Distribution of Income & Income Inequality

1. Distribution of Income & Income Inequality The Lorenz Curve & The Gini Index

2. Introduction to Income Distribution • One of the characteristics associated with free market economics is an unequal distribution of income. • Inequality occurs to different extents in different countries. • The reasons for difference in income and the consequences of inequality are many and complex. • The can form the basis of considerable debate among economists, politicians, sociologists, parents, and students.

3. Income Inequality is Unfair • One argument suggests that huge inequalities in income are unfair. • People with low incomes will experience relatively low living standards, and fewer opportunities than people with high incomes • They may live in a state of absolute poverty whereby they do not have access to basic necessities needed to sustain life. • Or they may live in relative poverty whereby their living standards are well below the observed “average” in an economy.

4. REASONS FOR INCOME INEQUALITYBorn into Poverty • Incomes may be low because they themselves were born into a household where incomes were low and they experience little opportunity to break out from the conditions associated with poverty such as poor education, malnutrition, and perhaps the necessity to find work before completing an education.

5. REASONS FOR INCOME INEQUALITYHuman Capital • Incomes may be low because human capital keeps some people in low paying jobs.

6. REASONS FOR INCOME INEQUALITYUnemployment • Income may be low due to unemployment. • The reason the person is unemployed and their time without employment will be key issues.

7. Higher Incomes are Incentive to Worker Harder • Even though unequal distribution of income is unfair, economic reasoning will show that higher incomes act as an incentive for people to work harder. • If people did not believe that their hard work in school or at work would allow them to raise their human capital and provide them with an opportunity to earn higher incomes, then this would have huge implications for the supply side of an economy, resulting in a lower level of economic activity.

8. What level of income inequality is acceptable? • Purely economic analysis will not lead to an answer as to exactly how much inequality is acceptable or appropriate. • This is very much a normative issue. • What can be agreed upon is the fact that market economies do result in inequality of income.

9. The Lorenz Curve & The Gini Index • Income Inequality in an economy can be measured. • The most common representation of inequality comes in the form of a Lorenz Curve. • This takes data about household income gathered in national surveys and presents them graphically.

10. Historical Data: The Gini Index

11. Analysis of the Data • Households are ranked in ascending order of income levels and the share of total income going to groups of households is calculated. • Eg: If we look at Brazil, the poorest 20% of households receive only 3% of the total household income, while the richest 20% of households receive 58.7% • This contrasts with Croatia, where the data suggests more equality in distribution, with the poorest 20% receiving 8.8% of total household income and the richest 20% receiving 37.9%.

12. Evaluating the Importance of Gini Index • Although a reduction in income inequality may be important objective of development, one must be very careful in using the Gini index numbers as a basis for evaluating a country’s economic development progress. • While low-income countries tend to have higher levels of inequality than high-income countries, there is no hard and fast correlation between the level of development as measured by the HDI and its Gini Index.

13. Graphing Inequality: The Lorenz Curve The x-axis shows the cumulative percentage of the total population divided up into quintiles. The y-axis shows the cumulative percentage of total income earned by the quintiles. The line of absolute equality indicates a perfectly equal distribution of income. Eg: 10% of the population would earn 10% of the income. 90% of the population earns 90% of the income. Each country has its own Lorenz curve based on the income data. The farther away a country’s curve is from the line of absolute equality, the more unequal is the distribution of income. In this example, Brazil is clearly further way than Croatia.

14. How do we calculate the gini index? • As an IB student you are not required to calculate the Gini Index, but you should know.. • The gini index is derived from the Lorenz curve. • It is the ratio of the area between the line of equality and a country’s Lorenz curve (a) to the total area under the line of equality (a) + (b) • The higher the Gini index the, more unequal is the distribution of income.

15. Evaluating the Importance of Gini Index • There are countries with a high level of human development such as US, that has a relatively high gini index, and countries with a low level of human development, such as Ethiopia, with a much lower gini value.

16. Do we need more equality to raise living standards? • It would not be correct to assume that it is necessary to have more equality in order to raise living standards. • Assume that the poorest 20% of the population earns 3.0% of the national income. • If the national income rises and the income distribution pattern remains the same, the poorest will receive a largest amount, even if their share remains the same. • They get the same proportion of a larger amount.

17. Source: http://geo-mexico.com/?p=5044 Date Accessed: 13th March 2013