:

Inequality of outcomes:
Easier to measure (income or wealth)
However, outcomes reflect our own preferences
For example, could choose to be a professor rather than work at a high paying job —> your choice to do this shouldn’t reflect inequality but rather is your own preference

Inequality of opportunity:
Perhaps what we are more interested in, but harder to measure
Study in Ecuador kids - loving at inequality of opportunity for the young.
Differences in cognitive ability scores start small and then widen over time for rich vs poor people with rich people having much better scores

35

Measurement:
Characteristics of a Good Inequality Measure:

Anonymity Principle: It shouldn’t matter who is earning the income
Population Principle: Population size doesn’t matter, only the proportions of population earning different levels does (clone population, shouldn’t have an impact)
Relative Income Principle: Only relative incomes matter, absolute sizes don’t. Doubling all incomes shouldn’t change inequality
Transfer Principle: If transfer of income from one person to another who is richer, then new distribution is more unequal

36

Measuring Inequality

1. Lorenz Curve
Fits all four characteristics
Curve with the cumulative percentage of households on the X axis and cumulative percentage of household income on the Y axis
A 45 degree straight line would be a line of perfect equality
In reality, it is a curve. The wider the curve is (I.e. more flat at the beginning and then more vertical), the more inequality there is. Further from the 45 degree line, more unequal
So consider the point (80, 49.4) on a Lorenz curve —> 80% of households earn 49.4% of income, meaning that the other 20% of households earn a crazy 50.6%

2. Gini Coefficient:
Also meets all four characteristics and maps to the Lorenz Curve
On the curve, G = area between the 45 edge line and the curve / whole triangle between 45 degree line and the X axis
More unequal will have a larger G, as the area between the line and the curve is larger for those curves
The mean of all pairwise comparisons of income
Take the sum of differences of person 1 from everyone else, then person 2, etc (and then normalize so the value is between 0 and 1)

Example calculation:
Consider 4 people, who make 1, 2, 8, and 9
For person one, the sum of the yj-yk term is (0+1+7+8) = 16, by taking the difference between their income (1) and the other incomes
Person 2 it is 14, 3 it is 14, and 4 it is 16 —> total differences = 60
So, Gini = 60 (adding up the total differences)/(2*16*5) = .38 where 5 is the mean of the incomes (mu), and 16 is N^2

3. Kuznet’s Ratio (90/10 or 80/20) compares two points in the distribution (ratio of the shares of income of the poorest x% to the richest y%)
Does not always satisfy the Transfer principle
If transfer from 50th to 60th percentile, then not reflected here

37

Theory and Evidence on Inequality and Growth:
Kuznet’s Theory:

Inverted U-shaped hypothesis where X axis is the GDP per capita and the Y axis is income inequality. Graph like an inverted U (lower case “n”) so when have low GDP or high GDP, less inequality than when at the middle
In the initial phase of growth, inequality widens as certain groups benefit. Then, others catch up and inequality falls
During process of development, shift of workers from old sectors to new (I.e. from agriculture to industry and/or from rural to urban)
Three stages:
1. Everybody works in low pay old sector —> low inequality
2. Some workers shift to high pay new sector —> high inequality
3. Everyone works in high pay new sector (wages depressed in new sector and less competition in agriculture) —> inequality low again
Policy implications —> even with increased inequality, don’t need intervention because will naturally fall on its own —> but could take a while, so could need to intervene to accelerate
England and Wales from 1823-1915 exhibited this inverted U shape
But, looking at Gini coefficients across countries, we don’t see a clear relationship (we would expect an inverted U if each country is at different stage)

38

Inequality and Well-Being

First graph is of inequality (measured with Gini coefficient in the world) vs violent crime rate —> clear positive relationship
Second graph is same thing but looking at robbery on Y axis —> similar positive relationship
Third graph is in the US, looking at Gini coefficient on the X axis and log odds of mortality on the Y axis. See a positive relationship, and even controlling for own income, more likely to die with more inequality
Subjective well-being: happiness:
Typical questions - how happy are you, how satisfied with your life are you, where are you on the satisfaction latter
See that people are happier with less inequality over time in the US measure by Gini Coefficient

