Lec5 PT Aza05 GZ93 Handout

Economic Growth
Poverty Trap
Hosny Zoabi
New Economic School
Hosny Zoabi (New Economic School) Poverty Trap 1/1

Poverty Trap Introduction
Poverty Trap
In the basic Solow Model we observed one stable steady state
We introduced two extensions:

Heterogeneous agents with different saving rate
Endogenous saving rate.

Poverty Trap
What is a Poverty Trap?
A self-perpetuating condition where an economy suffers from

persistent underdevelopment.
So far we have explained differences in income across countries

by differences in factors accumulation and TFP differences.
Thus, the different theories and mechanisms of poverty trap

address the adverse impact on the acquisition of physical or
human capital, and on the adoption of modern technology.

Poverty Trap
Trap arise both from market failure and also from institution
failure. That is, from traps within the set of institutions that
govern economic interaction.
Institutions - in which we include the state, legal systems, social

norms, conventions and so on - are determined endogenously
within the system, and may be the direct cause of poverty traps;
or they may interact with market failure, leading to the
perpetuation of an inefficient status quo.

Poverty Trap Some Facts
Facts and Data

What does it mean to live on one or two dollars per day?
Poverty translates into hunger, lack of shelter, illness without
medical attention.
Calorie intake in the poorest countries is far lower than in the
rich.
The malnourished are less productive and more susceptible to
disease than those who are well fed.
Infant mortality rates in the poorest countries are up to 40 or 50
times higher than the OECD average.
Many of the common causes, such as pneumonia or dehydration
from diarrhea, cost very little to treat.
Facts and Data
The poor are more vulnerable to events they cannot control.

They are less able to diversify their income sources.
They are more likely to suffer from famine, violence and natural
disasters.
They have lower access to credit markets and insurance, with
which to smooth out their consumption.
Their children risk exploitation, and are less likely to become
educated.

Facts and Data

Measured in 1996 US dollars and adjusted for purchasing power
parity, average yearly income per capita in Luxembourg for 2000 was
over $46,000.
In Tanzania by contrast, average income for 2000 was about $500.
In other words, people in Luxembourg are nearly 100 times richer on

average than those living in the very poorest countries.
Luxembourg is rather exceptional in terms of per capita income, but

even in the US average income is now about 70 times higher than it
is in Tanzania.
Some countries record per capita income even lower than Tanzania.
1997 average income in Zaire is measured at $276.
Facts and Data

How has the gap between the richest and the poorest evolved over
time?
Increased dramatically, even in the postwar era.

In 1960, per capita income in Tanzania was $478. After rising
somewhat during the 1960s and 1970s it collapsed again in the
1980s. By 2000 it was $457
Many other poor countries have had similar experiences, with income
hovering around the $500.
Meanwhile, the rich countries continued exponential growth.
Income in the US grew from $12,598 in 1960 (26 times that of
Tanzania) to $33,523 in 2000 (73 times).
Other rich industrialized countries had similar experiences. In
Australia over the same period
Hosny Zoabi (New Economic School) per
Poverty Trapcapita GDP rose from $10,594 to
8/1
Facts and Data

How the rich have gotten richer relative to the poor?
Left: Average of 5
richest and poorest
countries. right 10
countries.
Income disparity has
widened dramatically in
the postwar era, and the
rate of divergence is, if
anything, increasing.
Figure 1.

Poverty Trap History
Economic Development
How did the massive disparities arise?
Although the beginnings of agriculture some ten thousand years
ago marked the start of rapid human progress, for most of the
subsequent millennia all but a tiny fraction of humanity was
poor.
Poverty: Suffering regularly from hunger and highly vulnerable
to adverse shocks.
Early improvements in economic welfare came with the rise of
premodern city-states.
Collective organization of irrigation, trade and communications.
Handicraft manufacture became more specialized over time, and
agriculture more commercial.
Hosny Zoabi (New Economic School) Poverty Trap 10 / 1
While such city-states and eventually large empires rose and fell
over time, and the wealth of their citizens with them, until the
last few hundred years no state successfully managed the
transition to what we now call modern, self-sustaining growth.
Throughout the history, increased wealth was followed by a rise
in population. Malthusian pressure led to famine and disease.
The overriding reason for lack of sustained growth was that in
the premodern world production technology improved only
slowly.
While the scientific achievements of the ancient Mediterranean
civilizations and China were remarkable, in general there was
little attempt to apply science to the economic problems of the
peasants.
Scientists and practical people
Hosny Zoabi (New Economic School) had only limited interaction.
Poverty Trap 11 / 1
Early signs of modern growth appeared in Western Europe

