Abstract
This paper argues that the existence of competitive labor markets, in combination with imperfect capital markets, can lead to increasing inequality. Formulating an infinite-horizon neoclassical growth model with missing capital markets and indivisible labor, I show that the population will group into three occupations, denoted capitalists, independents, and workers. Following a labor market improvement, income increases for people everywhere in the wealth distribution. However, while labor markets decrease inequality in the very short run, poorer agents will move toward having zero wealth in the long run, even with perfect foresight. The results are discussed mainly in light of the development of the Western world during industrial transition, but the model also has relevance for understanding the development process of today's developing countries in the twentieth century.
The paper was later developed into a memo 21/2011 in the ECON Working Paper series. Go to new version of paper.