EF331 Topics in Applied Economics

Dr. Silvia Rocchetta

silvia.rocchetta@dcu.ie
Course Outline

1. Foundations of Innovation
economics
2. Intellectual property and
knowledge spillovers
3. Evolutionary Economic
Geography
4. Inequality
Course Outline

5. International Trade
6. Behavioral Economics
7. Labour Economics
8. Macroeconomics and Fiscal
Policies
 INCOME INEQUALITY
Chapter 4
Global Income Convergence and Inequality

• Cross-country Convergence

• Convergence in average GNI

(gross national income) per
capita across countries

• Within-country Convergence

• Reduction in the dispersion of

incomes around the average
GNI per capita within a country
 Cross Country Convergence
• Inter-country Convergence
• Measured by comparing the mean GNI per capita across
countries over time
• Known as Beta Convergence
• Absolute Beta Convergence - in the long run, GDP per capita
converges to the same growth path and leads to the same
level of income per capita between countries resulting in the
same capital-labour ratio, output per capita and consumption
per capita with an equal growth rate.
• Conditional Beta Convergence – in the long run countries
growth rates can converge but given that countries often differ
based on their basic structural characteristics and their levels
of saving and investment their steady state level of GDP per
capita can remain different over time
 Examining Convergence and Inequality
• Milanovic (2002) and Firebaugh &
Goesling (2004) first looked at cross
country convergence and global
inequality
• Milanovic found that if the world was
divided into three groupings - first world,
middle income and third world - 78% of
the world was poor, 11% classified as
middle income and 11% of the world
would be considered rich
 Within-Country Convergence
• Within-country Convergence

§ Reduction in the dispersion of incomes around

the average GDP per capita within a country
• Measured using statistical measures such as

• Gini Co-efficient
• Theil Index
• Mean Log Deviation
 Measures of Income Inequality

• The Coefficient of Variation

• The Gini Coefficient

• Theil’s T Statistic
 The Coefficient of Variation
• The Coefficient of Variation is a distribution’s standard
deviation divided by its mean.

Both distributions above have the same mean, 1, but the

standard deviation is much smaller in the distribution on the
left, resulting in a lower coefficient of variation.
 The Coefficient of Variation

Pros Cons

• Fairly easy to understand • Requires

• If data is weighted, it is
immune to outliers
• Incorporates all data
• Not skewed by inflation
comprehensive
individual level data
• No standard for an
acceptable level of
inequality
 The Gini Coefficient

• The Gini Coefficient has an intuitive, but possibly unfamiliar

construction.
• To understand the Gini Coefficient, one must first
understand the Lorenz Curve.
• In the graph the population percentile by income is plotted
on the horizontal axis and the cumulative income on the
vertical axis
 The Gini Coefficient
• An equality diagonal represents perfect equality: at every
point, cumulative population equals cumulative income

• The Lorenz curve measures the actual distribution of

income.

• A – Equality
Cumulative Income

A
Diagonal
Population =
C Income
• B – Lorenz Curve
B • C – Difference
Cumulative Population
Between Equality
and Reality
The Gini Coefficient
 The Gini Coefficient

Another way of thinking about the Gini coefficient is as a

measure of deviation from perfect equality
 The Gini Coefficient
• The Gini coefficient is a measure of the degree of
inequality of income in a country.
• It measures the area between the 45-degree line and
the Lorenz curve.
• The Gini coefficient is a number between 0 and 1.
• A Gini coefficient of 0 means that income equality is
perfect.
• It is calculated by dividing area A by area A +B in Figure
3.
! "#$" %$&'$$( )$#*$+& $,-"./&0 ./($ "(1 23#$(4 5-#6$
• Gini=
"7% "#$" -(1$# &8$ ./($ 3* )$#*$+& $,-"./&0
The Gini Coefficient
 The Gini Coefficient
• Mathematically, the Gini Coefficient is equal to twice the
area enclosed between the Lorenz curve and the equality
diagonal.
• When there is perfect equality, the Lorenz curve is the
equality diagonal, and the value of the Gini Coefficient is
zero
• When one member of the population holds all of the
resource, the value of the Gini Coefficient is one.
 The Gini Coefficient
Pros
Cons
• Generally regarded as gold
• Requires
standard in economic work
comprehensive
• Incorporates all data individual level data
• Allows direct comparison • Requires more
between units with different sophisticated
size populations computations
• Attractive intuitive
interpretation
Gini Coefficients 2017

