Pareto Distribution of Income in Neoclassical Growth Models

This paper constructs a Bewley model, a dynamic general equilibrium model of heterogeneous households with production, which accounts for the Pareto distributions of income and wealth. We emphasize the role played by concavity of the consumption function in generating the Pareto distribution. We show that the Pareto distribution is obtained when households face idiosyncratic investment shocks on household assets and are subject to the borrowing constraint, which leads to concavity of the consumption function. The model can quantitatively account for the observed income distribution in the U.S. under reasonable calibration. In this model, labor income shocks account for the low and middle parts of the distribution, while investment shocks mainly affect the upper tail.