Heterogeneous Mark-ups, Demand Composition, and the Inequality-Growth Relation

We explore the relationship between inequality and demand structure in an endogenous growth model where consumers expand consumption along a hierarchy of needs and desires. The consumption hierarchy is captured by non-homothetic preferences implying that the shape of the demand curves for various goods depends on the distribution of income. This setting enables us to study a mechanism that so far has been largely neglected in the literature: the role that inequality plays for the prices that innovators can charge and the corresponding quantities that innovators can sell. Thus, the influence of inequality on innovation incentive and growth can be analyzed. We get the following results: (i) Changes in inequality affect the aggregate price structure and there may be market exclusion of the poor due to high prices. (ii) If there is exclusion, higher inequality tends to increase growth because the profit share increases. However, higher inequality due to a bigger group of poor people may reduce growth. (iii) If the innovators always sell to the whole population, inequality has an unambigously negative impact on growth. Prices are then determined by the willingness to pay of the poor. An even more egalitarian distribution allows the monopolist to set higher prices and earn higher profits as the poor are the ’critical’ consumers that determine demand at the extensive margin.