around the middle of the last millennium.
Science from the ancient world had been preserved, and now
began to be extended.
The revolutionary ideas of Copernicus led to intensive study of
the natural world and its regularities.
The printing press and movable type dramatically changed the
way ideas were communicated.
Innovations in navigation opened trade routes and new lands.

These technological innovations led to changes in institutions.
The weakening of local fiefdoms was followed in many countries
by a consolidation of central authority, which increased the scale
of markets and the scope for specialization
Growing trade with the East and across the Atlantic produced a
rich and powerful merchant class, who subsequently leveraged
their political muscle to gain strengthened property and
commercial rights.
Increases in market size, institutional reforms and progress in
technology at first lead to steady but unspectacular growth in
incomes.
In 1820 the richest countries in Europe had average per capita
incomes of around $1,000 to $1,500 some two or three times
that
Hosny Zoabi (Newof the School)
Economic poorest countries today.
Poverty Trap 13 / 1
Richness in our sense begins with the Industrial Revolution in Britain
(although the rise in incomes was not immediate) and, subsequently,
the rest of Western Europe.
Industrialization - the systematic application of modern science to

industrial technology and the rise of the factory system - led to
productivity gains entirely different in scale from those in the
premodern world.
In terms of proximate causes, the Industrial Revolution in Britain was

driven by a remarkable revolution in science that occurred during the
period from Copernicus through to Newton, and by what Mokyr
(2002) has called the Industrial Enlightenment, in which traditional
artisanal practices were systematically surveyed, cataloged, analyzed
and generalized by application of modern science. Critical to this
process was the interactions Poverty
Hosny Zoabi (New Economic School)
of scientists
Trap
with each other and with 14 / 1
The structure of the British economy was massively transformed in a
way that had never occurred before.
Employment in agriculture fell from nearly 40% in 1820 to about

12% in 1913 (and to 2.2% in 1992).
The stock of machinery, equipment and non-residential structures per

worker increased by a factor of five between 1820 and 1890, and then
doubled again by 1913.
The literacy rate also climbed rapidly. Average years of education

increased from 2 in 1820 to 4.4 in 1870 and 8.8 in 1913 [Maddison
(1995)].
As a result of these changes, per capita income in the UK jumped
from about $1,700 in 1820 to $3,300 in 1870 and $5,000 in 1913.
Looking forward from the start of the last century, it might have
seemed likely that these riches would soon spread around the world.
The innovations and inventions behind Britains productivity miracle

were to a large extent public knowledge and they were profitable.
Such a forecast would have been far too optimistic. Relatively few
countries besides Western Europe and its off-shoots have made the
transition to modern growth.
Much of the world remains mired in poverty.

Among the worst performers are Sub-Saharan Africa and South Asia,
which together account for some 70% of the 1.2 billion people living
on less than $1 per day.
Why is it that so many countries
Hosny Zoabi (New Economic School)
are still poorer than 19th Century16 / 1
Poverty Trap
World Income Distribution - Log(y), 1960 & 1990

The world distribution of income is thinning in its middle ranks
In 1960 only 26% of

118 countries in the
extreme 8 columns
(17% in the 4 richest
and 9% in the 4 poorest
income categories)
In 1990 35% of 129
countries in these tail
positions (23% in the 4
richest and 12% in the
4 poorest income
categories)
Poverty Trap The Mechanics of Poverty Trap
The Mechanics of Poverty Trap
Assume that the state of the economy in period t is represented

by a single variable, xt .
A higher x means that the economy is more developed.
The equilibrium path follows a deterministic one dimensional

difference equation xt+1 = F (xt ).
Once the initial condition, x0 , is given, this law of motion can be

applied iteratively to obtain the entire trajectory of the economy.

