The Cost of Being Poor

The existence of the “poverty premium”, the notion that poor households pay more for the same goods and services as wealthy households do, has been noted in Kenya’s housing, water and retail markets. Rent charges on households living in slums carry a premium rent estimate of 16-18 percent over those paid by people living in formal settlements; water prices in informal areas could even be tripled compared to formal areas; while the poor consumers in Kenya’s “kadogo economy” encounter a mark-up on each unit purchased against bulk purchasers of the same commodities. The purpose of this paper is to show that these three seemingly unrelated pricing problems are in fact one and the same microeconomic phenomenon emanating from two distinct reasons: a liquidity problem on the demand side which involves small transactions often and hence higher per unit costs, and a problem of thinness of the market on the supply side due to land tenure problems, just like the issue of land titling in this series.

1. The Question

“Fortune at the Bottom of the Pyramid” by C.K. Prahalad introduced poverty premium as a stylized fact in development economics, where poor households pay a higher effective cost of water, loans, and even everyday consumable goods than richer households paying for the same good. There exists an exemplary case of the city of Nairobi, which is full of literature on the topic. Around 56 percent of the total urban population in Kenya lives in slums, and different studies have established that poorer quality comes with a higher cost.

This paper asks: is Nairobi’s poverty premium best explained as opportunistic price discrimination by individual landlords and vendors, or does it reflect a more structural, and more economically interesting, pattern of constrained demand meeting thin, uncompetitive supply? The distinction matters because it changes what kind of intervention would actually lower the price poor households pay.

2. The Microeconomic Mechanism

Two distinct mechanisms, operating on opposite sides of the market, jointly generate a poverty premium, and disentangling them is the analytical core of this paper.

Demand-side: Liquidity constraint leads to purchasing in small quantities. A family living hand to mouth from an uncertain income of wages or piece rates in the informal sector cannot afford to purchase the quantity that will give them enough of a product for a whole month at once. Even though the price per unit in a large packet is cheaper, it still cannot afford to purchase it all at once in one payment due to liquidity constraint. It therefore means that the only way to go about it is to purchase the commodity in small quantities always, this is the “kadogo economy” in Kenya whereby commodities are packaged in such a manner that the smallest unit of measurement of the commodity is what forms the packet size in order to fit in the purchasing power of poorer consumers. In this case, it is true that the poor pay high prices due to liquidity constraints because the poverty premium in this case is “small packets leading to higher price per unit”.

Supply-side: tenure insecurity thins out competition. The very same ambiguity regarding land-tenure discussed in the land titling essay that forms part of this series has a second economic impact other than its role in preventing access to credit; that is, that it prevents the entry of the large capital-intensive competitors that one would normally expect to drive prices down within a market environment. It is hard for formal firms to invest in the infrastructure or the shops that will sell their products on land that is insecure in its tenure and the disorganized nature of informal settlements makes the costs of providing formal services like piped water into such a settlement higher. The consequence of this is that the markets are dominated by informal small-scale suppliers of goods and services like water vendors, landlords and even kiosk operators who are able to keep a premium because of lack of competition. There is even another element of risk that is built into the landlords’ charges due to the risk involved in such tenancies.

3. Evidence

Housing: a measured, not just perceived, rent premium. A hedonic pricing analysis of rent paid for similar-quality houses in the formal and informal settlements of Nairobi has revealed that people in the slums pay roughly 16% more for rental housing of comparable quality than those in the formal areas, an empirical observation made in an academic study and explained by the “low-quality, high-price puzzle” in Nairobi’s informal rental market. Another revelation from the same research stream reveals that even the few formal tenancy arrangements in the slums are priced at an 18% premium above informal tenancy agreements in the slums, clearly implying that part of the premium is a price for security.

Water: one of the largest and most consistently documented gaps. The Ministry of Housing in Kenya has noted that people living in informal settlements have to pay about 175% higher rates of water than those living in formal neighborhoods because of their reliance on water vendors rather than municipal water infrastructure. Alternative figures of the water price differential in Nairobi's Mukuru informal settlement are that it could be even three times the price charged in formal areas. This corresponds with the supply-side mechanism discussed earlier, in which piped water infrastructure is a capital-intensive endeavor and therefore unlikely to be invested in informal settlements with uncertain property ownership.

Everyday goods: a documented per-unit markup in small-package retail. A study carried out by the World Bank in Nairobi’s low income markets (2010-2011) showed that low income earners end up paying more per unit of a commodity than middle and upper class buyers buying the same commodity in bulk; thus the research explicitly links Kenya’s ‘kadogo economy’, that is, an economy of small packaged commodities, to a system where, despite reducing cost per transaction for the buyer, the cost per unit, hence the cost of living in the long run, is relatively high for the poor. This is exemplified by the fact that a 50 grams pack of cooking oil, sold at about KSh. 25, costs roughly KSh. 100 per week when used normally, compared to a 500 grams tinned oil, costing about KSh. 160 and enough for almost a month’s consumption.

