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Investment Efficiency and the Distribution of Wealth Iii Acknowledgments WORKING PAPER NO.53 Investment Effi ciency and the Distribution of Wealth Abhijit V. Banerjee Cover_WP053.indd 1 5/11/2010 11:01:03 PM WORKINGPAPERNO.53 = InvestmentEfficiencyand theDistributionofWealth AbhijitV.Banerjee = = = = = = = = = ©2009TheInternationalBankforReconstructionandDevelopment/TheWorldBank OnbehalfoftheCommissiononGrowthandDevelopment 1818HStreetNW= Washington,DC20433 Telephone:2024731000 Internet: www.worldbank.org = www.growthcommission.org Email: [email protected] = [email protected] = Allrightsreserved= = 1234511=100908 = ThisworkingpaperisaproductoftheCommissiononGrowthandDevelopment,whichissponsoredby thefollowing=organizations: = AustralianAgencyforInternationalDevelopment(AusAID)= DutchMinistryofForeignAffairs SwedishInternationalDevelopmentCooperationAgency(SIDA) U.K.DepartmentofInternationalDevelopment(DFID) TheWilliamandFloraHewlettFoundation TheWorldBankGroup= = Thefindings,interpretations,andconclusionsexpressedhereindo=notnecessarilyreflecttheviewsofthe sponsoringorganizationsorthegovernmentstheyrepresent. = Thesponsoringorganizationsdonotguaranteetheaccuracyofthedataincluded=inthiswork.The boundaries,colors,denominations,andotherinformationshownonanymapinthisworkdonotimply anyjudgmentonthepartofthesponsoringorganizationsconcerningthelegalstatusofanyterritoryor theendorsementoracceptanceofsuchboundaries. = Allqueriesonrightsandlicenses,includingsubsidiaryrights,should=beaddressedtothe OfficeofthePublisher,TheWorldBank,1818HStreetNW,Washington,DC20433,USA; fax:2025222422;email:[email protected]. = = = Coverdesign:NaylorDesign = = = AbouttheSeries The Commission on Growth and Development led by Nobel Laureate Mike= SpencewasestablishedinApril2006asaresponsetotwoinsights.First,poverty= cannotbereducedinisolationfromeconomicgrowth—anobservationthathas been overlooked in the thinking and strategies of many practitioners. Second,= thereisgrowingawarenessthatknowledgeabouteconomicgrowthismuchless definitivethancommonlythought.Consequently,theCommission’smandateis to“takestockofthestateoftheoreticalandempiricalknowledgeoneconomic growthwitha=viewtodrawingimplicationsfor=policyforthecurrentandnext generationofpolicymakers.” To help explore the state of knowledge, the Commission invited leading academics and policy makers from developing and industrialized countries to= explore and discuss economic issues it thought relevant for growth and development, including controversial ideas. Thematic papers assessed= knowledgeandhighlightedongoingdebatesinareassuchasmonetaryandfiscal policies, climate change, and equity and growth. Additionally, 25 country case studieswerecommissionedtoexplorethedynamicsofgrowthandchangeinthe contextofspecificcountries. WorkingpapersinthisserieswerepresentedandreviewedatCommission workshops, which were held in 2007–08 in Washington, D.C., New York City,= and New Haven, Connecticut. Each paper benefited from comments by workshop participants, including= academics, policy= makers, development practitioners, representatives of bilateral and multilateral institutions, and Commissionmembers. The working papers, and all thematic papers and case studies written as contributions to the work of the Commission, were made possible by support fromtheAustralianAgencyforInternationalDevelopment(AusAID),theDutch MinistryofForeignAffairs,theSwedishInternationalDevelopmentCooperation= Agency(SIDA),theU.K.DepartmentofInternationalDevelopment(DFID),the WilliamandFloraHewlettFoundation,andtheWorldBankGroup.= TheworkingpaperserieswasproducedunderthegeneralguidanceofMike= SpenceandDannyLeipziger,ChairandViceChairoftheCommission,andthe Commission’s Secretariat, which is based in the Poverty Reduction and Economic Management Network of the World Bank. Papers in this series= representtheindependentviewoftheauthors.= Investment Efficiency and the Distribution of Wealth iii Acknowledgments I am grateful to Roberto Zagha for his encouragement.= = = iv Abhijit V. Banerjee Abstract= The point of departure of this paper is that in the absence of effectively functioning= asset= markets the distribution of wealth matters for efficiency.= Inefficient asset markets depress total factor productivity (TFP) in two ways: first,bynotallowingefficientfirmstogrowtothesizethattheyshouldachieve= (this could include many great firms that are never started); and second, by allowinginefficientfirmstosurvive=bydepressingthedemandforfactors(good= firmsaretoo=small)andhencefactorprices.Bothoftheseeffectsaredampened whenthewealthoftheeconomyisinthehandsofthemostproductive=people,= again,fortworeasons:first,becausetheydonotrelyasmuchonassetmarketsto= getoutsideresourcesintothefirm;andsecond,=becausewealthallowsthemto selfinsureandthereforetheyaremorewillingtotaketherightamountofrisk.