Paper #: 95-07-061
This paper explores the evolution of the cross-section income distribution in economies where endogenous neighborhood formation interacts with positive within-neighborhood feedback effects. We study an economy in which the economic success of adults is determined by the characteristics of the families in the neighborhood in which a person grows up. These feedbacks take two forms. First, the tax base of a neighborhood affects the level of education investment in offspring. Second, the productivity of education investment with respect to offspring income is affected by a neighborhood's income distribution, reflecting factors such as role model or labor market connection effects. Conditions are developed under which endogenous stratification, defined as the tendency for families with similar incomes to choose to form common neighborhoods, will occur. Endogenous stratification can lead to pronounced intertemporal inequality as different families provide very different interaction environments for offspring. When neighborhood feedback effects are strong enough, cross-section income differences may grow across time. As a result, endogenous stratification and neighborhood feedbacks can interact to produce permanent inequality.