The premium is large enough to be a rational investment thesis, not just an anomaly. The Kenyan authorities responsible for housing have openly pointed out that investments made into rental housing in informal areas can prove more profitable than their equivalents in the upscale formal areas of Nairobi, where the “build-to-rent” approach could provide a faster payback of about 2.5 times compared to the formal area investments. Such a powerful testimony clearly disproves the idea that the premium is purely opportunistic or unsustainable; rather, it is big enough to become a long-term strategy for investment by landlords.

4. Argument

This structural explanation of the Nairobi poverty premium seems more convincing than a purely behavioral account of the same. If this price premium were merely a function of some predatory landlords and sellers in Nairobi, one might expect its instability, unevenness, and fragility in the face of competitive entry. Rather, the price premium appears consistently in three independent markets (rental housing, water services, and retail goods) and appears large enough to be a claimed business motive for professional investors, particularly in the case of water and rental housing where the poverty premium directly correlates with the friction of insecure property rights previously identified as a deterrent to the formal investment in land titling papers. It seems highly likely that poverty premium and underinvestment of rural farmers are fundamentally the same problem looked at from two sides: insecure and informal property rights discourage the entry of formal competitive organizations (from banks lending money for agriculture to utilities providing water services).

This additional retail premium through the kadogo economy creates a second mechanism, which is purely demand-side and purely liquidity-based: while competitive retail may be available (and usually is available for consumer goods such as packaged foodstuffs, which contrast with services like water or housing), a household with liquidity constraints cannot take advantage of the reduced bulk price and pays a real markup simply because they don’t have the money to make the purchase at once, a poverty premium created wholly through the demand side of things.

5. Implications

For housing and utilities policy: Due to the fact that housing and water premia seem to be highly related to the discouragement of formal sector entry, measures that can lessen the impediments to formal investments created by the issue of tenure, including recognized occupancy rights that reduce demolition threat (discussed in the paper on land titling), could potentially lead to price reduction by attracting competitive and capital-intensive suppliers into this market.
For retail and consumer policy: Because the kadogo-economy premium is a liquidity problem, not a competition problem, the more direct intervention is on the financing side, bulk-buying cooperatives (as Kenyan economists have specifically proposed for kiosk owners) or small consumer credit products that let households pre-finance a bulk purchase and repay from future income, effectively converting a demand-side liquidity constraint into a manageable debt.
For future primary research: A well-defined and realistic first project in this research effort could be a systematic price survey that compares the unit prices of selected items (cooking oil, maize flour, soap, airtime) in both small packages and bulk quantities within one or two Nairobi neighborhoods-a straightforward and inexpensive approach to updating the existing decade-old estimates of the kadogo economy referenced in this paper.

6. Limitations

The housing and water premiums referred to above were obtained in distinct research papers via different methodologies (hedonic regression for housing, official announcements and settlement-level estimates for water); they can therefore only be considered similar in direction, not comparable in magnitude. The primary price study related to the kadogo economy is now more than a decade old (based on field research conducted in 2010-2011). It seems likely that both prices, packaging strategies and the nature of competition in the small format retail market in Nairobi have changed since then due to the emergence of new micro-retailing and delivery platforms based on the use of mobile money technology, and that the mark-ups should thus be considered illustrative rather than reflective of current realities. Finally, the fundamental hypothesis of this article, that tenure insecurity constitutes a prevalent structural factor behind both housing and water premiums, was drawn up based on parallels between this and the existing land titling literature; it is an inference that has yet to be tested empirically in relation to either housing or water.

References (selected)

Marx, B., Stoker, T., & Suri, T., cited framework on informal settlements and urbanization (as referenced in Nairobi slum rent-premium literature).
Gulyani, S. & Talukdar, D. (2008). Slum real estate: the low-quality, high-price puzzle in Nairobi’s slum rental market and its implications for theory and practice. World Development.
Talukdar, D. (2018). Cost of being a slum dweller in Nairobi: living under dismal conditions but still paying a housing rent premium. World Development.
World Bank (fieldwork 2010-2011, reported via Daily Nation). Study on the “kadogo economy” and low-income consumer pricing in Kenya.
Prahalad, C. K. (2004/2010). The Fortune at the Bottom of the Pyramid.
Kenya Ministry of Housing and Urban Development, public statements on informal-settlement water pricing and real estate investment returns.
Naipolitans / Mukuru Special Planning Area situational analysis reporting on the “poverty penalty” in water and housing costs.
UN-Habitat (2016). Global slum population estimates.

Prepared as part of the East Africa Microeconomics Research Series. This is a student working paper that synthesises existing research and published data rather than presenting original fieldwork; feedback and data corrections are welcome via the contact page.