ECONOMICS FOR PUBLIC POLICY

Teaching Session 11
Michaelmas Term 2018

Anandi Mani
 Plan for the Week
¨ Monday Lecture with me: Poverty
¨ Tuesday
¤ Lecture with me: Welfare Reform
¤ Karen Croxson – Case study on Affordable Care Act
¨ Wednesday:
¤ Macro Lecture with Sir John Vickers
¤ Weekly Test Clinic with Ingo
¨ Friday:
¤ Summary of the week with me
¤ Test Review with Ingo
¤ Seminar -- Presidential Debate on Fair Pay
 Learning Outcomes
¨ By the end of Week 6, you should:
¨ appreciate that defining and measuring poverty is difficult and
always involves value judgements;
¨ understand the inefficiencies related to poverty (and inequality)
¨ understand the rationale for government provision of cash benefits;
¨ be aware of the potential disincentives effects to work that welfare
and social insurance programmes could introduce.
Implications for the Role of the State
¨ High levels of Poverty (and Inequality) are undesirable
¤ They reduce Social Welfare (Equity argument)
¤ But they might also reduce Efficiency
¤ There may be No Equity-Efficiency trade-off

¨ The role of the State: State policies can influence both top and bottom
inequality
¤ Redistributive strength of tax (Week 4)
¤ Redistributive strength of Service Delivery (Weeks 5 and 6)

¨ State policies can address market inefficiencies

¤ by providing Social Insurance and Poverty Relief schemes (Week 5)
¤ but these could create some disincentives for work effort
 Plan for Today
¨ (A) Introduction: Poverty & Inequality
¨ (B) Measurement
¨ (C) Arguments for State intervention in alleviating poverty
¨ (D) Summary and Policy Implications
Poverty (& Inequality) in the World Today

¨ Substantial progress has been made in reducing extreme poverty

(over past 30 years). (Animation)

¨ But extreme poverty continues to affect large swathes of Africa,

Asia and other regions

¨ Furthermore, within country inequalities remain important

¤ Within-country inequality is sometimes larger than between-country
inequality
World Income Distribution 1988
World Income Distribution 2008
 Plan for Today
¨ (A) Introduction
¨ (B) Measurement
¨ (C) Arguments for State intervention in alleviating poverty
¨ (D) Summary and Policy Implications
 (B) Measurement
¨ Poverty measures can be evaluated using Social welfare functions.
¤ Special case of a SWF, with no weight to the well-off.

¨ Two steps to poverty measurement (Sen, 1976):

¤ (1) Identification: Decide who is poor à define a Poverty line, X
n A critical threshold of income, consumption or access to goods and services below
which individuals are declared to poor
¤ (2) Aggregation: Add up individuals (or their incomes) into one poverty
index, P(X) – various measures available to aggregate up

¨ In identifying who is poor, there are two broad concepts applied

¤ Absolute Poverty & Relative poverty
 Absolute Poverty

¨ A person is poor in absolute terms if her money income is too low to keep her
alive and healthy’ (Barr, p109).
¨ Normally calorie-based food poverty line (minimum requirement to function
properly, usually 2000 calories per equivalent adult) PLUS essential non-food
goods (see Deaton 1997). Typically applied in LDC.
 Relative Poverty

¨ A person is poor in relative terms if he cannot participate in the sorts of activities

pursued by the generality of the population’ (Barr, p109). Not only material
deprivation but also social exclusion
 Measuring Poverty: Key Issues to Consider
¨ Which indicator of welfare?
¤ Full Income: ‘Money and non-money income’, where the latter includes
value of: own production, leisure or job satisfaction. (Barr, Chapter 5)
¤ Capabilities approach : “Poverty is not just a lack of money, but not
having to capability to realise one’s full potential in all dimensions of a
human being’s life” -- Sen (1992, Ch 3)
n Multi-dimensionality of poverty: health, nutrition, education, etc. Human
Development Index (HDI)
¨ What is the relevant unit?
¤ Households or Individuals?
¨ Absolute poverty or Relative poverty?
¤ i.e. Resources needed to be alive and healthy alone or also social exclusion
 Poverty Lines in Practice
¨ Income vs. Consumption-based PLs:
¤ Commonly indicators of wellbeing are: consumption, food expenditure or
money income
¤ Consumption indicators more common in LDCs given importance of food
in poor’s budget, ease of measurement and stability (as compared to
income).
¤ Adjustments to Consumption/Income: Given
n HH size and composition differences and
n Price variations across places and time
¨ National vs. International PLs (e.g. $1.25 a day)
 Commonly used Poverty Measures
¨ Once a poverty line has been defined, aggregate across individuals.
¨ The most popular measures belong to the Foster-Greer-Thorbecke (FGT)
family

¨ Poverty Count: % of individuals with income below poverty line.

