HOLISTIC MEASURES OF THE STANDARDS

OF LIVING
1
 THE FOLLOWING ARE THE MEASURES OF THE STANDARDS OF LIVING:
THE TRADITIONAL HUMAN DEVELOPMENT INDEX
 THE HDI ATTEMPTS TO RANK ALL COUNTRIES ON A SCALE OF 0 (LOWEST HUMAN
DEVELOPMENT) TO 1 (HIGHEST HUMAN DEVELOPMENT) BASED ON THREE GOALS
OR END PRODUCTS OF DEVELOPMENT:
i. LONGEVITY AS MEASURED BY LIFE EXPECTANCY AT BIRTH,
ii. KNOWLEDGE AS MEASURED BY A WEIGHTED AVERAGE OF ADULT LITERACY
(TWO-THIRDS) AND GROSS SCHOOL ENROLLMENT RATIO (ONE-THIRD), AND
iii. STANDARD OF LIVING AS MEASURED BY REAL PER CAPITA GDP ADJUSTED FOR
THE DIFFERING PURCHASING POWER PARITY OF EACH COUNTRY’S CURRENCY
TO REFLECT COST OF LIVING AND FOR THE ASSUMPTION OF DIMINISHING
MARGINAL UTILITY OF INCOME.
 USING THESE THREE MEASURES OF DEVELOPMENT AND APPLYING A FORMULA TO
DATA FOR 177 COUNTRIES, THE HDI RANKS COUNTRIES INTO FOUR GROUPS:
i. LOW HUMAN DEVELOPMENT (0.0 TO 0.499),
ii. MEDIUM HUMAN DEVELOPMENT (0.50 TO 0.799),
iii. HIGH HUMAN DEVELOPMENT (0.80 TO 0.90),
iv. VERY HIGH HUMAN DEVELOPMENT (0.90 TO 1.0).
 HOLSTIC MEASURES OF INEQUALITY
CONTINUES…. 2
 Calculation of the traditional HDI underwent a number of changes since its inception.
 In the past a relatively complicated formula was used to convert PPP income into
“adjusted” income.
 More recently, adjusted income is found by simply taking the log of current income.
1. The Income Index
 To find the income index, one subtracts the log of 100 from the log of current income, on
the assumption that real per capita income can not possibly be less than $100 PPP.
 The difference gives the amount by which the country has exceeded this “lower goalpost.”
 Consider it in relation to the maximum that a developing country might reasonably aspire
to have over the coming generation. The UNDP takes this at $40,000 PPP.
 So we then divide by the difference between the log of $40,000 and the log of $100 to find
the country’s relative income achievement.
 This gives each country an index number that ranges between 0 and 1.
Example
 For the case of Bangladesh, whose 2007 PPP GDP per capita was
estimated by the UNDP to be $1,241, the income index is calculated as
follows:
HOLSTIC MEASURES OF INEQUALITY
CONTINUES…. 3
Income Index
 The effect of diminishing marginal utility is clear.
 An income of $1,241,which is just 3% of the maximum goalpost of $40,000, is already
enough to reach more than two-fifth of the maximum value that the index can take.
 For countries that have already exceeded the $40,000 PPP income target, the UNDP
assigned the maximum value of $40,000 PPP income, and so the country gets the
maximum income index of 1.
2. The Life Expectancy (Health Proxy) Index
 To calculate this, the UNDP starts with a country’s current life expectancy at birth and
subtracts 25 years.
 The latter is the lower goalpost, the lowest that life expectancy could have been in any
country over the previous generation.
 Then the UNDP divides the result by 85 years minus 25 years, or 60 years, which
represents the range of life expectancies expected over the previous and next generations.
 That is, it is anticipated that 85 years is a maximum reasonable life expectancy for a
country to try to achieve over the coming generation.
The Life Expectancy (Health Proxy) Index Continues…
4
Example
 or the case of Bangladesh, whose population life expectancy in 2007
was 65.7 years, the life expectancy index is calculated as follows:
Life expectancy index= 0.678
 Notice that no diminishing marginal utility of years of life are assumed;
 The same holds for the education index.
3. The Education Index
 It is made up of two parts, with two-thirds weight on literacy and one-
third weight on school enrollment.
 Because gross school enrollments can exceed 100% (because of
older students going back to school), this index is also capped at
100%.
The Education Index Continues…