39

Summary lecture 4

May want to reduce inequality due to fairness concerns or for functional reasons related to business development and economic growth
Including through channels of crime, health, stress, and happiness

40

Trends in Inequality:

By Country:
Looking at Gini coefficient by country over time, expecting to see an inverted u per the Kinnetz theory, but we don’t see this for most countries. Some do at times, but not much
US has rising inequality and France falling
World Gini coefficient:
Has fallen overall since 1970 with slight rises at time, but pretty big fall overall. Growth in poor places brings this down, oil price shocks important too
World Gini excluding areas:
Without China, growing inequality
China growth contributes to decrease in global inequality
Without US and Africa, less inequality and declining more
Role of Africa: lack of Africa growth is contributing to global inequality, as China, India, OECD, and other middle-income and rich countries diverge away from Africa. So, Africa should be a focus if trying to lower overall global inequality

41

Inequality Between Countries in 1970 vs 2000:

Look at curves showing distributions of income for World, China, India, USSR, Japan, USA
In 1970, overall way more people making below $1 per day
China and India massively up from 1970 to 2000

42

Income Inequality in the US

Rising in the US (about .46 in 2005 vs .44 in 1950 and .41 in 1970)
Share of the top 10% is on the rise after a fall during the depression - about 48%
And the US has more income inequality than Europe - rising in Europe too but not as much

43

Summary of Trends:

Inequality across countries falling
Global inequality falling: driven by China
Inequality within countries is increasing in the US, varies for other countries

44

Theories for Trends in the US:

1. Skill biased technological change
The idea:
Technology replaces low skilled jobs
Technological change favors highly skilled whose skills are complementary with new technology
Evidence:
Timing of increase in inequality coincides with introduction of personal computers and related information technology
Looking at computer use at work from 1984 to 1997 - see that all workers are using computers more, and that while college graduates use way more than college dropouts than high school graduates than high school dropouts, this proportion has stayed relatively similar (in 1984 - 4.8% of high school dropouts used computers compared to 11.3% in 1997. For college grads, it was 41.5% increased to 75.2%. The proportion 41.5/4.8 and 75.2/11.3 are relatively similar)
Conclusion—> Yes, this is a possible explanation, but not overwhelming support for it


2. Immigration
Idea: 1.25M immigrants enter the US every year; 1/3 are illegal workers from Mexico and Central America - do they compete with low skilled workers for jobs and drive down low skilled wages (thereby increasing inequality)?
Study uses variation across cities and across time in numbers of immigrants and natives and their wages
Key result:
Within education groups, immigrants and natives are imperfect substitutes
Therefore, illegal immigration is not the key explanation for rising inequality
The point here is that they don’t drive down natives’ wages because they aren’t perfect substitutes - not competing for same jobs, immigrants take worse jobs than low skilled Americans
—> Not a factor, more immigrants don’t drive down low skilled earnings 


3. Minimum wage changes
Team presentation discusses this (not on exam, but seems like yes, it can, as a deadweight loss results)


4. Returns to capital
Piketty’s argument in his book: the rate of return on the wealth, r, has systematically exceeded the rate of growth, g, of the economy
Idea that the rich get richer because of such a high return on capital
Look at a graph over time showing the share of the top percentile in total income on the Y axis and time on the X axis.
The share of top income percentile in total income is increasing but the share of that excluding capital gains is not much lower —> so capital gains isn’t such a large amount
While the share of top wage percentile in total wage bill is fairly significantly below the total income they have showing that the wage bill isn’t why the top 1% is doing so well, the gap also doesn’t seem to be coming from capital gains
University of Chicago initiative on global markets survey of economists:
Asking people if they think “The most powerful force pushing towards greater wealth inequality in the US since the 1970s is the gap between the after-tax return on capital and the economic growth rate”
Most people disagree/strongly disagree with this
So, while this may explain some inequality, doesn’t explain most of it