Collecting data
across countries
is difficult because
they have
different ways of
collecting data.
 Theil’s T Statistic

• Theil’s T Statistic lacks an intuitive picture and

involves more than a simple difference or ratio.
• Nonetheless, it has several properties that make
it a superior inequality measure.
• Theil’s T Statistic can incorporate group-level
data and is particularly effective at parsing effects
in hierarchical data sets.
 Theil’s T Statistic
• Theil’s T Statistic generates an element, or a
contribution, for each individual or group in the
analysis which weights the data point’s size (in
terms of population share) and weirdness (in terms
of proportional distance from the mean).
• When individual data is available, each individual
has an identical population share (1/N), so each
individual’s Theil element is determined by his or
her proportional distance from the mean.
 Theil’s T Statistic
• Mathematically, with individual level data Theil’s T statistic
of income inequality is given by:

n ì
ïæ 1 ö æç y p ö æy öü
T = å íç ÷ * ÷ * lnç p ÷ï
è n ø çè µ y ÷ ç µy ÷ý
p =1ï
î ø è øï
þ

• where n is the number of individuals in the population, yp

is the income of the person indexed by p, and µy is the
population’s average income.
 Theil’s T Statistic
The formula on the previous slide emphasizes several
points:
• The summation sign reinforces the idea that each person
will contribute a Theil element.
• yp/µy is the proportion of the individual’s income to
average income.
• The natural logarithm of yp /µy determines whether the
element will be positive (yp /µy > 1); negative (yp /µy < 1);
or zero (yp /µy = 0).
 Theil’s T Statistic – Example 1
The following example assumes that exact salary information is known for each
individual.

Number of employees Exact Salary

2 $100,000
4 $80,000
6 $60,000
4 $40,000
2 $20,000

For this data, Theil’s T Statistic = 0.079078221

Individuals in the top salary group contribute large positive elements. Individuals
in the middle salary group contribute nothing to Theil’s T Statistic because their
salaries are equal to the population average. Individuals in the bottom salary
group contribute large negative elements.
 Theil’s T Statistic
• Often, individual data is not available. Theil’s T Statistic
has a flexible way to deal with such instances.

• If members of a population can be classified into mutually

exclusive and completely exhaustive groups, then Theil’s
T Statistic for the population (T ) is made up of two
components, the between group component (T’g) and the
within group component (Twg).
 Theil’s T Statistic
• Algebraically, we have:

T = T’g + Twg

• When aggregated data is available instead of

individual data, T’g can be used as a lower bound
for Theil’s T Statistic in the population.
 Theil’s T Statistic
• The between group element of the Theil index
has a familiar form:
m ìæ pi ö æ yi ö æ yi öü
T ' g = å íç ÷ * çç ÷÷ * lnçç ÷÷ý
i =1 îè P ø è µ ø è µ øþ

• where i indexes the groups, pi is the population of

group i, P is the total population, yi is the average
income in group i, and µ is the average income
across the entire population.
 Theil’s T Statistic – Example 2
Now assume the more realistic scenario where a researcher has average salary
information across groups.

