The Economics of Poverty: Taking a step back (Part 1.1)

It has been quite a while since my last update. For the last 4-5 months, I had little time to sleep, let alone writing articles for Economind. I am back now and will try to pick up the pace.

This will be a short article intended to tie up some loose ends of our first article on the topic: “The Economics of Poverty: Taking a step back (Part 1)” . The second part is in the making (to be posted soon).

Previously on Economind, we talked about poverty, not poverty in traditional sense, but poverty as a symptom of more serious social ailments such as intra- and inter-generational capital deficit, dysfunctional credit market, hyperbolic discounting, adverse geographic conditions, sub-standard system of resource governance, etc. We discussed rather extensively the idea of capital deficit, that the challenges confronting the poor are not simply the lack of resources, but more damaging is the higher marginal spending per unit of goods and services consumed, in addition to the loss of ability to utilize debt financing in raising capital. Simply put, the poor is locked in the present, being unable to do what economists call “Inter-temporal resource allocation”, that is to smooth consumption by saving for the unforeseeable future and borrowing for elevating income generating capabilities as well as offsetting present consumption shortage. Last time, I left without explaining much about the importance of having access to loanable fund and deposit account. Being able to borrow is pivotal to raising future return on one’s own labour and capital; thus, crucial to wealth accumulation. Starting a business of any sort requires capital investment, and not having or having too little capital (resource) at hands preclude this option from the poor. This leads to social loss since capital investment tends to have positive net return beyond private return, which is the idea of “externalities“.

Extra content:

Externalities and General equilibria

Imagine a local businessman starting a bee-keeping farm. Not only do bees produce honey which can be directly consumed as a final product or used as input in the production of other goods, but bees also enhance crop yield nearby (due to crop pollination). An article by John W. Siebert published in the American Journal of Agricultural Economics estimated that the externalities were immense, that the pesticide-induced beekills cost the almond growers nearby approximately $200,000 per year (in 1980) on top of the $1 million loss to the bee-keepers. In economics, this loss is merely at the level of partial equilibrium, meaning not every market is accounted for. Side tracking for a bit, partial equilibrium analysis in economics concerns itself with only the effect of changes on an individual market or a part of the market. But economic shocks can travel far and wide. A sudden price hike, for instance, can affect multiple markets simultaneously, and very often the impact spreads over time. One market might experience the shock immediately while another market only feels the impact some periods after (the so-called lagged response). In this case, General Equilibrium Analysis provides us with a more complete picture as it takes all markets into consideration on the ground that all markets are in one way or another interconnected. For instance, increasing tax in beer market for health reason has distortionary effect in various other markets. It might lead to higher consumption of stronger alcohol while lowering the price in the wheat market. Furthermore, an ineffective tax might even lead to reduced consumption in all other markets as the demand for beer is not very elastic, meaning an increase in the price of beer does not have very strong effect on decreasing its consumption. People then spend more on beer and less on other goods. This type of scenario applies to other addictive substances markets as well. It is worth noting that in General Equilibrium analysis, goods can be differentiated, not only by their types, but also by time and state of the world. For instance, an umbrella when it is raining is a completely different good from an umbrella when there is no rain. Both its use and exchange values rise considerably in the later state of nature.

And, back to the main track…

What then are the impacts of capital deficit of the poor on the economy?

The perpetual capital deficit therefore adversely affects the whole society’s wellbeing. The direct victims are the impoverished, and that should be pretty obvious. However, the reason why capital deficit is so destructive has to do with the less apparent and more insidious effects on the overall economy. Think for a bit here. A possible group of second degree victims might be suppliers or producers of primary, intermediate and final products/services in various markets who face lower demand for their produces. If we further assume that each and every industry has diminishing average cost (i.e, economies of scale), then lower demand implies lower capacity and lower production; thus, higher average fixed cost as cost of operation is spread over fewer goods. Other second degree victims can be the government who now earn low tax revenue due to the sub-optimal growth of capital stock and per capita income. Why? Because the growth of SMEs (conducive to poverty alleviation) greatly depends on the availability and accessibility of micro-finance. But, as pointed out, financial lubricant for those at low-income bracket is severely lacking. In a sense, inter-generational capital deficit prevents an entire nation from reaching its full economic potential.

