Lotteries, inequality, and market imperfection: Galor and Zeira go gambling

This paper analyzes a simple extension to the work of Galor and Zeira (Rev Econ Stud 60:35–52, 1993). Allowing for endowment lotteries alters the dynamics of the model fundamentally: the poverty trap found in the original work vanishes for a wide class of parameters. Moreover, it turns out that in the presence of lotteries the relationship between the severity of credit market imperfections and long run aggregate income may be non-monotonic. We identify cases such that reducing the scope for moral hazard on the capital market decreases aggregate utility and may create a poverty trap and persistent income inequality in the economy. I am grateful for many helpful comments to Hans-Peter Grüner and an anonymous referee and for valuable discussion to Stefan Behringer and Petr Zemčík, and to seminar participants at Mannheim University and ENTER Jamboree 2003, Tilburg. Financial support from DFG is gratefully acknowledged.