N of employees in group Group Average Salary

2 $95,000
4 $75,000
6 $60,000
4 $45,000
2 $25,000

For this data, T’g = 0.054349998

The top salary two salary groups contribute positive elements. The middle salary
group contributes nothing to the between group Theil’s T Statistic because the group
average salary is equal to the population average. The bottom two salary groups
contribute negative elements.
 Group analysis with Theil’s T Statistic:
As Example 2 hints, Theil’s T Statistic is a powerful tool for
analyzing inequality within and between various
groupings, because:
• The between group elements capture each group’s
contribution to overall inequality
• The sum of the between group elements is a reasonable
lower bound for Theil’s T statistic in the population
• Sub-groups can be broken down within the context of
larger groups
 Theil’s T Statistic
Pros Cons

• Can effectively use group • No intuitive

data • Cannot directly
• Allows the researcher to compare populations
parse inequality into within with different sizes or
group and between group group structures
components • mathematically
complex
How is Cross Country Convergence Achieved
H-O theory of Comparative Advantage

Factor Price Equalisation: as countries move towards

free trade, their incomes will equalise

Solow-Swan Growth Theory

Income Convergence: countries’ growth rates converge

towards the steady state level of output, causing
incomes to converge across countries

Endogenous Growth Theory

Access to technology will enable poorer countries to
increase their labour productivity and their income will
rise as a result
 Theoretical Views on Convergence
Neoclassical growth theory predicts:
• Absolute convergence for economies with equal
rates of saving and population growth and with
access to the same technology
• Conditional convergence for economies with
different rates of savings and/or population growth
® steady state level of income differ, but growth
rates eventually converge
Endogenous growth theory ® no convergence
4-33
GDP per Capita Growth 2017
Economic Recovery Average Growth 2009-2017
Inequality Around the World: Gini Coefficient
World Bank Estimates, Most Recent
Observation
Inequality Around the World: Gini Coefficient
World Bank Estimates, Most Recent
Observation
Source: http://www.indexmundi.com/facts/indicators/SI.POV.GINI/rankings
Gini changes in OECD
Ginis worse in many countries, late
2000s vs. 1980s
Share of World GDP
 Global Income Inequality
• There are still significant differences in the income per capita
across countries, globally

GDP per capita 2015

Afghanistan - $660
Brazil - $9990
Ireland - $52,550
US - $55, 980

Source: World Bank 2017 World

Development Indicators

• There are still significant differences in the income per capita,

within many countries
Key Empirical Facts on Income Inequality

In the US, labor

income inequality
has increased
substantially since
1970
Key Empirical Facts on Income Inequality

In the US, top

income shares
dropped
dramatically from
1929 to 1950 and
increased
dramatically since
1980 [Piketty and
Saez, 2003]
Key Empirical Facts on Income Inequality

Top incomes used

to be primarily
capital income.
Now, top incomes
are divided 50/50
between labor and
capital income
(due to explosion
of top labor
incomes with
stock-options,
bonuses, etc.)
 Key Empirical Facts on Income Inequality
Fall in top
income shares
from 1900-1950
happened in
most OECD
countries. Surge
in top income
shares has
happened
primarily in
English speaking
countries, not as
much in
Continental
Europe and
Japan [Atkinson,
Piketty, Saez
JEL'11]
Inequality In Ireland (in Gross Income)
Source: TASC
Inequality In Ireland (in Gross Income)
Source: TASC
 World Inequality Report 2018
• Income inequality varies greatly across world regions. It is
lowest in Europe and highest in the Middle East.
• Income inequality has recently increased in nearly all
countries, but at different speeds.
• Observe rising inequality in most of the world’s regions,
but with different magnitudes
• Inequality levels are different among countries, which
share similar levels of development, this is highlighting the
important role that national policies and government
institutions play in shaping inequality.
 Trends in Income Inequality
• Since 1980, income inequality has increased rapidly
in North America, China, India, and Russia
• Top 10% richest individuals in the world captured
twice as much growth as the bottom 50%
individuals since 1980
• In the United States, the bottom 50% income share
has collapsed while the top share has boomed
since the 1980s
 Trends in Income Inequality
• Divergence in inequality levels has become extreme
between Western Europe and the US – 1980s top
1% circa 10% of income in both regions - in 2016
US top 1% had 20% of income while in Europe top
1% had 12% of income
• Continental European countries more successful in
preventing the rise of incomes inequalities
• In China, India, and Russia, three formerly
communist or highly regulated economies, inequality
surged with the opening of the economies
 Regional Income Inequality In EU