¨ Poverty Gap: Takes into account distance from poverty line.

¤ It represents the shortfall in average income, needed to pull everyone out of poverty.
¤ E.g. P(Gap)= 5% would suggest that an increase in average income by 5% of the
poverty line would eliminate entire country’s poverty.

¨ Poverty Gap Squared: Captures severity of poverty – unlike the above two
measures.
¤ Sensitive to the distribution among the poor by giving a higher weight to larger
Poverty Gaps
 Plan for Today
¨ (A) Introduction
¨ (B) Measurement
¨ (C) Arguments for State intervention in alleviating poverty
¨ (D) Summary and Policy Implications
 (C) Arguments for State Intervention
¨ (1) Efficiency Arguments for State intervention
¤ (a) Consumption & Income Smoothing
¤ (b) Poverty Traps
¤ (c) “S-curves” with no Poverty Traps
¨ (2) Relative Poverty & Equity Arguments for State intervention
 (C.1) Efficiency Rationale for State
Intervention in PA
¨ In previous lectures, we have seen that market imperfections lead to
inefficient outcomes, which often justifies state intervention.
¨ Market imperfections hurt the poor more
¤ E.g Credit markets: Harder/Costlier to borrow if you lack collateral
¤ E.g. Lack of Insurance hurts more when income is both low and uncertain

¨ This can trigger

¨ (a) Inefficient investment & consumption choices that perpetuate poverty..
¨ (b) …or even result in Poverty Traps
¨ (c) An “S-Curve” relationship between income today and income
tomorrow – even if not necessarily Poverty Traps
 (a) How the poor respond to imperfect
markets
¨ For the poor, small reductions in consumption & income have large
adverse effects on well-being. So they try harder to ‘smooth’ (reduce
variation in) these.
¤ Consumption Smoothing: E.g. Excess buffer stock of grain to avoid starvation,
Take kids out of school to supplement income, Low savings
¤ Income Smoothing: E.g. Choose low-yield but less risky crops and technologies
(seeds) and delay adopting innovations

¨ These ‘second-best’ consumption and income smoothing efforts of the poor

have negative long term effects on health, productivity & income (Morduch
(1995))

¨ Being unable to borrow reduces their ability to make indivisible

investments (in skill or physical capital) with high longer term returns
 (b) Poverty Traps
¨ Red line shows how income evolves
!"#$%& '()(*&

between today and tomorrow

0
¤ If it is below 45 degree line
Inside =>income tomorrow is lower than
Poverty
Trap today (opposite if it is above)
C
Outside
Poverty Trap
¨ 2 stable equilibrium income levels:
A & B – very low or high income
¤ Small shocks around threshold C can
/
result in a person ending up very
poor – or much better off
!"#$%& +$,-. ¤ C is an unstable equilibrium
Poverty Trap: A situation where a person
remains poor because he is poor
 Potential Poverty Trap Mechanisms
¨ Nutritional Poverty Traps: Poor nutrition makes the poor are less
productive => low earnings & involuntary unemployment. Dasgupta
and Ray (1986). (Poor Economics, Ch.2).

¨ Savings/Investment based Poverty Traps

¨ Many investments are lump-sum, but the poor lack savings & face
borrowing constraints, hence can’t make high-return investments & remain
poor (Galor-Zeira, 2003), Chapter 8 Poor Economics

¨ Geographical Poverty traps (Jalan and Ravallion, 2001):

¤ Geographic externalities might lead to local increasing returns.

¨ Risk & Vulnerability (Poor Economics, Ch.6. Banerjee, 2000):

¤ Small shocks can have large neg. effects for the poor => so they make
low-risk, lower-return investments which keep them poor
 Behavioral Poverty Traps
¨ Poverty is not just low material resources but it lowers mental resources too

¨ Cognitive Traps: Poverty reduces Mental Bandwidth:

¤ Low & uncertain incomes => the poor remain mentally preoccupied with on
daily/urgent choices (Mullainathan-Shafir 2013, Mani et al 2013, Lichand & Mani
2016)
¤ Hence make worse choices on important issues (health, finances and parenting)
that keeps them poor. ( World Economic Forum talk )

¨ Aspirations Traps: Poverty lowers Aspirations

¤ Poverty involves failure => Lower aspirations and lower effort in in becoming
economically mobile. (Ray, 2003, Ghosal, Dalton & Mani 2016)

¨ These kind of poverty traps may be prevalent in LDCs & DCs – even when
basic needs are satisfied.
 Implications of Poverty Traps
¨ Vulnerability – as uninsured exposure to shocks – can have a long-
term effect because one-time shocks can push a household under the
threshold

¨ Thus, very small improvements in income will have no structural

effect: It is difficult to escape the poverty trap.

