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Introducing Uncertainty into Baland and Robinson’s Model of Child Labour

William Pouliot1
Carleton University

Baland and Robinson (2000) develop a model of child labour in which child labour can be inefficiently high when parents are credit constrained or bequests are at a corner. We show here that, when returns to human capital are uncertain and insurance markets do not exist, then the level of child labour can be inefficiently high even when parents are not credit constrained and bequests are interior.

I. Introduction Baland and Robinson (2000) construct a model of child labour for the purpose of studying how household decisions affect child labour, the child’s ability to acquire human capital, and the welfare implications of this. In essence, it is a two period model without uncertainty that relies, though not exclusively, on market imperfections in the form of credit constraints to generate conditions in which child labour can be inefficiently high. This theme of market imperfections is continued here by adding uncertainty in returns to human capital along with insurance markets, both complete and incomplete. Under the scenario of uncertainty in returns to human capital, we first show that when insurance markets are complete, then Propositions 1, 2 and 3 of Baland and Robinson (2000) remain valid. Our second scenario again considers uncertainty in returns to human capital but now insurance markets are incomplete. We find that these two assumptions serve as sufficient conditions for child labour to be inefficiently high. More specifically, we find Proposition 1 of Baland and Robinson (2000) no longer holds, i.e. child labour is inefficiently high even when savings and bequests are interior. In the absence of insurance markets, parents are no longer able to purchase insurance to offset uncertainty in returns to human capital, and as such, parents allocate away from the risky asset, human capital, and towards the riskless asset savings. Some might find our assumption regarding returns to human capital as questionable. More specifically, why should returns to human capital be uncertain? If one were to interpret human capital as education, and accumulation of human capital as higher education, it then seems rather obvious; returns to education will depend on labour market conditions, the overall state of the economy, and on advances in technology. All of these factors affect labour market conditions, its productivity, and thereby, affect future returns to education. Interpreting accumulation of human capital along these lines provides some motivation for incorporating uncertainty into Baland and Robinson’s model of child labour, and by doing so, we see how uncertainty over returns to human capital affects household choices. In particular, we shall see that, via Proposition 7, households substitute out of the risky asset,
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I would like to thank Chris Worswick and Jeff Bernstein for providing many valuable comments.

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human capital, and child labour becomes inefficiently high. II. Baland and Robinson’s Model We limit description of Baland and Robinson’s (2000) model to that of the household’s maximization problem. Their model is comprised of two periods, referred to as 1 and 2. At the beginning of period 1, parents decide how to allocate their children’s unit time endowment between child labour lc and human capital accumulation, where lc represents the fraction of a child’s unit labour endowment allocated to work. For simplicity, we assume that parents earn income, A, in periods 1 and 2. In period 2, each child supplies h(1 − lc ) units of labour, where h(·) represents human capital, and h (·) > 0 and h (·) < 0. We normalize the return to human capital to 2 1. The parent’s utility function is separable in c1 p and cp , consumption in periods 1 and 2 respectively, and is denoted by
2 1 2 Wp (c1 p , cp , Wc (cc )) = U (cp ) + U (cp ) + Wc (cc ),

(1)

where U (·) and Wc (·)† are both twice continously differentiable and strictly concave, and where Wc (·) denotes the child’s utility function. Parents can also choose to provide transfers, denoted b and referred to as bequests, to their children in period 2 and can transfer income between periods by saving, denoted s. Capital markets are imperfect which prevents parents from borrowing. They can, nevertheless, save. The household maximization problem can be represented as,
2 max U (c1 p ) + U (cp ) + Wc (cc ) s,b,lc

(2)

subject to c1 p = A + lc − s, c2 p = A − b + s, cc = h(1 − lc ) + b. After substituting the constraints for each variable in the maximization problem, we arrive at the following first-order conditions, (3)

U (A − b + s) = Wc (h(1 − lc ) + b) b > 0, U (A + s) > Wc (h(1 − lc )) U (A + lc − s) = U (A − b + s), U (A + lc ) > U (A − b), b = 0, s > 0, s = 0. U (A + lc − s) = Wc (h(1 − lc ) + b)h (l − lc ),

(4) (5) (6) (7) (8)