Czechia and Slovenia had the lowest income inequality in 2017 (3.4). These were
followed by : Finland (3.5), Slovakia (3.5), and Belgium (3.8).
In contrast, income inequalities were much higher (above 6.0) in Greece (6.1), Latvia
(6.3), Romania (6.5), Spain (6.6), Lithuania (7.3) and highest in Bulgaria (8.2)
Top 10% Income Share Around the World
Top 1% vs Bottom 50% National Income
Share US
Top 1% vs Bottom 50% National Income
Share Western Europe
 Piketty’s models
• Piketty and others have provided important data through
which we can see an increase in inequality, especially at the
top
• The question is: how do we explain it? Piketty has offered a
particular model (effectively, two-class model, based on
earlier work of Pasinetti, Samuelson-Modigliani, and Stiglitz)
• Capitalists save all (most) of their income
• So wealth grows at the rate r (return on capital)
• If r > g ( growth of the economy), their wealth grows faster
than the economy
 Main Piketty’s models findings

• Growth in 2015-2019 weakest since Global Financial Crisis

and one of poorest performances in recent decades;

• Underlying problem: lack of global aggregate demand

• One of the reasons: high level of inequality

• Inequality also affects aggregate demand indirectly

• Increases instability

• Realization of this creates uncertainty

 Main Piketty’s models findings
• Repeal” of previous economist findings
• Economies with less inequality and less inequality of
opportunity perform better
• Equality and economic performance are
complements
• Many reasons for this:
• Lack of opportunity means that we are wasting most valuable
resource
• Macro-economic • Instability: Link between inequality and
frequency of crises has been shown by IMF as well as others.
 Main Piketty’s models findings
• Weaker growth
• Richest consume a smaller proportion of their incomes than the poor or
middle
• Greater equality would strengthen aggregate demand

• Small and medium-sized businesses, buoyed by strong middle class,

are drivers of economic growth
• Political economy
• Harder for divided society to make needed public investments in
infrastructure, technology, education, etc.
• As democratic processes are skewed (e.g. in U.S.), policies that
protect interests and rents of wealthiest replace those that support
broad-based growth
• Erosion of trust
 Main Piketty’s models findings
• Weaker growth
• Richest consume a smaller proportion of their incomes than the poor or
middle
• Greater equality would strengthen aggregate demand

• Small and medium-sized businesses, buoyed by strong middle class,

are drivers of economic growth
• Political economy
• Harder for divided society to make needed public investments in
infrastructure, technology, education, etc.
• As democratic processes are skewed (e.g. in U.S.), policies that
protect interests and rents of wealthiest replace those that support
broad-based growth
• Erosion of trust
 Main Piketty’s models findings
• We can afford to have more equality
• In fact, it would help our economy
• Some much poorer economies have chosen more
equalitarian policies
• Because inequality is the result of policies, it is shaped by
politics
• Economic inequality gets translated into political
inequality
• Political inequality leads to economic inequality
• Vicious circle
 Policy Recommendations
• More equal access to education and well-paying
jobs is key to addressing the stagnating or
sluggish income growth rates of the poorest half
of the population
• Governments need to invest in the future to
address current income and wealth inequality
levels, and to prevent further increases in them
• Tax polices can be used to combat rising income
and wealth inequality
 Policy Recommendations (Piketty)
• The history of income and wealth inequality is
political. It involves beliefs systems, national
identities, sharp reversals. Wars & revolutions
played a key role in 20c inequality dynamics. It will
probably be chaotic as well in 21c .
• Both Marx and Kuznets were wrong: there are
powerful forces pushing in the direction of rising or
reducing inequality; which one dominates depends
on the institutions and policies that different
societies choose to adopt
 Policy Recommendations (Piketty)
• The ideal solution involves a combination of
inclusive institutions, including progressive tax on
income & wealth; education & labor laws; economic
democracy, new forms of property, power structure
and participatory governance.
• Inequality regimes need to be put into a historical
and comparative perspective, so as to invent new
solutions and go beyond nationalism and perceived
exceptionalism. Social sciences can help
 Thank you
silvia.rocchetta@dcu.ie

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