xt+1 F(xt) 45

If F (x) stays above the 45
line everywhere, then the
economy grows forever.
Figure 1a
Example: The endogenous
growth models, (AK).
The curve does not have to
be linear. xt
O
No poverty trap, since the long run performance of the economy

x
is independent of the initial condition
Hosny Zoabi (New Economic School) Poverty Trap

F 19 / 1

F xt+1
45
If F (x) is concave .
The economy grows in
F(xt)
the transition to the
stable steady state and
converges to x .
Example: The Solow
models. x xt
O x*
No poverty trap, since the long run performance of the economy is

independent of the initial condition. x
Note: (Confusions) sometime the term trap,Fdescribes
F unsustainable growth. However, this should be more appropriately
called,
Hosny Zoabi the limit
(New Economic School) to growth.
Poverty Trap 20 / 1

xt+1
The long run
performance depends on F(xt)
45
the initial condition.
Figure 2a 2
When the economy
starts above xc , it will
stay above xc and may
either grow forever or
reach a higher
xc xt
stationary state. O
Example: Solow with heterogenous agents; endogenous saving rate.
Poverty trap, if it starts below xc , xit will be trapped forever below xc .
The economy caught in the trap will converge to the low-level
stationary state. F

xt+1
The long run
F performance depends on F(xt)
45
the initial condition.
When the economy
starts above xc , it will
stay above xc and may
either grow forever or
reach a higher
x x xt
stationary state. O xc
Poverty trap, if it starts below xc , it will be trapped forever below xc .
The economy will fluctuate below xxc .
The economy will remain poor only because it is poor. Thus, the
F poverty becomes its own cause. F

The previous examples
project the very stark
xt+1
view that the economy
can never escape from F(xt)
the poverty trap. This 45
should not be taken
Figuretoo
3a 3
literally. The essential
message of poverty
traps is that poverty
tends to persist, and
that it is difficult, not xt
O
necessarily impossible,
for the economy to
escape. x F
Here poverty trap in its weak form. The economy has to experience

The previous examples
project the very stark
xt+1
view that the economy
F can never escape from F(xt)
the poverty trap. This 45
should not be taken too
literally. The essential
message of poverty
traps is that poverty
tends to persist, and
x
that it is difficult, not xt
O
necessarily impossible,
for the economy to
escape.
x F
The economy may or may not manage to escape the trap after

The situations depicted in previous figures are difficult to
separate, but the message is the same; the self perpetuating
nature of poverty.
This analysis can be extended in many directions. First, one

could add stochastic shocks to the system, as xt+1 =
F (xt ; t+1 ).
This can be viewed as a jump in the state variable in the case of

the additive shocks, xt+1 = F (xt ) + t+1 . Examples: natural
disasters, plagues, and wars could cause the capital-labor ratio
to jump up and down.
Thus, in the presence of such stochastic shocks, the economy

may occasionally and recurrently escape or fall into the trap.

