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 invest- ment. This uncertainty implies the prospect that aspirations will not be fulfilled, the probability of which is greater the lower is the human capital endowment of an agent. We show that agents with sufficiently low human capital endowments may experience such a strong influence of loss aversion that they abstain from human capital investment. We further show how this behaviour may be transmitted through succes- sive generations to cause initial inequalities to persist. These results do not rely on any credit market imperfections, though they may ap- pear as if they do.