Using equations (4) through (8), Baland and Robinson (2000) establish the following propositions.
†We assume Wc (·) is uniformly continuous so the operations of differentiation and integration may be interchanged.
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Proposition 1 If bequests and savings are interior, then the laissez-faire level of child labour is efficient, i.e. h(1 − lc ) = 1. Proposition 2 If bequests are at a corner, then the laissez-faire level of child labour, lc , is inefficiently high, i.e. h(1 − lc ) > 1. Proposition 3 If savings are at a corner, then the laissez-faire level of child labour, lc , is inefficiently high, i.e. h(1 − lc ) > 1. III. Uncertainty in Returns to Human Capital For the first consideration along these lines, we now permit the return to human capital to be an absolutely continuous random variable and insurance markets to exist. With regards to the latter, we incorporate uncertainty through the following parametrization. Let cc = ∆h(1 − lc ) + b, (9)

where ∆ is a random variable with positive support, E [∆] = 1. We note here that cc increases with ∆, a result that will be used in the proof of Proposition 7. The generic household’s maximization problem now becomes
2 max E U (c1 p ) + U (cp ) + Wc (cc ) , s,b,lc

(10)

subject to c1 p = A + lc − s, c2 p = A − b + s, cc = ∆h(1 − lc ) + b.
2 Replacing c1 p , cp and cc in the objective function given by (10) with the corresponding values that are detailed in the budget constraint found in (11), and then differentiating the objective function in (10) with respects to lc , b and s results in the following first order conditions,

(11)

E [U (A − b + s)] = E [Wc (∆h(1 − lc ) + b)] U (A + s) > E [Wc (∆h(1 − lc ))] U (A + lc − s) = E [U (A − b + s)] U (A + lc ) > E [U (A − b)]

b > 0, b = 0, s > 0, s = 0.

(12) (13) (14) (15) (16)

U (A + lc − s) = E [Wc (∆h(l − lc ) + b)∆h (l − lc )],

Our next three propositions, Propositions 4, 5 and 6, establish equivalent versions of Propositions 1, 2 and 3 but now for the case when returns to human capital are random and insurance markets are complete. In order to establish the propositions that follow, we assume that the two parties enter into a binding insurance contract, where ∆ and h(1 − lc ) are common knowledge. Moreover, we assume that parents contract on behalf of their children for insurance in period 1, with the period-2 payout affecting only the child’s period-2 consumption. 3

Proposition 4 If parents have access to competitive insurance markets where they can contract at rate π = ∆ − 1, per unit of human capital, returns to human capital are an absolutely continuous random variable, and both savings and bequest are interior, i.e. s > 0 and b > 0, then child labour will be efficiently allocated. Proof. To establish this, we first show that expected profit of the insurance company is zero. The profit Π of the insurance company is defined as Π = π h(1 − lc ). Taking expectation in (17), we conclude that E [Π] = E [π ] h(1 − lc ) = 0, (18) (17)

as E [π ] = 1 − E [∆] = 1 − 1 = 0, and h(1 − lc ) is predetermined. We now show that the household’s budget constraint with insurance reduces to that given in (3). Without insurance, the child’s consumption is given by cc = ∆h(1 − lc ) + b. With insurance, the child’s consumption becomes cc = ∆h(1 − lc ) + b − π h(1 − lc ) = ∆h(1 − lc ) + b + (1 − ∆)h(1 − lc ) = h(1 − lc ) + b, which is the consumption given in equation (3), and the maximization problem reduces to that given in (2) and (3). According to Proposition 1, we can conclude that Proposition 4 holds. Proposition 5 If parents have access to competitive insurance markets where they can contract at rate π = ∆ − 1, per unit of human capital, returns to human capital are an absolutely continuous random variable, bequests are at a corner and savings are interior, i.e. b = 0 and s > 0, then child labour will be inefficiently high. Proof. We saw in the proof of Proposition 4 that the budget constraint of the parents given in (11) reduces to the budget constraint in (3). As a direct consequence of Proposition 2, we can conclude that Proposition 5 holds. (19)

