EC1103

applied Economic Policy

Lecture 9 – Measuring Inequality

Dr. Gabriel Facchini

What’s your position in the UK’s
income distribution?

Mentimeter: Perception of inequality

Perceptions of inequality

▪ A nationally representative sample would be

depicted as a horizontal line at a 10% density.
▪ The higher concentration in deciles 5 to 9 is
accounted for by the presence of higher average
income levels in Buenos Aires relative to the
countrywide average
▪ the proportion of biased individuals is more than
55% when considering only respondents who
deviate from their true position by two deciles or
more
Perceptions of inequality

OECD Compare your income platform

https://www.compareyourincome.org/en

World Inequality Database (WDI) income comparator

https://wid.world/income-comparator/

IFS –Your household’s income: Where do you fit in?

https://ifs.org.uk/tools_and_resources/where_do_you_fit_in#tool-results-
section
EC1103 Lecture 9 - Inequality

Outline

▪ Introduction
▪ Theoretical Underpinnings
▪ Illustrative Example
▪ Measuring Inequality
▪ Inequality and Growth
▪ Empirical Evidence
▪ Conclusion
EC1103 Lecture 9 - Inequality

Inequality

The United Nations Millennium Declaration, adopted by the General

Assembly, includes the following:

“We recognize that, in addition to our separate responsibilities to our

individual societies, we have a collective responsibility to uphold the
principles of human dignity, equality and equity at the global level. As
leaders we have a duty therefore to all the world’s people, especially the
most vulnerable and, in particular, the children of the world, to whom the
future belongs.”
EC1103 Lecture 9 - Inequality

Income Inequality

▪ A person’s earnings depend on the supply and demand for that

person’s labor,
▪ which in turn depend on natural ability, human capital, compensating
differentials, discrimination, and so on.
▪ How much inequality is there in our society?
▪ How many people live in poverty?
▪ What problems arise in measuring the amount of inequality?
▪ How often do people move among income classes?
EC1103 Lecture 9 - Inequality

Political Philosophy of Income Redistribution

Three main political philosophies:

▪ Utilitarianism
▪ Liberalism
▪ Libertarianism
EC1103 Lecture 9 - Inequality

Utilitarianism

▪ Utilitarianism is the political philosophy according to which the

government should choose policies to maximize the total
utility of everyone in society.
▪ The founders of utilitarianism are the English philosophers
Jeremy Bentham and John Stuart Mill.
▪ The utilitarian case for redistributing income is based on the
assumption of diminishing marginal utility.
▪ An extra dollar of income to a poor person provides that person with
more utility, or well-being, than does an extra dollar to a rich person.
▪ By taking a dollar away from the rich and giving to the poor, society is
better off!
EC1103 Lecture 9 - Inequality

Liberalism

▪ Liberalism is the political philosophy according to which the

government should choose policies deemed to be just, as
evaluated by an impartial observer behind a “veil of
ignorance.”

▪ This view was originally developed by the philosopher John

Rawls.
EC1103 Lecture 9 - Inequality

▪ Design your model society.

▪ There will be two groups or classes of equal size, one
called ‘richer’ and the other ‘poorer’.
▪ You will get to live in the society you design after you
have answered the question ‘how rich should the richer
class be and how poor should the poorer class be?’

▪ But there is a hitch: which class you get to be in will be

determined by the flip of a coin after you have decided how
unequal the society will be.
EC1103 Lecture 9 - Inequality

Liberalism

▪ Public policy should be based on the maximin criterion, which

seeks to maximize the utility or well-being of the worst-off
person in society.
▪ That is, rather than maximizing the sum of everyone’s utility,
one should maximize the minimum utility.
▪ This idea would allow for the consideration of the
redistribution of income as a form of social insurance.

Mentimeter: Veil of Ignorance

EC1103 Lecture 9 - Inequality

Libertarianism

▪ Libertarianism is the political philosophy according to which

the government should punish crimes and enforce voluntary
agreements but should not redistribute income.
▪ Libertarians usually see the kind of large-scale, coercive wealth
redistribution in which contemporary welfare states engage as
involving unjustified coercion.
EC1103 Lecture 9 - Inequality

Some Fundamental Questions

▪ But what exactly is inequality?

