Economic Development, Urban Underemployment, and Income Inequality

The evolution of inequality in permanent income is investigated during the course of a less developed country's transformation from a primarily agricultural to a primarily urban-industrial economy. The source of inequality is market luck in obtaining employment in the protected urban "formal sector" versus employment in the unprotected urban "informal sector." It is shown that with development the log variance measure of inequality in this country tends to follow an "inverted U": it rises when urbanization is low and consequent pressure on the land keeps rural incomes low, making agents willing to incur high risks of "underemployment" in the urban informal sector, and eventually falls after urbanization and consequently rural incomes has increased sufficiently to allow agents to make better than even bets in the industrial sector. These results in combination with new empirical evidence suggest that rather than being an unimportant artifact of the design of inequality indices, inverted-U behavior of inequality may be driven by the important social phenomenon of mass urban underemployment.