5. Positive assortative matching
Richer people marrying richer people - study sees that you marry people from similar income classes as similar education
Study assigns a random assignment of spouses by education level —> would reduce level of inequality but doesn’t change the increasing inequality trend over time
Again, this may explain some inequality, but not most of it

So, skill biased technological change and minimum wage seem like the best. returns to capital and positive assortative matching somewhat, and immigration bad explanation

45

Solutions
Policy Approaches:

Investment in skills; barriers to immigration; increasing minimum wage; changing tax system; wealth tax

46

Perry Pre-School Experiment:

From 1962-67, 123 low income 3 and 4 year-olds randomly assigned:
Treatment: pre-school program
Control: no pre-school
Collected annual data until age 11, then follow up at 14, 15, 19, 27, and 40
Results:
Pre-school group arrested less by age 40, earned more money by age 40, more likely to graduate high school, more likely to have basic achievement at 14, more likely to do homework at 15, and more likely to have an IQ above 90 by age 5. All of these are very significant results
Large and long-lasting effects of pre-school education for low-income children
This (and other studies) motivate current policy changes in some areas to provide free universal pre-K
Some concerns could be small sample size and partial equilibrium results vs general eq policy changes

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Synthesis Class 5

Considered several theories for rising inequality in the US:
Evidence supporting skilled biased technological change
Evidence against illegal immigration
Returns to capital
Positive assortative matching
Lots of possible solutions to the market failure
Direct (change tax code)
Other (investment in skills, changing minimum wage, reducing immigration)

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Adidas, Nike Urged to Ensure Fair Wages (Reading):

People criticize big corporations like Nike and Adidas for paying their workers in their factories abroad low wages by American standards

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Multinationals and Wages:

Nike pays factory workers in Indonesia about $3.5-4 per day - are these wages too low? Is there a market failure?
Evidence:
Look at the average wage paid by multinational affiliates compared to domestic manufacturing wages in high income, middle income, and low income countries
While the wage for low income countries is much lower than middle income which is much lower than high income, the multinational companies may much more than the domestic firms in each of these places (ratio of MNC/domestic is 2.0 in low income, 1.8 in middle income, and 1.4 in high income)
So, paying much more than market rate for wages in these countries
Other evidence:
Glewwe: Workers in foreign-owned apparel and footwear factories in Vietnam rank in top 20% of population by household expenditure
Lukacs: Workers in USS owned factories in Shanghai earn three times the average wage of workers in other local factories
ILO finds that wages paid in export-processing zones are higher than in villages from which the worker came
Lipsey and Sjoholm find that foreign-owned plants in Indonesia pay 12% more for unskilled labor and 22% more for skilled labor than locally-owned plants do
—> MNCs pay more than domestic firms

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Where Do Wages Come From:

The real wage tells you how much you can produce per hour of work
Recall: competitive firms —> zero profits
So, if we assume the only price is labor here and firms are perfectly competitive:
Profit = p*Q - w*L = 0
Where w is the nominal wage and L is the amount of hours of work (w*L is the cost)
So, w/p (real wage) = Q/L
So, this is the quantity of output per hour of work
So, low wages signal low productivity, as being paid based off quantity of output per hour
Competitive firms cannot pay wages above worker’s productivity as will be paying more than it earns per unit of output, making firm go out of business
Competitive firms would be making profits if they pay wages below productivity - but then competitive firms would either (1) undercut each other’s prices or (2) hire more workers, driving wages back to productivity
These arguments assume competitive markets, which may or may not be reasonable
Evidence of wages reflecting productivity:
Graph labor costs vs productivity across different countries at a specific time —> strong positive relationship —> lower labor costs associated with lower productivity
Another graph with South Korea specifically —> massive growth in productivity from 1980 to 1995, and wages are growing with this productivity —> moving together