▪ How is it measured?
▪ How can we make meaningful comparisons over time, or
across space?
▪ How can we begin to analyze the underlying structure of
inequality?
▪ What policies can successfully reduce inequality?
EC1103 Lecture 9 - Inequality

Global Inequality

Source: Credit Suisse Global wealth report

Global Inequality: It’s Not What Marx
Predicted

Source: Milanovic (2013)

EC1103 Lecture 9 - Inequality

Global Inequality
EC1103 Lecture 9 - Inequality

Inequality around the World

EC1103 Lecture 9 - Inequality

Inequality around the World

EC1103 Lecture 9 - Inequality

Reasons for Increase in Inequality

▪ The following have tended to reduce the demand for unskilled

labor and raise the demand for skilled labor:
▪ Increases in international trade with low-wage countries
▪ Skill-biased-technological-change (SBTC)
▪ Therefore, the wages of unskilled workers have fallen relative
to the wages of skilled workers.
▪ This has resulted in increased inequality in family incomes.
▪ Oxfam report, ‘An economy for the 1%’: the returns to capital
have increased tremendously
EC1103 Lecture 9 - Inequality

Inequality Measurement

▪ Consider the distribution of a given variable (income,

consumption, or some other welfare indicator or attribute)
▪ Usually inequality is captured as the “dispersion” of a
distribution, whether that be income, consumption or some
other welfare indicator or attribute of a population.
▪ Even if we agree on the concept of inequality, the
measurement may be problematic, and it is not simple to find a
good indicator that summarizes the distribution
▪ Note: equality of income does not guarantee equality of
capabilities.
▪ From an empirical point of view, it is an acceptable way to proceed.
EC1103 Lecture 9 - Inequality

Lorenz Curve

▪ The Lorenz curve plots the cumulative share of income against

the cumulative population share. The diagonal (450 line)
represents perfect income equality.
▪ The further away society is from the diagonal, the more
unequal it is.
▪ The Gini Concentration Ratio, or simply Gini Coefficient, which
indicates the degree of overall inequality in income
distribution, is derived from the Lorenz curve.
EC1103 Lecture 9 - Inequality

Lorenz Curve

Gini index=A/(A+B)
EC1103 Lecture 9 - Inequality

Gini Coefficient and Lorenz Curve

▪ To compute the Gini coefficient, first measure

area between Lorenz Curve and 450 equality
line.
▪ The Gini coefficient is the area shaded in pink
divided by total of the areas shaded in pink and
blue-green.
▪ For a perfectly equal distribution, there would
be no area between the 45 degree line and the
Lorenz curve – a Gini coefficient of 0
▪ For complete inequality, in which only one
person has all income, the Lorenz curve would
coincide with the straight lines at the lower and
right boundaries of the curve. The Gini
coefficient would then be 1
▪ In practice, the Gini coefficient ranges between
0.25 and 0.60
Inequality Measurement

▪ A widespread measure of inequality is the Gini concentration

ratio (also called Gini coefficient; or Gini index)
▪ Gini = 2 * area between 45-degree line and Lorenz curve
▪ Gini=0 means perfect equality
▪ Gini=1 means complete inequality (top person has all the
income)

1 n n
Gini = 2   yi − y j
2n y i =1 j =1

= half the average difference between all pairs of incomes,

normalized by the mean.
EC1103 Lecture 9 - Inequality

Interpreting the Gini Coefficient

▪ A thought experiment: Suppose two people in a country are to

meet at random. What will be the expected income gap
between the two?
▪ If the all individual incomes are known, we can derive the
average gap between any pair
▪ That expected gap can be expressed as a percentage of that
society’s average income
▪ Halving that percentage gives us the Gini index.
EC1103 Lecture 9 - Inequality

Interpreting the Gini Coefficient

▪ In 2019, China’s official Gini was 46.5%

▪ ie, the expected gap was 93% (twice the Gini) of China’s
average disposable income
▪ If average disposable income was 30,733 yuan ($4,449)…

▪ Expected gap would be about $4,138

▪ An alternative Gini Index calculated by the World Bank looks
better (38.5% in 2016), because it adjusts for cheaper prices in
rural areas.
EC1103 Lecture 9 - Inequality