5
Example
For the case of Bangladesh, adult literacy is estimated (rather uncertainly)
at 53.5%, so:
= 0.535
 For the gross enrollment index, for Bangladesh it is estimated that 52.1%
of its primary, secondary, and tertiary age population are enrolled in
school, so the country receives the following value:
Gross enrolment index= 0.521
 Then, to get the overall education index, the adult literacy index is
multiplied by 2/3 and the gross enrollment index is multiplied by 1/3.
 This choice reflects the view that literacy is the fundamental characteristic
of an educated person.
 In the case of Bangladesh, this gives us:
Education index (gross enrollment index)
Education index (0.521)= 0.530
THE FINAL HDI
6
 In the final index, each of the three components receives equal, or one-third, weight. Thus:
H(life expectancy index)+ (education index)
Example
For the case of Bangladesh:
H(0.678)+ (0.530)
Advantages of The HDI
1. One major advantage of the HDI is that it does reveal that a country can do much better
than might be expected
2. At a low level of income substantial income gains can still accomplish relatively little in
human development.
 Further, HDI points up that disparities in income are greater than disparities in other
indicators of development, at least health and education.
 HDI also reminds us that by development we clearly mean broad human development, not
just higher income.
 For instance, many countries, such as some of the higher-income oil producers, have been
said to have experienced “growth without development.”
 Health and education are inputs into the national production function in their role as
components of human capital and are indicators of development.
 Drawbacks of The HDI 7

 Gross enrollment in many cases overstates the amount of

schooling because;
 In many countries a student who begins primary school is
counted as enrolled without considering whether the student
drops out at some stage.
 There is no attention to the role of quality. E.g. The quality of
health and the quality of education is not considered.
 measures for health and education are chosen partly on the
criterion that sufficient data must be available to include as
many countries as possible.
 8
 The following Table shows the 2009 Human Development Index (using 2007
data) for a sample of 24 developed and developing nations ranked from low
to very high human development.

 Along with their respective real GDP per capita and, a measure of the
differential between the GDP per capita rank and the HDI rank A positive
number shows by how much a country’s relative ranking rises when HDI is
used instead of GDP per capita, and a negative number shows the opposite.

 If country rankings did not vary much when the HDI is used instead of GDP
per capita, GDP per capita would serve as a reliable proxy for
socioeconomic development, and there would be no need to worry about
health and education indicators.
9
 10
 The table above shows that the Human Development Index project is
worthwhile.
 Ranking countries only by income, or only by health or education, causes us
to miss important differences in countries’ development levels.
The New Human Development Index
In November 2010, the UNDP introduced its NHDI, intended to address some
of the criticisms of the HDI.
What is New in The NHDI?
 Gross national income (GNI) per capita replaces gross domestic product
(GDP) per capita.
 The education index has been completely revamped.
 Two new components have been added:
1. The average actual educational attainment of the whole population and
2. The expected education attainment of today’s children.
What is New in The NHDI Continues… 11
3. Expected educational attainment, the other new component, is
some what more ambiguous: it is not an achievement but a UN
forecast.
4. The two previous components of the education index, literacy
and enrollment, have been correspondingly dropped.
5. The upper goalposts (maximum values) in each dimension
have been increased to the observed maximum rather than given
a predefined cutoff.
6. The lower goalpost for income has been reduced.
7. The NHDI now uses the natural log (ln) instead of the common
logarithm (log) to reflect diminishing marginal benefit of income.
8. The NHDI is computed with a geometric mean.
Computing the NHDI
12
 Income Inequality
13
 This is the disproportionate distribution of total national income among households.
Measures of Inequality
 There are two principal measures of income distribution:
1. The personal or size distribution of income
2. The functional or distributive factor share distribution of income
1. The personal or size distribution of income
 This is the measure most commonly used by economists.
 It simply deals with individual persons or households and the total incomes
they receive.
 The way in which that income was received is not considered.
1. The personal or size distribution of income…
14
 Economists and statisticians like to:
1. Arrange all individuals by ascending personal incomes and then divide the total
population into distinct, successive quintiles (fifths) or deciles (tenths) according
to ascending income levels and
2. Then determine what proportion of the total national income is received by each
income group.
 Table 5.1 shows a hypothetical but fairly typical distribution of income for a
developing country.
 In this table, 20 individuals, representing the entire population of the country
are arranged in order of ascending annual personal income, ranging from
the individual with the lowest income (0.8 units) to the one with the highest
(15.0 units).
 The national income of all individuals amounts to 100 units and is the sum of
all entries in column 2.
1. The personal or size distribution of income
continued… 15