The solution is thus to attract as many as possible the needed micro-finance institutions, and this simple comprehension of the requisite for a better economic outcome gives us at least a glimpse of what a bad policy might look like (thereby, what a good policy should avoid). We can thus infer that the golden rule for any developing countries is to NOT put a cap on interest rate of small loans. Interest rate ceiling would not only drive out private capital, but it also stimulates current consumption. Too much current consumption of non-capital goods that depreciate over time is bad for the economy in the long run since consumer demand raises price and larger consumption comes at lower saving. Since saving today is tomorrow’s capital, less saving means greater scarcity of capital and higher interest rate. A poor country should thus, by their utmost effort, try to bring their micro-finance scheme up to standard and to introduce sensible regulations that ensure protection on both borrowing and lending parties but not so much as to interfere with the incentive to lend/borrow. They should encourage private investment loan and discourage consumption loan. The marginal tax rate imposed on new business entrants, particularly for the SMEs, should also be relatively low. There are many other factors to be considered, but due to time constraint, let’s discuss just one more potentially bad policy, the minimum wage requirement.

Minimum wage is a good thing on a moral basis. In economics, it however remains a controversial issue. Empirically speaking though, minimum wage requirement tends to have adverse effect when the nominal wage exceeds the productive capacity of the labour force. There have been of course positive findings (theoretically and empirically validated) when minimum wage is imposed in inefficient markets, specifically in monopsony labour market (monopsony labour market means a single buyer of labour allowing the buyer to set wage below competitive rate) where workers are paid below their rate of productivity. Some research results, like that of David Card and Alan Krueger in their study of New Jersey’s minimum wage in the fast food industry, show that minimum wage in such markets increases wage earned as well as employment. This is nonetheless a study on a single industry with wage setting power, not a study at national level. Hence, it is not externally valid (meaning they cannot be generalized to other countries or markets). The lesson to take home is still that in economics, good intention is never a part of the solution. Compassion can be dangerous as it can lead to unfavorable consequence. For instance, too high a minimum wage (that exceeds labour productivity growth) will only cause aggregate demand to expand more than aggregate supply which leads to high inflationary expectation. Usually, depending on the level of competition and the demand elasticity (that is how quantity demanded change in response to changes in price), the minimum wage burden is partly or entirely passed on to consumers. Nonetheless, it tends to push price up but remember that the cost of production is also higher. Production might still end up at the same level, and inflationary expectation will likely result in the increase of present consumption (when people expect price to go up, they purchase goods more than their short-term need, and collective hoarding without automatic price adjustment mechanism due to the minimum wage ceiling will result in economic shortage of goods and excess of labour supply) and consumer loan which then drains loanable fund from the investment sector (lowering loan supply and raising interest rate, thus crowding out investment). This makes debt financing even harder for the poor. Also, if producers take it as a sign of greater actual demand, excessive inventory purchase likely leads to inventory surplus. Later in time as the minimum wage shock subsides, we might then experience an economic slump as everyone begins to realize that the real demand is not as high as initially thought. Unemployment would rise since wage cannot adjust to accommodate more workers. A vicious cycle is created as the unemployed cannot borrow and the job-creating SME sector cannot lower wage to hire more people. The poor will continue to be chained to the bottom of the income hierarchy, which is essentially the consequence of dysfunctional micro-capital market induced by bad policies as aforementioned.

These are just a couple of examples of how “NOT” to eradicate poverty, and they nicely wrap up our “capital deficit” episode. Next, we discuss “Hyperbolic Discounting”. It sounds fancy and technical, but the main idea is simple. It is the reason why we should discourage consumer loan and decrease liquidity of the micro-saving account. Lastly, note that constraints on borrowing and saving are also the main causes of chronic poverty in many regions of the world with adverse geographical conditions. More on these in our next post (soon!). Look forward to it!

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References:

John W. Siebert, “Beekeeping, Pollination, and Externalities in California Agriculture”, American Journal of Agricultural Economics, Vol. 62, No. 2 (May, 1980), pp. 165-171