Gini Coefficient – 10 most ‘unequal’ countries

Rank Country Gini Coefficient

1 South Africa 63.0
2 Namibia 59.1
3 Zambia 57.1
4 Sao Tome and Principe 56.3
5 Central African Republic 56.2
6 Eswatini (Kingdom of) 54.6
7 Mozambique 54.0
8 Brazil 53.9
9 Botswana 53.3
10 Honduras 52.1

Source: Human Development Reports, UNDP 2008-2018

EC1103 Lecture 9 - Inequality

Gini Coefficient – 10 most ‘equal’ countries

Rank Country Gini Coefficient

1 Slovenia 24.2
2 Czechia 24.9
3 Belarus 25.2
4 Slovakia 25.2
5 Moldova (Republic of) 25.7
6 Ukraine 26.1
7 Iceland 26.8
8 Norway 27.0
9 Belgium 27.4
10 Finland 27.4
Source: Human Development Reports, UNDP 2008-2018
EC1103 Lecture 9 - Inequality

Inequality in different world regions

▪ Latin America is the world region with the highest income

inequality.
▪ Variations across world regions are much larger than variations
across time.

▪ “Studying income
inequality is like
watching grass
grow” Henry Aaron
(American
economist)
 Growth and Poverty

Growth is obviously good for poverty reduction, but there is a lot of country
heterogeneity around the average relation.
Causality?
Growth and Inequality

Growth should decrease inequality if the poor benefit relatively more. The
cross-country evidence does not show that this has been happening.
Inequality & Growth

▪ Growth largely depends upon :

▪ Accumulation of physical capital
▪ Accumulation of human capital
▪ Technological progress

▪ How can inequality affect growth?

EC1103 Lecture 9 - Inequality

Redistribution and Growth:

a Political Economy Model

▪ Incentives to accumulate (human and physical) capital depend

on ability of individuals to appropriate the fruits of their efforts
▪ In a society where inequality is high, substantial redistribution
may be necessary
▪ However, high redistribution, by reducing the incentives to
accumulate, can imply less growth
EC1103 Lecture 9 - Inequality

Inequality and Growth:

Adverse Effects of Social Conflict

▪ High inequality is likely to generate social conflicts that may

have adverse consequences on growth through various
channels:
▪ Increase in political instability and social unrest that are
detrimental for investments (Alesina and Perotti, 1996)
▪ Reduced ability of political systems to respond effectively to
external shocks (Rodrik, 1997).
▪ High opportunity costs caused by violence (resources diverted
from productive activities to fighting crime and violence)
EC1103 Lecture 9 - Inequality

Inequality and Growth:

Adverse Effects of Social Conflict

▪ Violence levels, as measured by recorded homicide rates, have

recently increased sharply in both of the most unequal regions in
the world (Latin America and Sub Saharan Africa), and in the one
where its growth has been fastest (Eastern Europe, Russia and
Central Asia).
▪ Fajnzylber et. al. (1998) document these global trends, and find
evidence to suggest that income inequality is significantly
associated with violence levels, across countries.
▪ Bourguignon (1998) and others have documented the growing
importance of the social and economic burden imposed on
society by this rising violence,
▪ both in terms of the direct costs in lives and medical resources,
▪ and in terms of the opportunity costs of (both public and private)
resources diverted from other activities towards preventing and
fighting crime.
When should the government intervene
in the economy?

1) Market Failures: Market economy sometimes fails to

deliver an outcome that is efficient ) Government
intervention may improve the situation

2) Redistribution: Market economy generates substantial

inequality in economic resources across individuals ) People
willing to pool their resources (through government taxes
and transfers) to help reduce inequality
Main Market Failures

1) Externalities: (example: greenhouse carbon emissions) ) require

govt interventions (Pigouvian taxes/subsidies, public good
provision)
2) Imperfect competition: (example: monopoly) ) requires
regulation (typically studied in Industrial Organization)
3) Imperfect or Asymmetric Information: (example: adverse
selection in health insurance may require mandatory insurance)
4) Individual failures: People are not always rational. This is
analyzed in behavioral economics, field in huge expansion
(example: myopic people may not save enough for retirement)
 Inequality and Redistribution

▪ Even if market outcome is efficient, society might not be happy with the
market outcome because market equilibrium might generate very high
economic disparity across individuals.
▪ Governments use taxes and transfers to redistribute from rich to poor and
reduce inequality
▪ Redistribution through taxes and transfers might reduce incentives to work
(efficiency costs)
▪ Redistribution creates an equity-efficiency trade-off
▪ Inequality matters because people evaluate their economic well-being relative
to others, not in absolute terms ). Public cares about inequality.
▪ In advanced economies, people pool 30-50% of their income through their
government to fund many transfer programs.
 How Might the Government Intervene?