 In column 3, the population is grouped into quintiles of four

individuals each.
 The first quintile represents the bottom 20% of the population
on the income scale.
 This group receives only 5% (i.e., a total of 5 money units) of
the total national income.
 The second quintile (individuals 5 through 8) receives 9% of the
total income.
 Alternatively, the bottom 40% of the population (quintiles 1 plus
2) is receiving only 14% of the income, while the top 20% (the
fifth quintile) of the population receives 51% of the total income.
16
1. The personal or size distribution of income
continued… 17
 A common measure of income inequality that can be derived from column 3 is the
ratio of the incomes received by the top 20% and bottom 40% of the population.
 This ratio, sometimes called a Kuznets ratio after Nobel laureate Simon Kuznets, has
often been used as a measure of the degree of inequality between high- and low-
income groups in a country.
 In our example, this inequality ratio is equal to 51 divided by 14, or approximately
3.64.
 To provide a more detailed breakdown of the size distribution of income, decile
(10%) shares are listed in column 4.
1. The personal or size distribution
18
of income Continued…

 We see, for example, that the bottom 10% of the population (the two poorest
individuals) receives only 1.8% of the total income, while the top 10% (the two
richest individuals) receives 28.5%.
 Finally, if we wanted to know what the top 5% receives, we would divide the total
population into 20 equal groups of individuals and calculate the percentage of total
income received by the top group.
 In Table 5.1, we see that the top 5% of the population receives 15% of the income, a
higher share than the combined shares of the lowest 40%.
 THE LOREZ CURVE
19
 Another common way to analyze personal income statistics is
to construct what is known as a Lorenz curve.
 The numbers of income recipients are plotted on the horizontal
axis, not in absolute terms but in cumulative percentages.
 The vertical axis shows the share of total income received by
each percentage of population.
 Both the horizontal and vertical axis are cumulative up to 100%,
meaning that both axes are the same length.
 The entire figure is enclosed in a square, and a diagonal line is
drawn from the lower left corner (the origin) of the square to the
upper right corner.
 At every point on that diagonal, the percentage of income
received is exactly equal to the percentage of income
recipients.
 THE GINI COEFFICIENT
 A final and very convenient shorthand summary measure 20 of
income inequality in a country can be obtained by calculating the
ratio of the area between the diagonal and the Lorenz curve
divided by the total area of the half square in which the curve lies.
 In Figure 5.3, this is the ratio of the shaded area A to the total
area of the triangle BCD.
 This ratio is known as the Gini concentration ratio or Gini
coefficient, named after the Italian statistician who first formulated
it in 1912.
 Gini coefficients are aggregate inequality measures and can vary
anywhere from 0 (perfect equality) to 1 (perfect inequality).
 In fact, as you will soon discover, the Gini coefficient for countries
with highly unequal income distributions typically lies between
0.50 and 0.70, while for countries with relatively equal
distributions, it is on the order of 0.20 to 0.35.
21
2. Functional Distributions
22
 The second common measure of income distribution used by economists.
 Attempts to explain the share of total national income that each of the
factors of production (land, labor, and capital) receives.
 Instead of looking at individuals as separate entities, the theory of functional
income distribution inquires into the percentage that labor receives as a
whole and compares this with the percentages of total income distributed in
the form of rent, interest and profit (i.e., the returns to land, financial and
physical capital).
 Although specific individuals may receive income from all these sources,
