Poverty and Inequality

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1 Chapter 4 Poverty and Inequality Problems and Policies: Domestic

2 After completing this chapter, you will be able to 1. Measure poverty across countries using different approaches and explain how poverty has evolved over time. 2. Measure income inequality within a country and between nations. 3. Explain the relationship between income inequality and economic growth across countries and over time. 2

3 Introduction The study of poverty and inequality is at the heart of economics. Important questions for us include: How do we measure inequality and poverty? What is the difference between absolute poverty and relative poverty? How has poverty evolved over time? What are the trends in the different regions of the world? How has inequality evolved on a country-by-country basis? What determines the gap between the rich and the poor, both within and across countries? Does inequality tend to increase or decrease over time? Is inequality good, bad, or neutral for economic growth? 3

4 Poverty measurements and comparisons Economic development is the main measure to fight poverty. Measuring Poverty Poverty measurements are usually based on survey data from asking people about their income or consumption to identify who are poor. The poverty line is the amount of money required to survive, based on the food basket purchased by local people. The poverty headcount indicates the number of people earning below the poverty line (Q) in the population (N). This is known as absolute poverty. The poverty headcount ratio is a proportion of the population below the poverty line (H = Q/N). This is known as relative poverty. The PL should be adjusted year to year for inflation and other factors. The PL does not reflect the degree of poverty. E.g., a family with income 1% below the PL is counted the same as a family with 50% below. 4

5 Poverty Gap The poverty gap takes into account the degree of poverty, or the distance from the poverty line. It is computed by multiplying the poverty headcount by the average distance from the poverty line: PG = H (PL - yq) / PL where yq is avg income of those below PL The average poverty gap, APG = PG/N Table below provides two examples where H = 50%: A: yq = [ (20 x 0.25) + (80 x 0.75) ] / 100 = 0.65 APG = 50%(1 0.65)/1 = 17.5% B: yq = [ (40 x 0.25) + (40 x 0.75) ] / 100 = 0.35 APG = 50%(1 0.35)/1 = % Country B s poverty is more serious Unfortunately, detailed data on income distribution of individuals or households is often unavailable. 5

6 An Example of the Poverty Headcount Ratio and the APG. Income distribution below PL (Daily) Country A (millions of people) Country B (millions of people) $1 PHR APG % 17.5% % 32.5% Country A and country B both have 50% of the population below the PL. However, there is more extreme poverty in country B than country A according to the APG. 6

7 The poverty headcount ratio and the average poverty gap for selected countries. 7

8 How to Compare Poverty Levels Can we define poverty lines across countries with exchange rate? ER is based on prices for tradable goods and services. It fails to account for P of nontradable g&s which make up large budget shares for poor households. The PPP is used instead of ER. Other limitations of surveys: the average basket of g&s across countries is very different from the average basket consumed by the poor within countries. Also, surveys are done differently across countries. For example, some estimate expenditure while others estimate income. WB used HH consumption and PPP to compile internationally comparable poverty estimates across countries and time. Data is found in the annual World Development Report and are used for the Millennium Development Goals (MDG), global targets established at the 2000 Millennium Summit. There has been a reduction in absolute (number of persons) and relative poverty (%), especially in East Asia. Absolute poverty has increased in South Asia, sub-saharan Africa and Central Asia. $1 a day: World Bank established an international extreme PL of $1 per day. (Updated to $1.25 adjusted for inflation.) 8

9 Table The Poverty Headcount and Headcount Ratio Based on $1.25 a Day. 9

10 Measurement and comparisons of inequality Measuring Income Inequality In general, we measure the income distribution within countries. Divide population of a country into quantile groups: quartiles (4 groups), quintiles (5 groups), or deciles (10 groups). The quantile ratio is the average income in the highest quantile over the average income in the lowest quantile. Provides no information about people in the middle range of the income distribution. The Lorenz curve plots the cumulative share of income held by the different quantiles of the population. A completely equal distribution should match the diagonal perfectly while a completely unequal distribution should resemble a backward L-shape. 10

11 The Lorenz Curve. 11

12 Gini Coefficient Gini coefficient is a numerical representation of income inequality. It is defined as twice the area between the diagonal and the Lorenz curve. In the case of perfect income equality, the Gini coefficient would equal 0. In the case of complete income inequality, the Gini coefficient would equal 1. Thus, G = 1-2S. Where S is the area under the Lorenz curve. The ratio is between 0 and 1, and therefore can also be represented as percentages. Inequality seems not to fall within countries and over time. 12

13 The Lorenz Curve and the Gini Coefficient. 13

14 Income Inequality in Selected Countries 14

15 Income Inequality in Different Regions of the World ( ) 15

16 Economic determinants of inequality Education and Income Inequality The variance in access to education across countries is a possible determinant of income inequality. People in societies where access to education is limited will tend to acquire less skills and, thus, earn lower wages. Uneducated people also tend to be excluded from groups in society that are powerful enough to demand from their government. Data on the relationship between income inequality and education is indicative, but not conclusive. Africa, for example, has both high income inequality and low literacy rates. South Asia, on the other hand, has low income inequality but literacy rates are even lower than in Africa. Also, the direction of causality is not clear. Income inequality may lead to educational inequality, or vice versa. 16

17 ECONOMIC DETERMINANTS OF INEQUALITY Table 2.5. Education and Income Inequality. 17

18 Economic determinants of inequality A possible determinant is the historical access to property ownership. It is clear from the data that income inequality and land inequality are positively correlated, i.e. inequality of land wealth leads to inequality of income. Latin America and South Asia are inequitable in terms of land ownership. Knowledge, talent, skill Laziness vs. hard work Ethnicity Religion 18

19 Inequality, growth, and development Is inequality good or bad for economic growth? How does income inequality affect economic growth? What is the direction of causality? How has income inequality evolved historically? The Kuznets Hypothesis Over the course of development, inequality follows a U-curve relationship. Inequality first increases but then decreases. At initial stages, only small parts of society benefit, but income eventually trickles down to the rest. One process that generates U effect is the shift from agriculture to industry. However, there is little evidence to support this hypothesis in both cross-sectional and panel studies. 19

20 The Kuznets Curve. 20

21 Income Inequality and Economic Growth Since the early 1990s there has been almost unanimous consensus that income inequality is bad for economic growth. The data show a negative correlation between long-term growth rates of GDP per capita and the Gini coefficient. In recent decades, Latin America has experienced both high income inequality and poor economic growth. Asia, on the other hand, has relatively equitable distribution and high rates of growth. Some possible theoretical explanations include: Credit market imperfections: people in countries with a more equal income distribution will have access to more credit. Political economy: high inequality builds pressure for redistribution of income, possibly leading to high taxation of the rich. 21

22 Income Inequality and Economic Growth. 22

23 Inequality over Time Income inequality seems to have been increasing within countries in the past few decades. It has increased in Central and Eastern Europe and in China as a result of the transition from socialism to capitalism. It has increased in the US and many Western European countries. Alternatively, we can look at world-wide income distribution. Income inequality seems to be decreasing across countries as living standards increase in developing economies. Xavier Sala-i-Martin finds evidence that the Gini coefficients across countries have declined since around the 1980s. A possible explanation is the recent economic performance of China and India. As these countries develop, hundreds of millions of people have been pulled out of poverty. 23

24 The Evolution of the World Gini Coefficient. 24

25 Evolution of the World Gini Coefficient ( ), Excluding Various Countries. 25

26 END 26

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