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Wages and Location of Production:
Understanding Wages and Productivity:

Competitive markets: real wage = productivity of labor
Therefore, cost advantages of hiring cheap labor abroad are offset by lower productivity
So, why produce there?
Need to understand why certain countries tend to produce certain goods—> so, we need to understand why they are relatively better at producing these goods than other goods
Remember: the location of production is determined by competitive advantage (important determinant of how this works)

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Definitions:

Comparative advantage: relatively better at producing something better than others
Absolute advantage: bets at producing something
Point here is that even if I am the best at everything (absolute advantage), still would divide up production based on comparative advantages because I don’t have enough time to do everything

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Simple Production Model:

Imagine a world with two goods: Textiles (T) and Computers (C)
Labor is the only input in the production
Country A has total labor supply of L and can produce textiles and/or computers with the following technologies:
Qt = 2Lt
Qc = Lc
L = Lc + Lt
What this is saying is you can choose how to divide labor between textiles and computers, and for every 1 unit of labor, you produce 1 computer or 2 textiles.

Production Possibility Frontier in this Example:
Graph quantity of computers on X axis and quantity of textiles on the Y axis
Can produce 2 textiles for every 1 computer, so the slope = ΔT/ ΔC = -2
This -2 is the opportunity cost - how many textiles have to give up to get one computer

54

Prices and Wages here

Recall: competitive firms earn zero profits
Computer firms —> Profit = Pc*Qc - w*Lc = 0
Only cost is labor
Recall Qc = Lc in country A, so, plug in —> w = Pc
Wage equals price of computers in country A

Similarly, for textile firms —> Profit = Pt*Qt - w*Lt = 0
Recall Qt = 2Lt in country A, so plug in —> w = 2Pt
The wage is twice the price of textiles in country A

If workers can move freely between textile and computer production, then wage in both sectors will be equal, so w = 2Pt and w = Pc, so Pc/Pt = 2
Price of computers is double the price of textiles
Recall the production possibility frontier from above —> we said the slope is ΔT/ ΔC = -2 and now we see the relative prices Pc/Pt = 2 —> relative prices tell us the opportunity cost

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Gains from Trade:

If Country A does not trade:
Consumption is limited by domestic production (can allocate more labor to C or T, but capped by total labor L)
By reallocating its labor supply, it can produce more or less textiles (in exchange for computers) to find its most preferred mix
The cost of this reallocation (opportunity cost) is simply the relative prices of production domestically
Constrained by PPR domestically but could shift PPR out with technological innovation or trade
But, if country A does trade…

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Example 1: Gains from Trade
International Relative Prices Pc/Pt < 2

This means computers are cheaper to import than to produce at home. So, country A:
Specializes in producing T
Exchanges T for C through trade, rather than producing C directly
This expands the PPF outwards (textile amount stays same but can have more computers, so the slope gets less steep as further outwards horizontally)
Country A is better off as can get more computers for a given textile amount
Point here is that when the price of computers is relatively less abroad, you will buy the computers from abroad and make textiles at home.

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Example 2: Gains from Trade
Now, international relative prices Pc/Pt > 2

Now, international relative prices Pc/Pt > 2 —> other countries are better at producing textiles, textiles cheaper to import than to produce at home. So, country A will specialize in producing C and exchange C for T through trade, rather than producing T directly
The PPF expands outwards, making country A better off —> same point of C but get higher on the textiles line —> steeper slope now

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Gains from Trade

Whatever the prices on the world market, a country’s consumption possibilities expand through trade
Think of trade as a substitute for having to produce it yourself. By trading some goods, you allow yourself to specialize in the things you are relatively good at producing
Profits —> 0 in goods actually produced, where there is comparative advantage (wages = productivity)

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Examples

1. Assume that in country D, we have Pc/Pt = 4. What does this mean?
Means that in this country D, we can make 4 times as many textiles as computers

