ECONOMIA INTERNAZIONALE corso progredito B

THEIL INDEX DECOMPOSITION a note for students

The Theil index has many different possible formulations. In the Sala-i-Martins (S-i-M from here on) paper the Theil index is derived as a particular case of a more general entropy index. We limit our attention to this case; in the quoted paper we find the following presentation of the index:
Tt = 1 Nt

i =1 j =1

Nit

y ijt

y ijt ln y y

The various symbols have the same meaning than in S-i-M (y: per capita income; N: population; i: country; j: individual; t: time); y is the world average per capita income.The author also uses another notation, but we limit our attention to the previous and more intuitive one. It can be very easily transformed in the following: m N y ij y ij T = ln y i =1 j =1 Ny
i

Where the term Nt has been simply moved inside the operator. For sake of simplicity we have also omitted the index t, just to avoid a too heavy notation. The index is a weighted summation over individuals and countries; weights are represented by
y ij Ny

, that are the shares of individual incomes (income of individual j in country i) on the world

total income (equal to the world population times the world per capita income). It is possible to decompose the Theil index in a way highlighting the between (or across) and the within components of the world income distribution (the term between and within refer to countries). This procedure consists in adding and subtracting the same expression and in making a few algebraic manipulations. Let us add and subtract from the Theil index the following expression (see the S-i-M paper): m N i yi ln ( y i ) i =1 Ny As a consequence we get m N m y ij y ij m N i y i N i yi ( ) T = ln + ln y ln ( y i ) i i =1 j =1 Ny i =1 Ny y i =1 Ny
i

ij Considering that ln y = ln y ij ln y , we can express T in the following way m Ni y m Ni y m m N y N y ij ij T = ln y ij ln y + i i ln( y i ) i i ln ( y i ) i =1 j =1 Ny i =1 j =1 Ny i =1 Ny i =1 Ny

To simplify the notation we can indicate shares by the term s (as an example s ij = y ij / Ny , that is the share of the income of individual j of country i with respect to total world income). We then get

T = sij ln y ij sij ln y + si ln ( y i ) si ln ( y i )
i =1 j =1 i =1 j =1 i =1 i =1

Ni

Ni

Now consider the second algebraic addend of the right-hand side. Summing the shares (with respect to world total income) of all the individuals inside a country means to get the national income share (again with respect to world total income). That is to say that

sij ln y = si ln y
i= 1 j= 1 Ni i= 1

Ni

A similar transformation can be done for the first algebraic addend

s
i =1 j =1

ij

ln y ij = si ln ( y ij )
m i =1
m m

As a consequence we get T = s i ln ( y ij ) s i ln y + si ln( y i ) s i ln ( y i )

m m i =1 i =1 i =1 i =1

Now combine the second and the third addends together:

m m m yi s i ln y + s i ln ( y i ) = si ln y i =1 i =1 i =1 It is easy to see that this is an entropic index measuring differences among countries, since (for all m countries) it compares countries average income to the world average income. This is the between (or across) component we were looking for and we call it Tb. Then, combining the first and the fourth together we have m m m y ij si ln ( y ij ) si ln ( y i ) = si ln y i =1 i =1 i =1 i It is easy to see that this is an entropic index measuring differences inside countries, since (for all m countries) it compares individual income to the average national income. This is the within component we were looking for and we call it Tw. Summarizing, our initial Theil index can be expressed in the following way m y ij yi m T = s i ln y + s i ln y i =1 i =1 i or T = Tb+Tw This formulation underlines that T depends on a between and a within component. Entropic indexes are the only indexes that can be naturally decomposed in this way.