# Cours avancé « Economie des inégalités » (Master APE, année M2)

Advanced course « Economics of Inequality » (Master APE, M2 year)

Thomas Piketty

Course Notes A :

Basic Models of Inequality – Capital vs Labor

1. Notations

Y = F(K,L) = YK + YL = output = income = capital income + labor income

K = capital stock

L = labor input

YK = rK = capital income

YL = wL = labor income

w = wage rate = average labor compensation

Population i = 1, …, N

y = Y/N = average income

k = K/N = average capital stock

l = L/N = average labor input

yK =YK /N = rk = average capital income

yL = YL /N = wl = average labor income

2. The labor side: distribution of individual labor income yLi

Individual labor supply = li

Individual labor income yLi  = wli

One should view li as the number of efficiency labor units

E.g.   li = ei x hi

With ei = labor hours (part-time, full-time, etc.)

hi = human capital (measured in labor productivity units)

I.e. everybody gets the same wage rate w, but individuals differ by their number of efficiency labor units li , and therefore differ in their labor income yL

Implicit assumption = all types of labor are perfect substitutes, all what matters is the total number of efficiency labor units

Distribution of labor income yL :

g(y) = density function

G(y) = distribution function = % of population with labor income < y

1-G(y) = % of population with labor income > y

Exemple France 2008:

To fix ideas, let’s say l = 1 corresponds to full-time, minimum-wage labor

France 2008 : w = 12 000€ (annual wage, net of social contributions)

About 10% of workers are at the minimum wage: G(12 000€) = 10%

Median labor income = about 20 000€  :  G(20 000€) = 50%

Average labor income yL = about twice the minimum wage = 24 000€

Top 10% = workers above about 48 000€ : G(48 000€) = 90%

Top 1% = workers above about 96 000€ : G(96 000€) = 99%

Ratio yLa / yL = Pareto coefficient β = about 1.7-1.8 in France 2008

(yLa = average income above income threshold yL)

>>> Top 1% share = about 7%-8% of total income in France 2008

>>> Top 10% share = about 32%-34% of total income in France 2008

(US 2008: up to 23% for top 1% share, and up to 50% for top 10% share)

(all these numbers are approximative and illustrative)

>>> See Weeks 3 & 4 on top income shares

3. Opening the labor side black box

- labor supply behaviour, labor supply elasticity, work incentives for low income vs high income, optimal redistributive taxation of labor income

>>> see Week 5

- men vs women labor supply and labor income inequality: female participation, discrimination, assortative mating according to human K

>>> see Week 8

- investment in human capital: returns to education, school inputs, governance and financing of higher education

>>> see Week 8

- more complex production functions, relaxation of the perfect substitutability assumption between unskilled and skilled labor (Y = F(K,LU,LS) etc.)

- human capital vs labor market institutions: minimum wage, unions, governance rules for executive compensation

-dynamics of labor income:  yLi t+1   =  yLi t  ?

life-cyle dimensions (shocks, training, unemployment, retirement), intergenerational dimensions (intergeneration transmission of human capital)

4. The capital side

Individual capital stock = ki

Individual capital income yKi  = rki

One should view individual capital stock ki as the sum of all types of wealth owned by the individual: stock, bonds, savings accounts, housing, etc.

Implicit assumption = all types of capital are perfect substitutes and get the same return r, all what matters is total capital stock

Distribution of capital stock k :

h(k) = density function

H(k) = distribution function = % of population with capital stock < k

1-H(k) = % of population with capital stock > k

The distribution of capital stock h(k) translates mechanically into a distribution of capital income yK  = rk

Exemple:

If k = 1 000 000€ and r = 5%, yK  = rk = 50 000€

If k = 240 000€ and r = 5%, yK  = rk = 12 000€

5. Opening the capital side black box

- dynamics of capital accumulation: kLi t+1   =  kLi t  ?

life-cycle capital vs inherited capital, age structure of wealth

>> see Week 2

- optimal taxation of capital and capital income

>> see Week 6

- financial intermediation, long chain between household capital and firm ownership, financial regulation, wealth inequality and efficiency, family firms

>> see Week 7

6. Putting the labor side and the capital side together

Total income y = yL + yK = yL + rk

Distribution of total income y :

s(y) = density function

S(y) = distribution function = % of population with total income < y

1-S(y) = % of population with total income > y

Total inequality S(y) depends on several factors:

(i)                   inequality of labor income g(yL)

(ii)                 inequality of capital stock h(k)

(iii)                relative importance of capital vs labor income: α  = rk/y

(iv)                correlation µ between between g(yL) and h(k)  (i.e. to what extent top labor income earners and top capital holders are the same people?)

α  = rk/y = capital income share in total income (α = capital share, 1-α = labor share)

β  = k/y = capital/output ratio (i.e. capital stock = how many years of income flows?)

γ = k/yL = capital/labor income ratio (i.e. capital stock = how many years of labor income flows)

By definition:            α  = r β

γ = β/(1-α)

Exemple:

If capital/output ratio β = 6 and interest rate r=5%, then capital share α = 30%, labour share 1-α = 70%, γ = 6/0.7 = 8.6

7. Cobb-Douglas production functions

Cobb-Douglas production function: Y = F(K,L) = KαL1-α

(typically, α = 0.3 and 1-α = 0.7)

>>> Then for any interest rate r and wage rate w, YK = αY & YL = (1-α)Y

Intuition: with an elasticity of substitution between K and L equal to 1, the substitution effect exactly compensates the price effect

Demonstration: Take r and w as given. Then profit maximization leads to FK = r & FL = w

FK = r means α Kα-1 L1-α = r

I.e. αY/K = r

I.e. YK = rK = αY

[Alternatively, FL = w means (1-α) Kα L-α = w , i.e.  (1-α)Y/L = w, i.e. YL = wL = (1-α)Y]

[Putting the capital demand and labor demand equations together : K/L = [α/(1-α)]  w/r, i.e. if the relative price w/r rises by 1%, the capital-labor ratio increases by 1%, i.e. annihilates the price effect]

>>> with a Cobb-Douglas production function, the capital and labor shares are entirely determined by the production function

8. Beyond Cobb-Douglas production functions

In practice, F(K,L) does not seem to be exactly Cobb-Douglas: historically, capital share was lower when capital/output was lower >>> this suggests that the elasticity of substitution is above 1

(or that multi-sector model: Y = YH + YP , with YH = F(KH) vs YP = F(KP,L), etc.)

Y = F(K,L) = [(1-a) L(γ-1)/ γ + a K(γ-1)/γ]γ/(γ-1)

= CES production function with elasticity of substitution between K and L = γ

Then if competitive markets r = FK = a K-1/γ Y-1/γ

I.e. α = capital share = rK/Y = a (K/Y)1-1/γ

i.e. if we note β=K/Y, we have:

r = a β-1/γ

α = a β1-1/γ

I.e. r is always a declining function of β, but α is an increasing function of β if and only if γ>1, i.e. elasticity of substitution higher than 1

If γ=1, then Cobb-Douglas production function, α = a does not depend on β: price and quantity effects exactly offset each other

If γ is infinite, then linear production function, i.e. fixed capital return r, so that capital share increases proportionally with β

If γ=0, the putty-clay production function, i.e. extra capital is useless (and conversely capital destructions are devastating: when K/Y is divided by 2, output should be divided by 2)