Economics | Poverty and inequality

Welcome to the Chapter: Poverty and Inequality!

Hello future economist! This chapter is crucial because it takes us beyond simple GDP numbers and makes us think about who benefits from economic growth. As we study global development, understanding poverty and inequality helps us diagnose the deep-seated problems facing the world economy.

Don't worry if measuring inequality seems tricky – we will break down the graphs and calculations step-by-step! By the end of this, you’ll be able to analyze economic data like a pro.

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Section 1: Defining and Distinguishing Poverty

In Economics, the word "poor" isn't enough. We need specific definitions to measure global progress and design effective policies. We focus on two main types:

1. Absolute Poverty

Absolute poverty is the most severe form of deprivation. It exists when an individual or household cannot afford the basic necessities required for physical survival.

• What it means: A lack of sufficient food, clean water, shelter, clothing, and basic medical care.
• Measurement Standard: The World Bank often sets an International Poverty Line, currently defined as living on less than \$2.15 (or historically \$1.90) per day (adjusted for Purchasing Power Parity or PPP).
• Key Feature: This definition is fixed over time and across countries. If you are below the line, you are absolutely poor, regardless of where you live.

2. Relative Poverty

Relative poverty is defined in relation to the average income and standard of living in the society or country in which a person lives.

• What it means: You may have the basics to survive, but your income is significantly lower than most people around you, leading to exclusion from typical societal activities and opportunities.
• Measurement Standard: It is typically measured as a percentage of the country's median income. For example, in many developed countries, someone is considered relatively poor if their income is less than 60% of the national median income.
• Key Feature: This definition changes as the country’s standard of living changes. Economic growth will reduce absolute poverty, but it won’t necessarily reduce relative poverty.

Analogy: Imagine two countries. In Country A (very poor), if you have a pair of shoes, you are not absolutely poor. In Country B (very rich), if you cannot afford a car or decent housing, even though you have shoes, you are relatively poor compared to your neighbours.

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Section 2: Measuring Income and Wealth Inequality

Poverty refers to people lacking resources; Inequality refers to how those resources are distributed among the population. To address inequality in global development, we first need to measure it accurately.

Understanding the Terms: Income vs. Wealth

It is important not to confuse income and wealth:

• Income: A flow of money received over a period (wages, rent, dividends).
• Wealth: A stock of assets owned (property, savings, stocks). Wealth is generally much more unequally distributed than income.

1. The Lorenz Curve: The Visual Tool

The Lorenz Curve is a graphical representation of the distribution of income or wealth within an economy.

How to Construct the Lorenz Curve (Step-by-Step):

1. The horizontal axis (X-axis) measures the Cumulative Percentage of the Population (starting with the poorest 20%, then 40%, etc.).
2. The vertical axis (Y-axis) measures the Cumulative Percentage of Total Income earned by that population group.
3. The Line of Perfect Equality: This is a 45-degree straight line, indicating that 20% of the population earns 20% of the income, 50% of the population earns 50% of the income, and so on.
4. The Lorenz Curve: This shows the actual distribution. In reality, the curve always bows below the line of perfect equality (because perfect equality doesn't exist).

Interpretation: The further the actual Lorenz Curve bows away from the 45-degree line, the greater the inequality in that country.

2. The Gini Coefficient: The Numerical Tool

The Gini Coefficient (or Gini Index) converts the visual information from the Lorenz Curve into a single, measurable number.

The Gini Coefficient is the ratio of the area between the line of perfect equality and the Lorenz curve (Area A) to the total area under the line of perfect equality (Area A + Area B).

The formula is conceptually: \[ Gini = \frac{A}{A + B} \]

Interpreting the Gini Coefficient:

• Gini = 0 (or 0%): Represents Perfect Equality (Area A is zero).
• Gini = 1 (or 100%): Represents Perfect Inequality (One person has all the income, Area B is zero).

Most countries have Gini coefficients between 0.25 (highly equal) and 0.60 (highly unequal).

Common Mistake Alert! Don't confuse the two extremes. Remember: 0 is Great (zero inequality), 1 is Terrible (one person has everything).

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Section 3: Causes of Poverty and Income Inequality

Inequality is not random; it stems from structural and policy differences both within countries and between them. Understanding the root causes is the first step toward effective global development policies.

A. Determinants of Income Inequality

1. Differences in Human Capital

Human Capital refers to the skills, knowledge, and health that individuals possess.

• Highly educated or skilled individuals (e.g., surgeons, specialized engineers) command higher wages due to lower supply and higher demand for their expertise.
• Lack of access to quality education or healthcare traps individuals in low-skill, low-wage jobs, perpetuating poverty across generations.

2. Inheritance and Wealth Accumulation

Wealth is highly concentrated. If large sums of wealth are passed down through inheritance, it creates a significant advantage for the recipients, contributing to intergenerational inequality. Those born wealthy have assets that generate income (rent, dividends) passively, widening the gap.

3. Globalisation and Technological Change (Skill Bias)

• Globalisation: In developed countries, competition from low-wage economies can depress the wages of low-skilled workers (e.g., manufacturing jobs moving overseas).
• Skill-Biased Technological Change (SBTC): New technology (like AI or advanced robotics) often complements high-skilled labour but replaces low-skilled labour, increasing the demand (and wages) for the skilled and reducing demand for the unskilled.

4. Market Power and Trade Union Decline

Where firms hold significant monopoly or oligopoly power, they generate massive profits (which go to owners/shareholders) rather than increasing wages for ordinary workers. Simultaneously, the decline in trade union power in many developed economies has reduced the collective bargaining strength of workers.

5. Government Policy

The tax and benefit system heavily influences inequality:

• Regressive Taxes: Taxes (like sales tax) that take a larger percentage of income from the poor than from the rich increase inequality.
• Lack of Social Safety Nets: Weak or non-existent welfare benefits, unemployment support, or pensions in developing nations leave people vulnerable to falling into absolute poverty when economic shocks occur.

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Section 4: Consequences of Poverty and Inequality

Why does inequality matter for global economic development? High inequality is not just a moral issue; it imposes significant economic costs and acts as a brake on growth.

A. Negative Economic Consequences

1. Reduced Economic Growth and Efficiency

• Lower Human Capital: Poor households cannot invest in the education and health of their children, meaning a large segment of the population cannot reach its productive potential. This is a massive waste of human capital for the whole economy.
• Reduced Access to Credit: Poor people lack collateral, limiting their ability to borrow and start new businesses (entrepreneurship is stifled).

2. Weaker Aggregate Demand (AD)

The marginal propensity to consume (MPC) is typically higher for the poor than for the rich.

• The poor spend a larger proportion of any extra income they receive.
• If income is concentrated among the rich (who save a lot), overall spending (AD) in the economy will be lower than if income was distributed more equally. This can lead to slower growth.

3. Increased Social and Political Instability

Extreme inequality often breeds resentment, which can lead to:

• Higher crime rates.
• Social Unrest and political instability (protests, riots). This uncertainty discourages investment, harming long-run growth.
• Increased pressure for protectionist policies or populist governments, which can undermine global trade and cooperation.

B. The (Controversial) Argument for Inequality

Some economists argue that a degree of inequality can be beneficial because it provides incentives:

• The prospect of earning a very high income motivates people to work harder, take risks (entrepreneurship), invest in education, and innovate.
• If income was perfectly equal, this incentive might disappear, leading to lower productivity and lower overall growth.

Did You Know? The debate isn't usually about eliminating inequality entirely (Gini = 0), but finding the optimal level that maximizes incentives while minimizing negative social and economic fallout.