Theories For Remittances

Literature Review

Introduction

Remittances are transfers of money sent to home country by individuals working abroad. Remittance is mainly a household income and is sent back through formal channels such as cash or in kind and informal channels as well. Following a study carried out by Rapoport and Docquier (2006), the following reasons were found as main motivators behind the decision to remit: (a) altruism, migrant’s willingness to help family in home country, (b) insurance, whereby remittance acts as an additional source of fund in situations of adverse risks and shocks, (c) investment, whereby remittance is used for investment at home or to ensure potential family inheritance.

However, there is no consensus on the exact motive why a migrant remit. A combination of altruistic insurance and investment motives is mostly found in empirical studies. Brown and Poirine (2005) pointed out that the motivations to remit vary according to destination, gender and household composition.

Theories of International Migration

Various theoretical models based on different perspectives, levels and assumptions have been proposed to identify why an individual migrate.

1. The Neoclassical Approach

The neoclassical approach can be traced back to Smith (1776) and Ravenstein (1889). Borjas (1987c) postulated that an ‘immigrant market’ exists between countries. Potential host countries select suitable migrants through immigration policies for the human physical capital gain. In the same way, a migrant will choose to maximize his/her own utility subject to a budget constraint by seeking the country that will maximize his/her well-being. Other constraints might include immigration regulations imposed by potential country and emigration regulations by source country. The central argument is to maximize wages. This theory predicts a linear relationship between wage differentials and migration with the assumption that there is full employment. (Bauer and Zimmerman 1999; Massey et. Al. 1993; Borjas 2008) Wage differentials between regions cause the labor to shift from a low wage region to a high wage region. The larger the differential, the greater the flow will be. Hicks (1932, p.76) stated that ‘differences in net economic advantages chiefly in wages are the main causes of migration. However, subsequent studies found that it is the real expected earning gap that was the major factor in decision making and not absolute real wage differential (Todaro, 1969, 1976; Todaro and Maruszko, 1987)

The neo classical approach has been particularly criticized for ignoring the effects of sending and host countries, markets imperfections, asymmetric information, relative deprivation, the importance of politics and policies, which are accounted as distortions and additional migration costs.

2. New Economics of Migration

Taking a different level of analysis, the New Economics of Migration (NEM) (Stark and Bloom, 1985) stipulates that migration decisions are not taken by one individual only, but rather by families or households. People act collectively not only to maximize income in absolute terms, but also relative to other households. The theory of relative deprivation predicts that the chance of sending migrants abroad is greater when the amount of income earned is higher and income inequality is greater compared to the reference group. Stark and Taylor (1989) showed that relative income had a greater impact than absolute income on international migration based on a sample of Mexican households, except at the two ends of income distribution.

3. Human Capital Theory

The human capital theory is a microeconomic equivalent of the macroeconomic model of individual choice. This theory highlights the socio – demographic aspect of the individual as being a significant determinant in the decision making process (Bauer and Zimmerman, 1999). It puts forward that a migrant will estimate the costs and benefits associated to the displacement, and will migrate if the net return is positive and his destination will be where the expected discounted net returns are greatest over some time horizon (Borjas, 1990).The costs associated also include psychological costs such as separation from family in addition to monetary costs. Individual characteristics such as age, marital status, preferences, education, experience, training skills, languages skills increases the probability of migration as these would increase the likelihood of remuneration and being employed in the host country. Chiswick (1978) showed that migrants are positively selected as they are more motivated to work than the average individual. However, it may be possible that migrants will be negatively selected if we consider variables such as job experience and education.

The process of self-selection creates a ‘brain drain’ effect in the sending country which cannot satisfy the income and career expectations of the educated elites. The paradox is, as development occurs with the help of highly skilled labor of other economically advanced countries, they produce more human capital but it is lost in the form of brain drain emigration. This mainly occurs between the least developed or developing countries and developed countries as the income inequality is high.

4. Network Theory

Network formation is one of the most important structural mechanisms that support international migration. Bauer (1995) advocates that migration can become a self-perpetuating process because the costs and risks associated with migration are reduced by the existence of a diaspora or networks. Network theory increases the probability of migration as it reduces costs and risks while at the same time increases net returns. The fact of knowing people through friendship and shared community decreases relatively the monetary and psychic costs related to the displacement because of the availability of information. Every new migrant reduces the risks linked to movement and expands the network. When the number of migrants reaches a critical threshold, the cost of migration falls and the probability to migrate rises. In this theory, the effect of self-selection reduces over time and the network of migrants is more representative of the sending country.

One reason that can weaken the process of network migration is falling wages in the receiving country and rising wages in the sending country. This situation lowers the probability of moving and can act against the growth of the network.

If we compare the limited entries granted by receiving countries to the large number of people seeking entry with the assumption of asymmetric information on the worker’s side, the difference between the demand and supply of migrants creates an imbalance. This particular situation has given rise to a new theory, the institutional theory. As international migration rises, private institutions and voluntary organizations intervene in the migrant market to facilitate the entry of large number of people in rich countries. However, services provided by the profitable organizations are mostly based on the underground market. Such services may include smuggling across borders, fake documents and visas, arranged marriages between legal residents and migrants, credit facilities and labor contract between employers and migrants.

