Lesson 5: Poverty, Inequality and Development

Lesson Objectives
1. Discuss different policy options on income inequality and poverty
2. Distinguish between size and functional distributions of income
3. Define poverty, inequality and development
Measuring Inequality

In this lesson, we define the dimensions of the income distribution and poverty
problems and identify some similar elements that characterize the problem in many
developing nations. But first we should be clear about what we are measuring when we
speak about the distribution of income and absolute poverty.

Economists usually distinguish between two principal measures of income

distribution for both analytical and quantitative purposes: the personal or size distribution
of income and the functional or distributive factor share distribution of income.

Size Distributions

The personal or size distribution of income 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 they received that income is not considered. What matters
is how much each earns irrespective of whether the income is derived solely from
employment or comes also from other sources such as interest, profits, rents, gifts, or
inheritance. Moreover, the locational (urban or rural) and occupational sources of the
income (e.g., agriculture, manufacturing, commerce, services) are ignored. If Ms. X and Mr.
Y both receive the same personal income, they are classified together irrespective of the
fact that Ms. X may work 15 hours a day as a doctor while Mr. Y doesn’t work at all but
simply collects interest on his inheritance. Economists and statisticians therefore like to
arrange all individuals by ascending personal incomes and then divide the total population
into distinct groups, or sizes. A common method is to divide the population into successive
quintiles (fifths) or deciles (tenths) according to ascending income levels and then
determine what proportion of the total national income is received by each income group.

Lorenz Curves

Another common way to analyze personal income statistics is to construct what is

known as a Lorenz curve.1 Figure 5.1 shows how it is done. The numbers of income
recipients are plotted on the horizontal axis, not in absolute terms but in cumulative
percentages. For example, at point 20, we have the lowest (poorest) 20% of the population;
at point 60, we have the bottom 60%; and at the end of the axis, all 100% of the population
has been accounted for. The vertical axis shows the share of total income received by each
percentage of population. It is also 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—for example, the point halfway along the length of the diagonal represents 50%
of the income being distributed to exactly 50% of the population. At the three-quarters
point on the diagonal, 75% of the income would be distributed to 75% of the population.

Gini Coefficients and Aggregate Measures of Inequality

A final and very convenient shorthand summary measure of the relative degree 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. 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.

Functional Distributions

The second common measure of income distribution used by economists, the

functional or factor share distribution of income, 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 inquiries 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 and 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.

Measuring Absolute Poverty

Now let’s switch our attention from relative income shares of various percentile groups
within a given population to the fundamentally important question of the extent and
magnitude of absolute poverty in developing countries.

Income Poverty
 Absolute poverty is sometimes measured by the number, or “headcount,” , of those
whose incomes fall below the absolute poverty line, Yp. When the headcount is taken as a
fraction of the total population, N, we define the headcount index, H/N (also referred to as
the “headcount ratio”). The poverty line is set at a level that remains constant in real terms
so that we can chart our progress on an absolute level over time. The idea is to set this level
at a standard below which we would consider a person to live in “absolute human misery,”
such that the person’s health is in jeopardy.

The Foster-Greer-Thorbecke Index

We are also often interested in the degree of income inequality among the poor,
such as the Gini coefficient among those who are poor, Gp, or alternatively, the coefficient
of variation (CV) of incomes among the poor, CVp. One reason that the Gini or CV among
the poor can be important is that the impact on poverty of economic shocks can differ
greatly, depending on the level and distribution of resources among the poor. For example,
if the price of rice rises, as it did in 1998 in Indonesia, low-income rice producers, who sell
a little of their rice on local markets and whose incomes are slightly below the absolute
poverty line, may find that this price rise increases their incomes to bring them out of
absolute poverty. On the other hand, for those with too little land to be able to sell any of
the rice they grow and who are net buyers of rice on markets, this price increase can
greatly worsen their poverty? Thus, the most desirable measures of poverty.

