Fearing the Worst: The Importance of Uncertainty for Inequality

We present an overlapping generations model in which aspirational agents face uncertainty about the returns to human capital investment. This uncertainty implies the prospect that aspirations will not be ful…lled, the probability of which is greater the lower is the human capital endowment of an agent. We show that agents with su¢ ciently low human capital endowments may experience such a strong in‡uence of loss aversion that they abstain from human capital investment. We further show how this behaviour may be transmitted through successive generations to cause initial inequalities to persist. These results do not rely on any credit market imperfections, though they may appear as if they do. JEL Classi…cation: D31, D81, E24.