5. Push and pull migration

Ravenstein’s (1889) theory of push and pull migration states that migration is governed by unfavorable conditions assessed in terms of push and pull effect. Zimmerman (1994) later defined pull and push migration as changes in aggregate demand and aggregate supply curves of the receiving country. Internal factors affecting aggregate demand in the receiving country are classified as determinants on the pull side while internal or external factors in the sending country are classified as determinants on the push side. According to Zipf’s theory (1946), the volume of migration decreases as the distance between destination rises as the costs will increase with greater distances. Piore (1979) argued that only a permanent demand for labor and pull factors in the receiving countries create the need for international migration.

The main critique against this theory is that it assumes migrants have all information when migrating. It has been labeled as ‘rationalist’ because it only considers an individual choice based on economic factors such as costs of staying abroad. The relevant assumption should have been to consider other factors such as gender differences, community structure, the role of intermediaries and families or households taking migration decisions (Brettell and Hollifield, 2008).

The above models are based on an assumption of symmetric flow of information. In other words, employers have all required information about the skills of the migrants. Stark (1991) considered the various prepositions that could happen if asymmetric information was present. Assuming imperfect information on the side of employers and perfect information on the side of migrants, the following results are obtained. Immigrants with low level of skills benefit from a positive discounted wage differential and result in a reduction of quality or quantity of migration. In the long term however, employers may learn about the skills of the immigrants resulting in a rise in wages and immigrants might use signaling devices such as certificates which will result in a U-shaped migration pattern. Only the highest and the lowest skilled people will migrate.

Theories of consumption

1. Absolute Income Hypothesis

Consumption refers to the total quantity of goods and services that individuals and non-profit institutions want to purchase for consumption. Keynes (1936) found that the main factor that could affect an individual’s consumption was disposable income. He demonstrated the relationship between consumption and disposable income through the consumption function shown below:

= (1)

where is the real value of personal consumption expenditure, is the individual’s disposable income, both respectively in time t, is the autonomous consumption and represents the marginal propensity to consume (MPC).

Keynes set forth that as income increases, the portion of income saved will increase. The marginal propensity to consume decreases when there is income growth. The income elasticity of consumption is supposed to be less than unitary as income increases and unitary in the long run.

Investigations done by Friedman (1957) and Branson (1972) using cross section data backed up the hypothesis that consumption was highly correlated with income. Rich and poor households showed signs of increase in savings as income rose.

However, Kuznets (1946) using time series data in the United States showed that the consumption had not fallen after 1860s despite income had increased significantly. In the long run, the ratio of consumption to income was more or less at the same level. Predictions based on assumptions such as no differences between permanent and transitory income, volatility of consumption are considered to be unrealistic. Other factors such as time preference for consumption, ability to borrow, and individual’s expected income should be taken into consideration.

2. Permanent Income Hypothesis

Friedman (1957) proposed an alternative view of consumption through the permanent income hypothesis (PIH). The PIH focuses on the behavior of the consumer. Utility maximization is considered as the main driving block of this theory. Income y is divided into two parts: permanent income, and transitory income, . The permanent income is the amount of income that an individual gets on a regular basis over a long period and varies according to the current level of income. The transitory income fluctuates and nears zero as the number of periods rise. Consumption expenditure is broken down into two parts: permanent consumption, , which is planned consumption maximizing utility during a certain timeframe and transitory consumption, , consumption that captures the effects of other factors. The covariance between permanent and transitory consumption is expected to be zero.

Consumption is planned according to income of their expected income during their lifetime rather than current period. The PIH is given by taking the following equations into consideration:

= k (r, w, u) (2)

y = +

c = +

where r is the rate of interest at which the consumer can borrow or lend, w is the ratio of wealth to income, u represents consumer’s tastes and preferences. Equation (2) illustrates the relation between permanent income and permanent consumption. k(.) is marginal propensity to consume based on permanent income. The last two equations show the link between income and consumption (permanent and transitory).

Friedman (1957) suggested that the model should be approximated for geometrically declined weights averages of past and future incomes.

= r ( + + +….) (3)

where = is expectations.

The PIH states that consumption is smooth rather than volatile. Deaton (1986) tested the smoothness of consumption using time series data and results provided additional theoretical support.

One assumption is that the consumer can lend or borrow at the governing rate of interest. Atanasio (1994), Deaton (1991) and Zeldes (1989a) speculated that not all consumers are able to do so because of liquidity constraints arising from asymmetric information and adverse selection on consumer’s future incomes. Liquidity constraints are in terms of: firstly, limits in the amount of borrowing or lending and secondly, the rates of interest of lending and borrowing are different.

3. Life Cycle Income Hypothesis

Similar to the PIH is Modigliani’s Life Cycle Permanent Income Hypothesis (LCPI). In this theory, the consumer maximizes utility by considering resources available over his lifetime. Consumption is dependent on both wealth and income. Modigliani’s (1986) view is that income is low at the beginning and end of the consumer’s life, the consumer borrows and as salary increases with promotions, he will pay back and ultimately start saving. In this case, permanent income is constant, ceteris paribus. The following consumption function is derived after accounting for resources available, age of the consumer and the rate of return on capital.

= + + (4)

where c means aggregate consumption, y is current income, is annual expected income, A is net worth.

An assumption of this model is that as economic growth occurs, there must be a rise in savings rates. Tobin (1967) argued that the LCPI would actually show that the consumer consumed more in his early life and that dissaving occurred at both ends of his life cycle whilst in middle age he saved. In his opinion, high economic growth rates would result in a negative relationship between savings and economic growth. Modigliani acknowledged this fact but there was no empirical evidence.

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