2. What happens if international relative prices is Pc/Pt = 4?
Then, international trade its essentially irrelevant, as same price internationally as locally in your economy

3. What happens if international relative prices is Pc/Pt = 3?

Now, internationally has 1 computer cost 3 textiles while at home 1 computer costs 4 textiles. So, a textile internationally is 1/3 a computer while at home it is 1/4 a computer, so a textile is cheaper to make at home. So, will make textiles at home and trade for computers
—> country D has comparative advantage in textiles (would give up 4 textiles for 1 computer), and should produce textiles and trade with rest of the world for computers (which can produce 1 computer at cost of only 3 textiles)

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Conclusion/Cheat Sheet:

Assuming a perfectly competitive world where countries can produce 2 goods - X or Y
Profit = Px*Qx - w*Lx —> Profit = revenue - cost where cost is the wage * labor hours
Assume in this country A, Qx = Lx and Qy = 3Ly
This means that we can make 3 times as many Y as we can X
So, Px/Py = 3 after plugging in, we can make 3 times as many Y as X
w = the coefficient*denominator; w = numerator:
w = 3Py and w = Px
So, wage is three times price of Y but is the same as price of X
So, plug in and solve for w, Px = 3Py —> Px/Py = 3
This means that the price of X is triple the price of Y, so we can produce 3 times as many Y as X for a given quantity of labor
If the international relative price is LOWER (Px/Py < 3), then country A has the comparative advantage in Y. Consider when Px/Py is 2 internationally. This means that internationally, they can produce 2 times as many Y as X for a given quantity of labor while here we can produce 3 times as many Y as X. So, we are better at producing Y.
So, country A has comparative advantage in the denominator when the international relative prices are lower
If international relative price is HIGHER (Px/Py>3), then country A has comparative advantage in X. Consider when Px/Py is 4 internationally. This means internationally, they can produce 4 times as many Y as X for a given quantity of labor while here can produce 3 times as many Y as X, so they are better at producing Y, we will produce X and they produce Y
So, country A has comparative advantage in the numerator when the international relative prices are higher
If international prices is equal, then trade is essentially irrelevant

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What Determines Productivity:

In country A, Qt = 2Lt and Qc = Lc
Productivity is 2 in textile production and 1 in computer production
Where do 2 and 1 come from?
General production functions are that Qt = F(A,k,h)*Lt where:
k is the physical capital per worker (sewing machines)
h is the human capital per worker (education, health)
A is technology
With multiple inputs to production functions, there are many ways to produce the good - use lots of capital and little labor or some mix. Choose optimal mix based on production methods available and how much each input cost

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Scarce vs abundant factors:

If country A is poor, then physical capital, human capital, and technology will be scarce compared to raw labor. Country A will therefore choose mixes of inputs that are more labor intensive
If capital and technology are more important in computer production than textile production, then country A will find computer production more difficult than textile
For example, Country A’s labor productivity in textile production (2) is higher than computer production (1), as Qt = 2Lt and Qc = Lc
In country A, Pc/Pt = 2

If country B is rich, then physical capital, human capital, and technology will be abundant compared to raw labor. Country B will therefore choose mixes of inputs which are more capital and technology intensive
Country B will be more productive in both goods, say Qt=5Lt and Qc=5Lc
1 unit of labor —> get 5 of T or C —> has absolute advantage over both, but smaller advantage in textiles, as technology and capital are less important in textile production
Comparative advantage determined by relative abundance of a country’s resources
So, here Pc/Pt = 1, so international Pc/Pt is higher, so A has comparative advantage in computers, make those, trade for textiles

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Comparative Advantage:

Why are some resources relatively abundant or scarce in some countries? What are underlying causes?
Reason 1: Geography (oil, diamonds, bauxite, farmland)
Important for understanding trade in some goods
Doesn’t explain why some countries have advanced technologies or abundant capital while others don’t
Reason 2: Non-market factors (institutions)
Weak institutions (contracts, property rights, corruption, political instability) result in scarce physical capital, scarce human capital, and outdated technology