Multidimensional Poverty Measurement

Poverty cannot be adequately measured with income alone, as Amartya Sen’s

capability framework, makes apparent. To fill this gap, Sabina Alkire and James Foster have
extended the FGT index to multiple dimensions. As always, the first step in measuring
poverty is to know which people are poor. In the multidimensional poverty approach, a
poor person is identified through what is called the “dual cutoff method”: first, the cutoff
levels within each of the dimensions (analogous to falling below a poverty line such as
$1.25 per day if income poverty were being addressed) and second, the cutoff of the
number of dimensions in which a person must be deprived (below the line) to be deemed
multidimensionally poor. Using calculations analogous to the single-dimensional P index,
the multidimensional M index is constructed. The most basic measure is the fraction of the
population in multidimensional poverty—the multidimensional headcount ratio HM.

Poverty, Inequality, and Social Welfare

What’s So Bad about Extreme Inequality?

Throughout this chapter, we are assuming that social welfare depends positively on
the level of income per capita but negatively on poverty and negatively on the level of
inequality, as these terms have just been defined. The problem of absolute poverty is
obvious. No civilized people can feel satisfied with a state of affairs in which their fellow
humans exist in conditions of such absolute human misery, which is probably why every
major religion has emphasized the importance of working to alleviate poverty and is at
least one of the reasons why international development assistance has the nearly universal
support of every democratic nation. But it may reasonably be asked, if our top priority is
the alleviation of absolute poverty, why should relative inequality be a concern? We have
seen that inequality among the poor is a critical factor in understanding the severity of
poverty and the impact of market and policy changes on the poor, but why should we be
concerned with inequality among those above the poverty line?

There are three major answers to this question. First, extreme income inequality
leads to economic inefficiency. This is partly because at any given average income, the
higher the inequality is, the smaller the fraction of the population that qualifies for a loan or
other credit. Indeed, one definition of relative poverty is the lack of collateral. When low-
income individuals (whether they are absolutely poor or not) cannot borrow money, they
generally cannot adequately educate their children or start and expand a business.
Moreover, with high inequality, the overall rate of savings in the economy tends to be
lower, because the highest rate of marginal savings is usually found among the middle
classes.

Although the rich may save a larger dollar amount, they typically save a smaller
fraction of their incomes, and they almost always save a smaller fraction of their marginal
incomes. Landlords, business leaders, politicians, and other rich elites are known to spend
much of their incomes on imported luxury goods, gold, jewelry, expensive houses, and
foreign travel or to seek safe havens abroad for their savings in what is known as capital
flight. Such savings and investments do not add to the nation’s productive resources; in
fact, they represent substantial drains on these resources. In short, the rich do not
generally save and invest significantly larger proportions of their incomes (in the real
economic sense of productive domestic saving and investment) than the middle class or
even the poor. Furthermore, inequality may lead to an inefficient allocation of assets. As
you will see high inequality leads to an overemphasis on higher education at the expense
of quality universal primary education, which not only may be inefficient but is also likely
to beget still more inequality in incomes. Moreover, as you will see in Chapter 9, high
inequality of land ownership— characterized by the presence of huge latifundios
(plantations) alongside tiny minifundios that are incapable of supporting even a single
family—also leads to inefficiency because the most efficient scales for farming are family
and medium-size farms. The result of these factors can be a lower average income and a
lower rate of economic growth when inequality is high.
 The second reason to be concerned with inequality above the poverty line is that
extreme income disparities undermine social stability and solidarity. Also, high inequality
strengthens the political power of the rich and hence their economic bargaining power.
Usually this power will be used to encourage outcomes favorable to them. High inequality
facilitates rent seeking, including actions such as excessive lobbying, large political
donations, bribery, and cronyism. When resources are allocated to such rent-seeking
behaviors, they are diverted from productive purposes that could lead to faster growth.
Even worse, high inequality makes poor institutions very difficult to improve, because the
few with money and power are likely to view themselves as worse off from socially
efficient reform, and so they have the motive and the means to resist it. Of course, high
inequality may also lead the poor to support populist policies that can be self-defeating.
Countries with extreme inequality, such as El Salvador and Iran, have undergone upheavals
or extended civil strife that have cost countless lives and set back development progress by
decades. High inequality is also associated with pathologies such as higher violent crime
rates. In sum, with high inequality, the focus of politics often tends to be on supporting or
resisting the redistribution of the existing economic pie rather than on policies to increase
its size. Finally, extreme inequality is generally viewed as unfair. The philosopher John
Rawls proposed a thought experiment to help clarify why this is so. Suppose that before
you were born into this world, you had a chance to select the overall level of inequality
among the earth’s people but not your own identity. That is, you might be born as Bill
Gates, but you might be born as the most wretchedly poor person in rural Ethiopia with
equal probability. Rawls calls this uncertainty the “veil of ignorance.” The question is, facing
this kind of risk, would you vote for an income distribution that was more equal or less
equal than the one you see around you? If the degree of equality had no effect on the level
of income or rate of growth, most people would vote for nearly perfect equality. Of course,
if everyone had the same income no matter what, there would be little incentive to work
hard, gain skills, or innovate. As a result, most people vote for some inequality of income
outcomes, to the extent that these correspond to incentives for hard work or innovation.
But even so, most vote for less inequality than is seen in the world (or in virtually any
country) today. This is because much of the inequality we observe in the world is based on
luck or extraneous factors, such as the inborn ability to kick a football or the identity of
one’s great-grandparents.

