Inequality and Growth: Stable Demand vs. Increasing Returns to Scale

A good summary about the relationship between inequality and growth. They list four main possibilities as to why many empirical papers find a negative relationship between increased inequality and growth in real GDP per capita:

• A strong middle class promotes the development of human capital and a well educated population.
• A strong middle class creates a stable source of demand for goods and services.
• A strong middle class incubates the next generation of entrepreneurs.
• A strong middle class supports inclusive political and economic institutions, which underpin economic growth.

I’ve focused on the second bullet point, although I believe they are all important. Acemoglu and Robinson focus mainly on the last point.

Here’s what I think is missing from the discussion of the second bullet point about stable demand (I think I picked this up from Matt Yglesias). Most new products exhibit significant increasing returns to scale as they ramp up production. That is, the marginal cost to produce the millionth unit is much less than to produce the thousandth unit. In addition, many products are such that households do not need more than one or two (cars, refrigerators, washing machines, computers, etc).

The middle class, bu definition, has more households than the rich. But if the income of the middle class is not growing, they will not have the disposable income to purchase new products. If only the hundreds of thousands of rich household can buy these new products instead of the the millions in the middle class, many products may not be developed at all.

Ideally, companies in this situation will start with a high price point, sell to the rich (or industry), and then reduce the price as they experience these economies of scale so that they can reach a mass market. But there will be some products that will never be profitable except if they are bought widely. Maybe the fixed costs are too high or other reasons for an extreme economy of scale. In that case, increasing purchasing power by the middle class will lead to higher growth, not because of stable demand, but because of really high demand that the rich simply can’t match. One household earning $5 million is unlikely to buy as many cars as 100 household making $50,000.

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