Measuring and addressing inequality

Last time

Before we start: last time, in Maximum and minimum prices, buffer stocks, regulation and provision, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

How unequal?

In every economy, some people earn and own far more than others. Economists measure inequality with the Lorenz curve and the Gini coefficient. This lesson covers measurement, and the policies governments use to reduce inequality.

Income and wealth

Income is a flow: money received over a period, from wages, rent, interest and profit. Wealth is a stock: the value of assets owned at a point in time, such as property and shares. Wealth is usually more unequal than income, because it accumulates and is inherited.

The Lorenz curve

The Lorenz curve plots the cumulative percentage of income against the cumulative percentage of households. The straight diagonal is perfect equality. The further the curve bends below the diagonal, the more unequal the distribution.

The Gini coefficient

The Gini coefficient is the area between the line of equality and the Lorenz curve, divided by the whole area under the line of equality. It ranges from 0, perfect equality, to 1, perfect inequality. A government can use it to compare inequality over time and with other countries, and to judge its policies.

Limits of the Gini coefficient

It is a single number, so different shapes of distribution can give the same Gini. It does not show where inequality lies: among the very poor or the very rich. And data on income, especially in the informal economy, may be unreliable.

Causes of inequality

Differences in skills, education and productivity lead to different wages. Inherited wealth, unequal ownership of land and capital, and discrimination. Unemployment, and regressive taxes that take more from the poor.

Policies to reduce inequality

Progressive taxation: higher tax rates on higher incomes, and taxes on wealth and inheritance. Transfer payments: unemployment benefits, pensions, and cash transfers to the poor. A minimum wage, and state provision of education, health care and housing, which the poor use relatively more.

Do state services always help equality?

Free public services such as schools and health care benefit the poor most, relative to their income. But richer people may use some services more, such as universities, so the effect can be smaller than expected. And funding them needs taxes, which may reduce incentives if rates are very high. The effect depends on design.

The equity–efficiency trade-off

Policies that reduce inequality, such as high taxes, may reduce incentives to work and invest, lowering efficiency. But extreme inequality can also harm growth, by limiting education and demand. So governments seek a balance.

Mistakes that lose marks

Mistake one: confusing income with wealth. Mistake two: saying a Gini of 1 means perfect equality. Mistake three: listing policies without evaluating their effects on incentives. The fix: flow versus stock, the Gini range, and evaluation.

The full-marks tip

The full-marks tip: define income as a flow and wealth as a stock, and use the Lorenz curve to explain Gini. Evaluate redistribution with the equity–efficiency trade-off.

On one card

So, on one card: inequality. Keep it for revision.