= None of this, however, tells us that efficiencyenhancing redistributions must= alwaysbetargetedtothepoorest.Thereissome=reasontobelievethata=lotofthe inefficiencyliesinthefactthatmanymediumsizefirmsaretoosmall. = = Investment Efficiency and the Distribution of Wealth v = = = = Contents AbouttheSeries.............................................................................................................iii Acknowledgments=.........................................................................................................iv Abstract.............................................................................................................................v 1.Introduction..................................................................................................................9 2.AnExample...................................................................................................................9 3.WhytheDistributionofWealthMatters................................................................12 4.WhatWeKnowabouttheAbilitytoBorrow=.........................................................13 5.MitigatingFactors......................................................................................................15 6.ReinforcingFactors....................................................................................................16 7.TheEvidenceonUnderinvestment.........................................................................21 8.InvestmentEfficiencyandtheDistributionofWealth.........................................30 9.Conclusion:SomeTakeawayMessages................................................................34 References.......................................................................................................................38 Investment Efficiency and the Distribution of Wealth vii = = = = InvestmentEfficiencyand theDistributionofWealth AbhijitV.Banerjee1== 1.Introduction Oneofthepotentiallymostattractivefeaturesofmarketeconomiesisthatthey putinvestmentdecisionsinthehandsofthosewhohavethetalentandthedrive= toinvestwell.Unfortunately,noneofthisisquiteautomatic:Itallturnsonasset= marketsdoingtheirjobwell. 2.AnExample To appreciate what the issue is here, consider an economy where wealth has some distribution G(w)= with mean wealth W. There is only one good in this economy,andoneproductiontechnology:Thistechnologyrequiresa=minimum= investmentofK,butthenyieldsanoutputofaK=sometimelater,wherea=isthe= talent level of the entrepreneur making the investment. Assume that ais= distributed, once again uniformly,= between a and= a = and assume that talent is= distributedindependentlyofwealth. We will speak about this technology of investment as if the outputs are widgets, but there is nothing in the formalism that stops them from being educatedorhealthychildren.Inotherwords,thebasiclogicappliesasmuchto= investmentinhumancapitalasanyotherkind. HowdothosewhosewealthisbelowK=gettoinvest?Theobviousansweris thattheyborrow.Supposetheinterestrateisr.Theneveryentrepreneurwhohas= areturnofa1+rwouldbehappytoborrowtoinvest.Soassumingthatthereis not enough capital to make it worthwhile for everyone to invest—that is, the average wealth in the economy, W, is less than K, the minimum required= ====================================================== 1=AbhijitVinayakBanerjeeiscurrentlytheFordFoundationInternationalProfessorofEconomicsat the Massachusetts Institute of Technology.= In 2003 he founded the Abdul Latif Jameel= Poverty ActionLab,alongwithEstherDufloandSendhilMullainathanandremainsoneofthedirectorsof= the lab. He is a= past president of the Bureau= for the Research in the Economic Analysis of= Development,a=ResearchAssociateof=theNBER,a=CEPRresearchfellow,InternationalResearch Fellow of the Kiel Institute, a fellow of the American Academy of Arts and Sciences= and the= EconometricSociety,andhasbeena=GuggenheimFellowandanAlfredP.SloanFellow.Hisareas ofresearcharedevelopmenteconomicsandeconomictheory.Hehasauthoredtwobooksaswell= asa=largenumberofarticlesandistheeditorofa=thirdbook.Hefinishedhisfirstdocumentary film,“TheNameoftheDisease,”in2006. Investment Efficiency and the Distribution of Wealth 9 investment—then the interest rate will have to clear the capital market. Only thosewhose=a=ishighenoughwilltheninvest,andtherestwilllendthemtheir wealth.Inparticular,themarginalinvestorwillbesuchthat = a am K W = a a = or = W am a a a , = K = andthemarketclearinginterestratewillbe1+am. If W/K= were 1/10,2= example, this would imply that the market clearing interestratewouldhavetogouptothepointwhereonlythetop10percentmost talentedpeoplewouldinvest.Theaverageproductivityofthosewhoinvestwill be = m a a Aav 2 = 1 a a a 20 = The problem with this happy narrative is that it requires some people
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