that is not a matter of concern for the functional approach.
 Figure 5.5 provides a simple diagrammatic illustration of the traditional
theory of functional income distribution.
2. Functional Distributions cont’d
23
 We assume that there are only two factors of production: capital, which is a
fixed (given) factor, and labor, which is the only variable factor. Under
competitive market assumptions, the demand for labor will be determined by
labor’s marginal product.
 But in accordance with the principle of diminishing marginal products, this
demand for labor will be a declining function of the numbers employed.
 Such a negatively sloped labor demand curve is shown by line D L in Figure
5.5. With a traditional neoclassical upward-sloping labor supply curve S L ,
 The equilibrium wage will be equal to W E and the equilibrium level of
employment will be L E .
 Total national output (which equals total national income) will be represented
by the area 0REL E .
 This national income will be distributed in two shares: 0W E EL E going to
workers in the form of wages and W E RE remaining as capitalist profits (the
return to owners of capital).
 Hence in a competitive market economy with constant-returns-to-scale
2. Functional Distributions cont’d…
24

 production functions (a doubling of all inputs doubles

output), factor prices are determined by factor supply and
demand curves, and factor shares always combine to
exhaust the total national product.
 Income is distributed by function—laborers are paid wages,
owners of land receive rents, and capitalists obtain profits.
 It is a neat and logical theory in that each and every factor
gets paid only in accordance with what it contributes to
national output, no more and no less.
25
Growth and Inequality
26
 Empirical evidence shows that it is not just the rate but also the character of
economic growth that determines the degree to which that growth is or is not
reflected in improved living standards for the poor.
 Clearly, it is not necessary for inequality to increase for higher growth to be
sustained.

Causes of Income Inequality

The following diagram (on the next slide) shows 14
causes of Income inequality:
27
 SOLUTIONS TO INEQUALITY
28
 Developing countries that aim to reduce income inequality can use the following policies:
1. Altering the functional distribution—the returns to labor, land, and capital as determined by factor
prices, utilization levels, and the consequent shares of national income that accrue to the owners of each
factor.
2. Mitigating the size distribution—the functional income distribution of an economy translated into a size
distribution by knowledge of how ownership and control over productive assets and labor skills are
concentrated and distributed throughout the population.
 The distribution of these asset holdings and skill endowments ultimately determines the distribution of
personal income.
 Moderating (reducing) the size distribution at the upper levels through progressive taxation of personal
income and wealth.
 Such taxation increases government revenues that decrease the share of disposable income of the very rich
—revenues that can, with good policies, be invested in human capital and rural and other lagging
infrastructure needs, thereby promoting inclusive Growth. (An individual or family’s disposable income is
the actual amount available for expenditure on goods and services and for saving.)
4. Moderating (increasing) the size distribution at the lower levels through public expenditures of tax
revenues to raise the incomes of the poor either directly (e.g., by conditional or unconditional cash transfers)
or indirectly (e.g., through public employment creation such as local infrastructure projects or the provision of
primary education and health care). Such public policies raise the real income levels of the poor above what
their personal income level would otherwise be, and, as will become clear in later chapters, can do so
sustainably when they build the capabilities and assets of people living in poverty.