1. Tax or Subsidize Private Sale or Purchase: Tax goods that are

overproduced (e.g. carbon tax) and subsidized goods underproduced
(e.g., flu shots subsidies)
2. Restrict or Mandate Private Sale or Purchase: Restrict the private
sale or purchase of overproduced goods (e.g. fuel efficiency
requirements), or mandate the private purchase of underproduced
goods (e.g., auto insurance)
3. Public Provision: The government can provide the good directly, in
order to potentially attain the level of consumption that maximizes
social welfare (example is National Defense)
4. Public Financing of Private Provision: Government pays for the good
but private sector supplies it (e.g., privately provided health insurance
paid for by US government in Medicare-Medicaid)
Safety net as a consumption floor

▪ Statutory minimum wage rates: first appeared in late 19th

century in an effort to help raise the consumption floor.
▪ Universal Basic Income (UBI)/Basic-income guarantee (BIG):
From the 1970s, we started to see arguments in support of a
fixed cash transfer to every adult. A firm floor.
▪ Social policy as a “right of citizenship” rather than something to
be targeted based on “need.”
▪ e.g., demands for universal health insurance in the US.
Taxes and Redistribution
Taxes and Redistribution
The U.S. vs. other developed countries

▪ Inequality has increased more in the US than other developed

countries.

▪ Technology, globalization cannot explain this pattern.

▪ Domestic policies matter.

The U.S. vs. other developed countries

Top 1% vs. Bottom 50% national income shares in the US, 1980-2016
The U.S. vs. other developed countries

Top 1% vs. Bottom 50% national income shares in Western Europe, 1980-2016
EC1103 Lecture 9 - Inequality

▪ Alesina, Di Tella and McCulloch – Inequality

and Happiness: Are Europeans and Americans
Different? Journal of Public Economics 88, (2004)
▪ The answer is ‘yes’.

▪ Using a total of 128,106 answers to a survey question

about ‘happiness’, they find that there is a large,
negative and significant effect of inequality on happiness
in Europe but not in the US.
▪ There are two potential explanations.
▪ First, Europeans prefer more equal societies (inequality appears
in the utility function for Europeans but not for Americans).
▪ Second, social mobility is (or is perceived to be) higher in the US
so being poor is not seen as affecting future income.
Perceptions matter

▪ Increase in the probability of

signing the petition to increase
taxes on wealthy individuals in the
presence of inequality. But…
▪ …the placebo shows lower
probability of signing the petition
in general
▪ This is consistent with evidence
that upward social comparison
reduces political efficacy
What if relative income matters?

Which situation would you prefer?

Sate A. Having an annual income of $50,000, while the others
earn $25,000.
State B. Having an annual income of $100,000, while the others
earn $250,000.
This was asked of a sample of students and lecturers at Harvard
University.
Mentimeter Experiment: Relative Inequality

Over 50 percent opted for A (Solnick and Hemenway).

What do Capuchin’s monkeys think about
fairness?

▪ Two monkeys. Each trades a rock for food. One gets cucumber
in return for a rock, the other gets grapes. They see each other.
▪ Look how the one who gets cucumber reacts (Frans de Waal):
Equality vs Equity
Equality vs Equity
EC1103 Lecture 8 - Poverty

Other resources

▪ “Rising inequality one of our biggest challenges", Thomas Piketty -

Norad Conference 2022 Vendepunkt
▪ “The Globalization of Inequality”, François Bourguignon, 2015
▪ “Global Income Inequality in Numbers: in History and Now”, Branko
Milanovic, 2013.
▪ ONS UK “What are the regional differences in income and
productivity”.
▪ Our World in Data: Income Inequality
▪ Core book, Unit 19