Second, the above analysis assumes that xt+1 is uniquely determined
as a function of xt .
If the underlying economic xt+1 F(xt)
models permit multiple
equilibria, as often is the case 45
with models of external
economies and strategic
complementarity, then F ()
becomes a correspondence, and
the (deterministic) equilibrium
xt
path follows the difference O
inclusion, xt+1 F (xt ).
The example here depicts one possibility, suggesting that the
economy is stuck in a low-level stationary state, in part due to
coordination failures.
Some Notes
Poverty trap is often interpreted as an explanation for the
cross-country income difference. As such, it is frequently viewed
as an alternative to the models that attribute cross-country
income difference to the cross-country difference in, say, TFP
and/or the investment distortions.
This is a misinterpretation. First, the message of poverty trap
models is the self-perpetuating nature of poverty. It suggests
that the long run performance of an economy could be much
better if its initial condition were better.
It does not mean that the cross-country difference in the long
run performance is due mostly to the difference in their initial
conditions.
Second, the notion of poverty trap does not contradict the
Some Notes
Many calls for foreign assistance for underdeveloped countries
can be understood using the notion of poverty trap. See, e.g.,
Sachs et. al. (2004).
Thus, poverty trap is often viewed as a powerful case for policy
activism.
It is important to keep in mind that each model of poverty trap
is designed to highlight one particular feedback mechanism
behind the vicious cycle. Thus, other sources of poverty trap are
deliberately assumed away.
In reality, of course, many sources of poverty trap are likely to
co-exist and any policy intervention in an attempt to pull the
economy out of one trap may end up pushing it into another.
Poverty Trap Inequality and Economic Growth
The Galor-Zeira Model
Income Inequality and Economic Growth - Galor and Zeira (1993)
Overlapping-Generations economy
t = 0, 1, 2, 3, ...
One good
3 factors:
K Physical capital
Ls Skilled Labor
Lu Unskilled Labor

Production
Total output produced

Yt = Yts + Ytu
Production in the skilled-intensive sector:
Yts = F (Kt , Lst ) Lst f (kt ); kt Kt /Lst
Production in the unskilled-intensive sector:
Ytu = aLut

Inverse Demand for Factors
Capital:
rt = f (kt ) r(kt )
Skilled labor:
wts = f (kt ) f (kt )kt w s (kt )
Unskilled labor:
wtu = a w u

Factor Prices
Small open economy

World interest = r
=
rt = r
kt = f 1 (r) k
wts = w s (k) w s
=
(rt , wts , wtu ) = (r, w s , w u ) t

Individuals
Each generation consists of a continuum of measure 1

Each Individual has 1 parent and 1 child
Identical in:
Preferences
Innate abilities
Differ in:
Parental income Investment in HC

Member of Generation t: Period of Life
First period of life (Period t):
[invest in HC] or [work as unskilled]
Second period of life (Period t + 1):
[work as unskilled / no investment in HC] or [work as skilled /

investment in HC in 1st period]

Member of Generation t: Endowment and

Preferences
Time endowment:
1 units of time in each period
Capital endowment:
bt capital inherited in 1st period
Preferences:
ut = ln ct+1 + (1 ) ln bt+1 (0, 1)

Member of Generation t: Budget Constraint
Second period budget constraint:
ct+1 + bt+1 xt+1
ct+1 consumption
bt+1 transfers to offspring
xt+1 income in period t + 1

Member of Generation t: Optimization
{ct+1 , bt+1 } = arg max[ ln ct+1 + (1 ) ln bt+1 ]
s.t. ct+1 + bt+1 xt+1

Member of Generation t: Optimization
bt+1 = (1 )xt+1
ct+1 = xt+1
=
v t = ln (xt+1 ) + (1 ) ln ((1 )xt+1 )
= [ ln + (1 ) ln(1 )] + ln xt+1
= v t is monotonic increasing in 2nd period wealth xt+1

= Occupational choice is based on maximization of 2nd period
wealth xt+1

Assumptions
Imperfect Capital Markets:
r<i (A1)
r interest rate for lenders

i interest rate for borrowers (for investment in HC)
Fixed cost of education (Indivisibility of investment in HC)
h>0 (A2)

Income: Unskilled Individuals
xut+1 = (w u + bt )(1 + r) + w u
= w u (2 + r) + (1 + r)bt

Income: Skilled Individuals
s
w (h bt )(1 + i) if bt h
xst+1 =
w s + (bt h)(1 + r) if bt h

=
s
w (1 + i)h + (1 + i)bt if bt h
xst+1 =
w s (1 + r)h + (1 + r)bt if bt h


Assumptions
Investment in human capital is not beneficial for individuals who

must finance the entire cost of education via borrowing
w s (1 + i)h < w u (2 + r) (A3)
Investment in human capital is beneficial for individuals who can

finance the entire cost of education without borrowing
w s (1 + r)h > w u (2 + r) (A4)

