Inequality

A fundamental issue facing the global economy is the widening poverty gap between the developed and less developed world, and the widening distribution of income within countries and geographical regions.

Income and wealth

Impoverishment has several causes, including low of income as a result of unemployment, under-employment, or low wage employment. It may also be caused by a failure of government to provide a welfare safety-net in the event of the above.

Types of income

The opportunities to earn an income in a less developed economy are limited in comparison with developed ones.

The types of income that can be received are:

Earned income

Income can be earned from selling labour, including wages, which are the largest source of income, and salaries and commission, which represent a very small fraction of income in comparison with more developed economies.

Unearned income

Some income is unearned, such as rents from land ownership and interest from lending money. These sources of income are less available in developing economies.

Wealth in developing countries

In developing countries, wealth is commonly derived directly from land and natural resources and includes the land itself and livestock. Physical property and financial assets represent a relatively small proportion of wealth in a developing country.

Equity and inequality

Equity means fairness or evenness, and achieving it is considered an economic objective. Despite the general recognition of the desirability of fairness, it is often regarded as too normative a concept because it is difficult to define and measure. For most economists, equity relates to how fairly income and opportunity are distributed between different groups in a given society.

The opposite of equity is inequality, and this can arise in two main ways:

Inequality of outcome

Inequality of outcome from economic transactions occurs when some individuals gain much more than others do from an economic transaction. For example, individuals who sell their labour to a single buyer, a monopsonist, may receive a much lower wage than those who sell their labour to a firm in a highly competitive market. Inequality of income is an important type of inequality of outcome.

Inequality of opportunity

Inequality of opportunity occurs when individuals are denied access to institutions or employment, which limits their ability to benefit from living in a market economy. For example, children from poor homes may be denied access to high quality education, which limits their ability to achieve high levels of income in the future.

Does inequality serve a purpose?

Market economies rely on the price mechanism to allocate resources. This means that resources, including labour, are allocated prices that reflect demand and supply. Changes in demand and supply affect prices, which create incentives and provide signals to factor owners. For example, rising wages act as an incentive to labour to become more employable, and provide a reward for those that do. Therefore, inequality acts as an incentive to improve, and specialise in those goods and services that command the highest reward.

However, critics of unregulated market economies raise doubts about the need for such vast differences in income that exist and that considerably smaller differences will still create a sufficient incentive to reward effort and ability.

Measuring inequality

Inequality can be quantified by looking at the distribution of income or wealth. The distribution of wealth is likely to be much greater than income because wealth is built up over many decades, and for some families, over centuries.

The distribution of income is relatively easy to measure - valuing wealth is more difficult. This is because wealth is often hidden from view, and because it changes its value over time.

The Lorenz Curve

A Lorenz curve shows the % of income earned by a given % of the population. A perfect income distribution would be one where each % of the population receives the same % of income. Perfect equality is,  for example, where 60% of the population gain 60% of national income. In the above Lorenz curve, 60% of the population gain only 20% of the income; hence, the curve diverges from the line of perfect equality of income.

A ‘perfect’ income distribution would be one where each % received the same % of income.

Showing greater inequality

The further away the Lorenz curve is from the 450 line, the less equal the distribution of income. In the example, the curve for country Y is further away from the line of equal distribution than the curve country X, implying a wider distribution of income.

As can be seen, for country Y, only 15% of income is received by 60% of the population, compared with 20% for country X.

The Gini coefficient and index

The Gini coefficient, or index, named after the Italian statistician, Corrado Gini, is a mathematical devise to compare income distributions over time and between economies.

The Gini index can be used in conjunction with the Lorenz curve. It is calculated by comparing the area under the Lorenz curve and the area from the 450 line to the right hand and bottom axis.  The co-efficient ranges from 0 to 1, the closer to one the greater the inequality.

The Gini Index is the Gini coefficient, expressed as a percentage. The closer to 1 (or 100%), the greater the degree of inequality.

UK inequality 1977 - 2016

How does development affect inequality?

According to the Kuznets Hypothesis, after Nobel winning economist Simon Kuznets, the relationship between inequality and development can be illustrated as an inverse ‘U’ – the Kuznets curve.

The Kuznets curve

The greatest inequality can be observed as countries 'take-off' in their development, leading to considerable wealth creation for the few, who quickly gain from development relative to others.

At low levels of development in a pre take-off phase, the majority of the population will work on the land and be relatively poor, with only a small gap between rich and poor. As the economy takes-off, some individuals will gain considerably, relative to others, as in the case of Russia’s super rich followed by Russia’s growing middle class. These groups will exploit their advantage and open up a considerable gap between themselves and the poorest groups.

Eventually, as the economy develops, more resources are exploited and allocated to the poorest groups. This re-distribution is achieved through progressive taxes and welfare payments, and job creation.

See: How the Gini co-efficient is calculated

See: Inequality of wealth in the UK

Go to: Poverty