¨ Only transfers sufficiently large to help a poor person go beyond

the threshold (”Big Push”) will be effective in the long run.
 Evidence for Poverty Traps? 132 Journal of Economic Perspectives

Figure 2
Absolute Income Stagnation is Rare

50
United States

¨ Kraay and Mckenzie (2014) report 25 Greece

¤ limited evidence for most of the mechanisms

Real GDP per capita in 2010 (log scale)

Mexico
10
Turkey

except spatial poverty traps and suggestive

China
¤ 5

evidence for behavioral poverty traps… India

Ghana
Nicaragua

¨ But agree evidence on mechanisms taken 1

Haiti

individually may not reflect that the poor .5

Ethiopia

Burundi

face multi-dimensional constraints. Democratic Republic of Congo

.5 1 5 10 25 50
Real GDP per capita in 1960 (log scale)

Source: Penn World Tables, Version 7.1.

Policy implications:
Note: Real GDP per capita is in thousands of 2005 US dollars adjusted for differences in purchasing power.

¨
different for those who are initially rich and those who are initially poor. In this
¤ Lower barriers to internal and international section, we discuss the reduced-form evidence for the persistence of poverty, at both
the “macro” and “micro” levels. This distinction is relevant, because it is in principle

mobility possible to see persistently low incomes at the country level but considerable income
mobility at the individual level. Conversely, rising incomes at the country level can
coincide with pockets of stagnation at the individual level within the country.

¤ State Intervention and Foreign Aid can still At the aggregate level, the cross-country evidence over the last half-century or
so on the persistence of poverty across countries—the core pattern which many

improve outcomes and increase the speed of
convergence to better outcomes.
models of poverty traps aim to explain—is not particularly compelling. The truly
stagnant income levels predicted by standard models of poverty traps are in fact
quite rare in the cross-country aggregate data. Figure 2 puts the experience of Haiti,
Nicaragua, and Burundi noted in the introduction into a broader cross-country
context. It plots the log level of real GDP per capita in 2010 (on the vertical axis)
against the log level of real GDP per capita in 1960 (on the horizontal axis) for a set
 (c) S-Curve with no Poverty Trap
25

!"#$
¨ S-Curves – even if they do
D not lead to a poverty trap -
have strong implications
&
¤ Slow speed of convergence
C ¤ Affect investments
n E.g. returns to education
%
often considered to
have increasing returns
!"
– for the poor, returns
might be low.
(C.2) Relative Poverty & State Intervention

¨ Relative Poverty arguments for State Intervention are esp. relevant in DCs
¨ Markets work worse for the poor
¤ Poor suffer higher prices => Inequality is higher than in nominal terms (see
reading from the Economist, Guardian 2015)
¨ Poverty is a Stress-Factor (“Spirit Level” Wilkinson and Pickett)
¤ Poverty and inequality is related with high cortisol and anxiety levels.
¤ Chronic elevations of cortisol can lead to dysfunction in metabolic and immune system –
leading to accelerated aging.
¨ Poverty reduces Life Expectancy / Poor Physical / Mental Health (“Spirit Level”)
¤ Poverty and inequality affects access to health services, but also behaviour
¤ Poverty lowers self-esteem, inequality increases evaluation anxiety
¨ Behavioral Poverty Traps
¤ Poverty is not just about lower material resources, but also mental resources (see above)
 (D) Policy Implications of Poverty Traps
¨ (A) Big Push Policies
¤ Only large transfers are able to overcome poverty trap threshold.

¨ (B) Multi-dimensional Policies

¤ Policies that seek to address multiple-thresholds
¤ E.g. push for better education, health and nutrition.

¨ (C) Reduce Market Imperfections

¤ Micro-Finance Micro-credit Revolution has brought credit to the poor
¤ Growing set of micro-insurance and micro-saving schemes

¨ (D) Social Protection Programme

¤ Reduces vulnerability and the threat of poverty trap threshold.
¤ Can reduce insurance market imperfections for the poor.

¨ (E) Paternalistic Policies

¤ Even if S-curves don’t generate poverty trap, policies might be required to nudge individuals towards high
returns part of S-curve.
 Summary
¨ Measuring and Defining Poverty involves arbitrary choices and
value judgments

¨ There are both Equity and Efficiency Arguments for why the
State must intervene in alleviating Poverty
¤ Market inefficiencies justify Social Insurance and Poverty Relief
programs because
n Coping strategies by the poor, might result in choices that perpetuate poverty
n Market imperfections might even lead to poverty traps
n Even in the absence of poverty traps, poverty will be more persistent
¤ Relative poverty implies not just lower material resources, but also
mental well being of the poor.