Income from Being Unskilled Worker

xut+1 = w u (2 + r) + (1 + r)bt
xtu+1
wu ( 2 + r ) (1 + r )
bt

Income from Being Skilled Worker

s
w (1 + i)h + (1 + i)bt if bt h
xst+1 =
ws (1 + r)h + (1 + r)bt if bt h

xt +1 w (1 r )h (1 r )bt if bt h
xts+1
(1 + r ) xtu+1
ws
wu ( 2 + r ) (1 + r )
(1 + i )
w s (1 + i )h
h bt
Oded Galor Inequality and the Process of Development
Occupational Choice as a function of Bequest
xts+1
xtu+1
f h bt

Bequest and Occupational Choice

< f xut+1 > xst+1 (individual t becomes unskilled)
bt
> f xut+1 < xst+1 (individual t becomes skilled)

where
w u (2 + r) [w s (1 + i)h]
f=
ir

Bequest Dynamics
bt+1 = (1 )xt+1

w u (2 + r) + (1 + r)bt bt [0, f ]

bt+1 = (1 ) w s (1 + i)h + (1 + i)bt bt [f, h]

w s (1 + r)h + (1 + r)bt bt [h, )


Bequest Dynamics: Assumptions
(1 )(1 + r) < 1
(A5)
(1 )(1 + i) > 1
(f ) < f
(A6)
(h) > h

Bequest Dynamics
bt +1
(bt )
(1 ) ws (1 )(1 + r )
(1 )(1 + i )
(1 ) wu (2 + r ) (1 )(1 + r )
f h
bt
Hosny Zoabi (New Economic School) Oded Galor
Poverty TrapInequality and the Process of Development 49 / 1
Bequest Dynamics
bt +1
(bt )
bu g bs
bt
Interpretation of the Results
In the long run, the distribution of bequests has mass in two

points: bu and bs
Dynasties whose bequests in t are smaller than g, end up at bu .

Since bu < f it implies that they will be unskilled
Dynasties whose bequests in t are greater than g, end up at bs .

Since bs > f it implies that they will be skilled

bt +1
(bt )
bu bs
bt
s
l
lu (b0 )
bb
t
g t

Hence, if a country is sufficiently poor, such that the mean of

bequests is smaller than g, full equality implies that all
individuals will be unskilled in the long run
Hence, income inequality is beneficial for growth

Hence, if a country is sufficiently rich, such that mean of

bequests is larger than g, full equality implies that all individuals
will be skilled in the long run
Hence, income inequality is harmful for growth

Policy Implications of the Galor Zeira Model
Consider the following government policy:
The government provides public schooling free of charge

The government levies lump-sum taxes on skilled workers
The government budget constraint is balanced, i.e., the
lump-sum taxes finance the costs of schooling, h unit per
student
Lets show that this policy Pareto dominates the competitive
equilibrium

Recall that utility maximization maximization of 2nd period

income, xt+1
Therefore we only need to make sure that 2nd period income

under the government policy, denoted xPt+1 satisfies:
1 xPt+1 xt+1 for all individuals

2 xPt+1 > xt+1 for some individuals

2nd period income under the government policy unskilled individual
xP,u u
t+1 = (w + bt )(1 + r) + w
u
= w u (2 + r) + (1 + r)bt
An individual who chooses not to go to school doesnt benefit from

free schooling but doesnt pay taxes. Therefore he is unaffected by
the policy


2nd period income under the government policy skilled individual
xP,s s
t+1 = w + (1 + r)bt
Balanced budget constraint for the government implies
= (1 + r)h
Hence,
xP,s s
t+1 = w (1 + r)h + (1 + r)bt

2nd period income under the government policy skilled individual
Notice that xP,s s

t+1 > xt+1 if bt < h
Notice that xP,s s

t+1 = xt+1 if bt h

Occupational Choices
xP,s P,u
t+1 > xt+1
w s (1 + r)h + (1 + r)bt > w u (2 + r) + (1 + r)bt
w s (1 + r)h > w u (2 + r)
But this is A(4)! So everyone becomes skilled worker

We can already conclude that:
All individuals whose bequests bt < h are strictly better off under
the policy
All individuals whose bequests bt h are indifferent w.r.t the

policy
Hence the policy Pareto dominates the competitive equilibrium.