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Proposition 6 If parents have access to competitive insurance markets where they can contract at rate π = ∆ − 1, per unit of human capital, returns to human capital are an absolutely continuous random variable, savings are at a corner and bequests are interior, i.e. s = 0 and b > 0, then child labour will be inefficiently high. Proof. We saw in the proof of Proposition 4 that the budget constraint of the parents reduces to the budget constraint in (3). As a direct consequence of Proposition 3, we can conclude that proposition 6 holds. For our second consideration along these lines, we use the above first-order conditions detailed in equations (12) - (16) and equation (9) to establish Proposition 7, which is detailed below. It states that when the returns to human capital are random and insurance markets are incomplete, then even when both bequests and saving are interior, child labour can be inefficiently high. We see that such an outcome did not occur under certainty; as long as both bequests and savings are interior, child labour is efficiently allocated. This proposition emphasizes the importance of complete insurance markets in the sense that, in their absence, parents allocate out of the risky asset, human capital, and child labour becomes inefficiently high. With this introduction, we now formalize this in the following proposition. Proposition 7 When returns to human capital are an absolutely continuous random variable, insurance markets do not exist, and bequests and savings are interior, i.e. s > 0 and b > 0, then child labour is inefficiently high. Proof. Upon substitution of equation (12) into (15), we conclude that U (A + lc − s) = E [Wc (∆h(1 − lc ) + b)]. Substituting equation (20) into (14), we have E [Wc (∆h(1 − lc ) + b)∆h (1 − lc )] = E [Wc (∆h(1 − lc ) + b)]. (21) (20)

Subtracting E [Wc (∆h(1 − lc ) + b)]h (1 − lc ) from the left-hand side of equation (21), we obtain,

E [Wc (∆h(1 − lc ) + b)∆h (1 − lc )] − E [Wc (∆h(1 − lc ) + b)]h (1 − lc ) = E [Wc (∆h(1 − lc ) + b)∆h (1 − lc ) − Wc (∆h(1 − lc ) + b)h (1 − lc )] = E [Wc (∆h(1 − lc ) + b)(∆h (1 − lc ) − h (1 − lc ))] = E [Wc (∆h(1 − lc ) + b)(∆ − 1)]h (1 − lc ). (22)

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Now, subtracting E [Wc (∆h(1 − lc ) + b)]h (1 − lc ) from the right-hand side of equation (21), we arrive at E [Wc (∆h(1 − lc ) + b)] − E [Wc (∆h(1 − lc ) + b(B ))]h (1 − lc ) = E [Wc (∆h(1 − lc ) + b) − Wc (∆h(1 − lc ) + b)h (1 − lc )] = E [Wc (∆h(1 − lc ) + b)(1 − h (1 − lc ))] = E [Wc (∆h(1 − lc ) + b)](1 − h (1 − lc )). (23)

Replacing the left-hand side of equation (21) with equation (22), and the right-hand side of equation (21) with (23), results in the following equality, h (1 − lc )E [Wc (∆h(1 − lc ) + b)(∆ − 1)] = (1 − h (1 − lc ))E [Wc (∆h(1 − lc ) + b)]. Subtracting h (1 − lc )E E [Wc (∆h(1 − lc ) + b)](∆ − 1) = 0 = E [X ]E [∆ −

(24)

from the left-hand side of (24), where we used the result, E E [X ](∆ − 1) 1] = 0, we conclude with the following representation of (24), h (1 − lc )Cov (Wc , ∆) = E [Wc (∆h(1 − lc ) + b)](1 − h (1 − lc )).

(25)

Since cc increases with ∆, we have that Cov (Wc , ∆) < 0, and since h (1 − lc ) > 0, we have that the left-hand side of (25) is negative. For equality to hold in equation (25), the right-hand side must also be negative. We see that Wc (cc ) > 0 implies E [Wc (cc )] > 0. But for the left hand side to be negative, it must be that 1 − h (1 − lc ) < 0, or h (1 − lc ) > 1. As a result of these considerations, we now conclude that child labour is inefficiently high. We see from Proposition 7 that, when returns to human capital are uncertain and insurance markets are incomplete, then child labour will be inefficiently high even when both bequests and savings are interior. In this case, parents, aware that returns to human capital are risky, now allocate more of their child’s time to earning certain period-1 income, rather than permit the child to accumulate more human capital. IV. Conclusion It has been shown that when returns to human capital are uncertain and insurance markets are complete, Propositions 1, 2 and 3 of Baland and Robinson (2000) remain valid. However, when return to human capital is uncertain and insurance markets do not exist, then Proposition 1 no longer holds; even when savings and bequests are interior, child labour is inefficiently high. References Baland, Jean-Marie and Robinson, James A. ‘Is Child Labour Inefficient?’ J.P.E. 108, no. 4 (2000): 663-681. Varian, Hal. Microeconomic Analysis. New York: W. W. Norton & Company, 1992. 6 vol.