Dualistic Development and Shifting Lorenz Curves: Some Stylized Typologies

As introduced by Gary Fields, Lorenz curves may be used to analyze three limiting
cases of dualistic development:

1. The modern-sector enlargement growth typology, in which the two-sector economy

develops by enlarging the size of its modern sector while maintaining constant wages in
both sectors. This is the case depicted by the Lewis model. It corresponds roughly to the
historical growth pattern of Western developed nations and, to some extent, the pattern in
East Asian economies such as China, South Korea, and Taiwan.

2. The modern-sector enrichment growth typology, in which the economy grows but such
growth is limited to a fixed number of people in the modern sector, with both the numbers
of workers and their wages held constant in the traditional sector. This roughly describes
the experience of many Latin American and African economies.

3. The traditional-sector enrichment growth typology, in which all of the benefits of growth
are divided among traditional-sector workers, with little or no growth occurring in the
modern sector. This process roughly describes the experiences of countries whose policies
focused on achieving substantial reductions in absolute poverty even at very low incomes
and with relatively low growth rates, such as Sri Lanka, and the state of Kerala in
southwestern India.

Kuznets’s Inverted-U Hypothesis

Simon Kuznets suggested that in the early stages of economic growth, the
distribution of income will tend to worsen; only at later stages will it improve. This
observation came to be characterized by the “inverted-U” Kuznets curve because a
longitudinal (time-series) plot of changes in the distribution of income— as measured, for
example, by the Gini coefficient—seemed, when per capita GNI expanded, to trace out an
inverted U-shaped curve in some of the cases Kuznets studied.

Explanations as to why inequality might worsen during the early stages of economic
growth before eventually improving are numerous. They almost always relate to the nature
of structural change. Early growth may, in accordance with the Lewis model, be
concentrated in the modern industrial sector, where employment is limited but wages and
productivity are high.

Growth and Inequality

Having examined the relationship between inequality and levels of per capita
income, let us look now briefly at the relationship, if any, between economic growth and
inequality. During the 1960s and 1990s, per capita growth in East Asia averaged 5.5%
while that of Africa declined by 0.2%, yet both Gini coefficients remained essentially
unchanged. Once again, it is not just the rate but also the character of economic growth
(how it is achieved, who participates, which sectors are given priority, what institutional
arrangements are designed and emphasized, etc.) 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.

Chronic Poverty
 Research suggests that approximately one-third of all people who are income poor
at any one time are chronically (always) poor. Andrew McKay and Bob Baulch provide a
well-regarded “guesstimate” that about 300 to 420 million people were chronically poor at
the $1-per-day level in the late 1990s. The other two-thirds are made up of families that are
vulnerable to poverty and become extremely poor from time to time. These may be divided
between families usually poor but occasionally receiving enough income to cross the
poverty line and families usually non-poor but occasionally experiencing a shock that
knocks them temporarily below the poverty line. Chronic poverty is concentrated in India,
where the largest numbers are found, and in Africa, where the severity of poverty among
the chronically poor is greatest.