Whats the effect of government policy on the long-run equilibrium?
Recall that bt+1 = (1 )xt+1 . Hence
bPt+1 = (1 )[w s (1 + r)h + (1 + r)bt ]
= (1 )[w s (1 + r)h] + (1 )(1 + r)bt

Properties of P (bt )
1 P (0) = (1 )[w s (1 + r)h] > 0

2 P (bt ) = (1 )(1 + r) < 1

In words, P (bt ) is linear with a positive intercept and a slope which

is positive but smaller than 1.
Therefore, P (bt ) has a unique, globally stable steady-state.
Note that this is the high steady-state in the economy w/o
government policy.
Thus, the proposed government policy not only Pareto dominates the
competitive equilibrium, it also assures that in all future generations,
everybody becomes skilled workers and all dynasties converge to the
same wealth in the steady-state

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Economic Growth

New Economic School

Hosny Zoabi (New Economic School) Poverty Trap 1/1

In the basic Solow Model we observed one stable steady state

We introduced two extensions:

Hosny Zoabi (New Economic School) Poverty Trap 2/1

What is a Poverty Trap?

A self-perpetuating condition where an economy suffers from

So far we have explained differences in income across countries

Thus, the different theories and mechanisms of poverty trap

Hosny Zoabi (New Economic School) Poverty Trap 3/1

Institutions - in which we include the state, legal systems, social

Hosny Zoabi (New Economic School) Poverty Trap 4/1

Facts and Data

Facts and Data

The poor are more vulnerable to events they cannot control.

Hosny Zoabi (New Economic School) Poverty Trap 6/1

Facts and Data

In Tanzania by contrast, average income for 2000 was about $500.

In other words, people in Luxembourg are nearly 100 times richer on

Luxembourg is rather exceptional in terms of per capita income, but

Facts and Data

Increased dramatically, even in the postwar era.

Facts and Data

Hosny Zoabi (New Economic School) Poverty Trap 9/1

Early signs of modern growth appeared in Western Europe

Hosny Zoabi (New Economic School) Poverty Trap 12 / 1

Industrialization - the systematic application of modern science to

In terms of proximate causes, the Industrial Revolution in Britain was

Employment in agriculture fell from nearly 40% in 1820 to about

The stock of machinery, equipment and non-residential structures per

The literacy rate also climbed rapidly. Average years of education

The innovations and inventions behind Britains productivity miracle

Much of the world remains mired in poverty.

World Income Distribution - Log(y), 1960 & 1990

In 1960 only 26% of

The Mechanics of Poverty Trap

Assume that the state of the economy in period t is represented

A higher x means that the economy is more developed.

The equilibrium path follows a deterministic one dimensional

Once the initial condition, x0 , is given, this law of motion can be

Hosny Zoabi (New Economic School) Poverty Trap 18 / 1

The Mechanics of Poverty Trap

xt+1 F(xt) 45

No poverty trap, since the long run performance of the economy

Hosny Zoabi (New Economic School) Poverty Trap

The Mechanics of Poverty Trap

No poverty trap, since the long run performance of the economy is

The Mechanics of Poverty Trap

The Mechanics of Poverty Trap

The Mechanics of Poverty Trap

The Mechanics of Poverty Trap

The Mechanics of Poverty Trap

This analysis can be extended in many directions. First, one

This can be viewed as a jump in the state variable in the case of

Thus, in the presence of such stochastic shocks, the economy

The Mechanics of Poverty Trap

The Galor-Zeira Model

Income Inequality and Economic Growth - Galor and Zeira (1993)

Hosny Zoabi (New Economic School) Poverty Trap 29 / 1

Total output produced

Production in the skilled-intensive sector:

Yts = F (Kt , Lst ) Lst f (kt ); kt Kt /Lst

Production in the unskilled-intensive sector:

xt+1 F(xt) 45