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Firm Strategy:

Strategy 1: Basic market strategy is to locate production according to comparative adv:
Tasks that favor raw labor over capital should be produced in countries with relatively abundant low-skilled labor
Alignment of profit and social welfare
Strategy 2: Efficiency wage strategy is to treat workers better than minimum required (doesn’t work with competitive markets as they do earn profits)
Evidence: unemployment exists - must be that wages are higher than market clearing rate
Better nutrition; avoiding shirking

65

Synthesis Class 6

Are wages paid by MNC’s too high or too low?
Theory of labor markets and trade
Wages determined by productivity, comparative advantages determines what countries should produce, everyone better with trade

66

Wages of Chagrin Reading:

UAE policy change which allows for workers to have their visas picked up by new employer without needing to go to home country and wait to get a new visa —> this helps workers have their wages rise, as threat of going to somewhere else helps this. But, firms hire less new workers and pay them less money

67

NYU Abu Dhabi Reading:

Migrant workers here facing tough conditions and being paid very little

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A Radical Solution…US Like Qatar Reading:

Point here is that take in migrant workers to lower global inequality even if it increases inequality in your own country
Qatar and other oil countries doing this - pay these migrant workers very little, increasing inequality within country, but lowers overall global inequality

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Migrant Labor Markets:

Focusing on a particular migration corridor - from poor countries, mainly in South Asia, into richer Gulf countries
Gulf Cooperation Countries (GCC): Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, UAE
Authoritarian, large amount of oil, guest worker programs (temporary migration)
Massive growth in migration to the countries with about the same number of total locals as migrant workers
In UAE, about 8x more migrant workers than locals

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UAE Labor System:

Workers sign multi-year (2-3 year) contract with a firm
No pathway to citizenship (for men in most cases)
Women can get citizenship if they marry an Emerati man, but man can’t get citizenship if marry an Emerati woman
Need a job to get the contract
System of carrots and sticks:
Rewards for staying for full contract, including the firm paying for airfare home —> carrots
Government sanctions on those who fail to fulfill the contract, including not being allowed to sign another contract with another firm for 6 months —> sticks
Some coercive elements here

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Media Coverage:

Lots of western media newspaper headlines critiquing lack of human rights by UAE companies —> most of this coverage is about western companies in the UAE
Workers in Qatar building for the World Cup and workers in the UAE building NYU Abu Dhabi and Guggenheim and more —> criticizing them
Long working hours, poor working and housing conditions, lack of political/human/worker rights
Abuse, passport withholding, strikes—> jail
Suicides
But, which the media doesn’t acknowledge, it is so much better than their home country conditions!

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Repugnant Economic Transactions:

Hiring migrants in the GCC possible example
Culture and norms may play a role in defining this
Potential sources of repugnance (intense disgust):
Coercion (are they coerced), regret (do they regret entering contract), externalities (brain drain to rest of country), inequality, degradation (labor contract degrading them?)
Cultural and social norms decide what is normal vs. repugnant —> I.e. is it socially acceptable to hire someone to clean your home?
What benchmark?
Should we compare to other rich countries or to their origin countries (India, Pakistan)?

73

Posner/Weyl View:

Idea for reducing global inequality is to encourage international migration
GCC countries do more to improve global welfare than most other countries in the world
Global vs within-country inequality
Sharp contrast to media coverage
—> Point is that while it increases inequality within the countries, these labor contract help massively reduce global inequality, as making way more money in UAE working than in India
In the UAE, migrant workers (85% of workforce), earn average $5000 per year while Emiratis (15%) earn $300,000 per year —> extremely high inequality within country
However, migrant workers come from poor countries where average income is $1000 per year
Trade-off in openness to migration (reducing global inequality) and reducing within country inequality (and labor and political rights)
US, for example, has less immigrations but much better rights. UAE allows immigration but lack of rights and more inequality within country

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Mean Log Deviation: Inequality Measure:

MLD = (1/N)*sum of ln (x bar/xi) from i = 1 to N
N is number of households, xi is the income of household i, x bar is the mean of xi, value of 0 is perfect equality
Unlike the Gini coefficient which maxes out at 1, no max here. Places more weight on extreme values bc no maximum
Looking at this measure where we have post-tax internal inequality on X axis and impact of immigration on global inequality on the Y axis. Negative relationship with all the GGC countries very high on internal inequality but helping reduce global inequality the most
Look even more unequal because of the extremes. So, while bad for internal inequality, good in reducing global inequality

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Revealed vs stated Preferences:

Stated preferences - ask what people prefer and how much they prefer it
Limitations: people may find these questions hard to answer
For example, what kinds of courses would you like Penn to offer? Hard to answer this
Revealed preferences - preferences which are revealed by choices that people make
Look at choices students are making to infer their preferences
Real choices we make to understand real preferences
Ex: stated would be the stars given to a product while revealed would be how much you buy of the product 


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Revealed Preference Approach Example:

Preferences are revealed by the choices that individuals make
x1 and x2 are goods, p1 and p2 are corresponding prices, w is your earnings
Budget constraint: p1*x1 + p2*x2 ≤ w
How much you can afford
Indifference curve gives one level of utility - want to get to the highest level of utility
Graph on an indifference curve with x1 on the X axis and x2 on the Y axis —> represents how much of each of these goods you want
Have a line with your budget constraint connecting the axes. Can afford any point within that shaded triangle. But, we can draw curves to the line to find the optimal point on the line. We want the point where the curve is tangent to the line —> x*. This is the optimal point
Draw curves to each point on the line and we want the optimal curve so no curve is better —> tangent to the line

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Application to Migrant Workers:

Do migrants prefer living and working in UA than home?
Looking at proportion of Indian migrants re-signing after finishing a contract —> see that it is around 80%, dipped during the recession. Remember it is 2 sided, the firms may not give a contract, so not a great showing of demand. Also assuming not coerced re-signing.
Overall, large re-signing rates suggesting them seem to like it better than the alternative

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Empirical Evidence on Improving Workers’ Labor Rights:
Analysis of a Labor Reform (Naidu, Nyarko, Wang):

Major reform in 2011 allowed migrant workers to switch employers at the end of a contract in the UAE
Prior to that, workers needed written consent from their employer to switch to another firm even at the end of a multi-year contract
This increases job mobility and bargaining position of workers
Still needed written permission during contact to move
Difference-in-difference analysis where look pre/post 2011 reform
Months before and after same individuals’ contract expirations
Treatment: right after contract expires
Control: right before contract expires
Graph with contract expiration date on X axis and long change in contract compensation on the Y axis
See a massive increase in compensation after the new policy (while it is still negative change in compensation at first due to inflation, after the reform, paid a lot more)
Graph with contract expiration date on X axis and employer changes (3-month window) on Y axis
This shows the total number of employer changes that occur by contract expiration date. Total includes employer transitions that occur within 3 months of the contract expiration.
See a massive increase right after the new policy —> total job-to-job transitions massively up after the reform 

Conclusions:
Existing workers in the UAE: wages rose by 10%
Job transitions increased
However, firms hired fewer new workers and paid them 3% less
Idea is consistent with the idea that there is a trade-off between labor rights and the number of migrants that firms will hire
More labor rights, but hiring fewer people now
Positive and negative consequences of international pressure to give migrant workers more labor rights

79

Synthesis Lecture 7

Opposing views:
GCC countries and firms exploit poor migrant workers in a system like modern slavery, and international pressure/boycotts and government regulation is needed to protect workers
Migrant workers are better off in jobs in GCC countries than in their home countries
This is proven by the fact that they choose to take these jobs and to continue working in them
International pressure/boycotts and government regulation may make (potential) migrant workers worse off
As final thing shows - hire fewer new workers and pay less after human rights policy implemented