Chapter 5

Income Inequality, Poverty and Development:

Interconnections

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 5.1 Overview on Income Distribution, Poverty and Economic
Growth

 There is wide disparities both between and within countries. The richest 10% of
the global population currently takes 52% of global income, whereas the poorest
half of the population earns 8.5% of it. On average, an individual from the top
10% of the global income distribution earns €87,200 (USD122,100) per year,
whereas an individual from the poorest half of the global income distribution
makes €2,800 (USD3,920) per year in 2021.

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 About, 9.2% of the world population (689 million people) lived below the
International Poverty Line (IPL) in 2017. More than 60% of the world’s poorest
people live in Sub-Saharan Africa, which at 41% has the highest regional poverty
rate. Around a quarter of the world 24.1%; 1,811 million people live on less than
$3.20% day. While almost half 43.6%; 3, 271 million people live on less than
5.50 day.
 These people suffer from
 under nutrition and poor health,
 little or no literacy,
 live in environmentally degraded areas,
 have little political voice,
 socially exclusion, and
 attempt to earn a meager living on small and marginal farms
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 Overview on Income distribution, poverty and economic growth…continued

 Development requires a higher GNI, and hence sustained growth, is clear.

 The basic issue, is not only how to make GNI grow but also who would make it
grow, the few or the many.
 If it is the rich, it would most likely be appropriated by them, and progress against poverty would
be slow, and inequality would worsen.
 But if it is generated by the many, they would be its principal beneficiaries, and the fruits of
economic growth would be shared more evenly.

 Critical questions about the relationship among economic growth, income distribution,
and poverty:

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 Overview on Income distribution, poverty and economic growth…continued

Critical questions…..
 What is the extent of relative inequality, and how is this related to the extent of
poverty?
 Who are the poor?
 Who benefits from economic growth?
 Does rapid growth necessarily cause greater income inequality?
 Do the poor benefit from growth?
 Are high levels of inequality always bad?
 What policies can reduce poverty?

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5.2. Measures of Income Inequality and Poverty
• What is inequality?
“An unequal society cannot help but be an unjust society. ”
– Brad Delong, 2007
 Inequality means the quality of being unequal or an instance of being unequal; lack of evenness;
social disparity; disparity of distribution or opportunity; the condition of being variable.
 Our primary interest is, however, in economic inequality.
 Inequality measures the disparity between a percentage of population and the percentage of
income received by that population.
 Inequality increases as the disparity increases.
 Income inequality: disproportionate distribution of total national income among households.

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Approaches to Measures Inequality
Economists usually distinguish between two principal measures of income distribution:
personal or size distribution and Functional distribution of income.
1)Size distributions (Quintiles/20%/ & Deciles/10%/)
 Deals with individual persons or households total incomes they receive.
 The way in which that income was received is not considered. What matters is how much each
earns.
 The locational and occupations are ignored.
 Arrange all individuals by ascending personal incomes and then divide the total population
into distinct groups, or sizes.
 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. 7
Table 5.1 Typical Size Distribution of Personal Income in a Developing Country by Income Shares—
Quintiles and Deciles

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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 or-
der 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 total or national income of all individuals amounts to 100 units and is the sum of all entries
in column 2.
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.

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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.
 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.
 For example, that the bottom10% 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 (in our example, this would simply be each of the 20
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 (the twentieth individual) receives 15%
of the income, a higher share than the combined shares of the lowest 40%. 10
Lorenz curve
 A graph depicting the variance of the size distribution of income from perfect
equality.
 The numbers of income recipients are plotted on the horizontal axis, the share of
total income received on the vertical axis, not in absolute terms but in cumulative
percentages.
 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.
 Diagonal line: perfect equality in size distribution of income.
 Lorenz curve shows the actual quantitative relationship b/n the percentage of
income recipients and the percentage of the total income they did in fact receive
during, a given year.
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 The more the Lorenz line curves away from the diagonal, the greater the degree
of inequality represented.
 The extreme case of perfect inequality would be represented by the congruence
of the Lorenz curve with the bottom horizontal and right hand vertical axes.
 Because no country exhibits either perfect equality or perfect inequality in its
distribution of income, the Lorenz curves for different countries will lie
somewhere to the right of the diagonal
 The greater the degree of inequality, the greater the bend and the closer to the
bottom horizontal axis the LC will be.

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Figure 5.1 The Lorenz Curve

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Figure 5.2. The Greater the Curvature of the Lorenz Line, the Greater the
Relative Degree of Inequality

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 Gini coefficient
 An aggregate numerical measure of income inequality ranging from 0 (perfect
equality) to 1(perfect inequality).
 It is measured graphically by dividing the area between the perfect equality line
and the Lorenz curve by the total area lying to the right of the equality line in a
Lorenz diagram.
 The higher the value of the coefficient, the higher the inequality of income
distribution; the lower it is, the more equal the distribution of income.
 The Gini coefficient: highly unequal income distributions lies between 0.50
and 0.70, relatively equal distributions, it is on the order of 0.20 to 0.35.
 Whenever two Lorenz curves cross the Lorenz criterion states that we “need
more information”.

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 The Gini coefficient measures satisfy four highly desirable properties: the
anonymity, scale independence, population independence, and transfer
principles.
 The anonymity principle: measure of inequality should not depend on who has
the higher income
 The scale independence principle: measure of inequality should not depend on
the size of the economy or the way we measure its income;
 The population independence principle: measure of inequality should not be
based on the number of income recipients.
 The transfer principle: holding all other incomes constant, if we transfer some
income from a richer person to a poorer person , the resulting new income
distribution is more equal.

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Figure 5.3 Estimating the Gini Coefficient

17
Figure 5.4 Four Possible Lorenz Curves

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Functional distribution of income (factor share distribution of income)
 The distribution of income to factors of production without regard to the
ownership of the factors.
 Explain the share of total national income that each of the factors of production
(land, labor, and capital) receives.
 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.

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Figure 5.5 Functional Income Distribution in a Market Economy: An Illustration

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 Figure 5.5 provides a simple diagrammatic illustration of the traditional theory of functional
income distribution.
 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.
 i.e., additional workers will be hired up to the point where the value of their marginal
product equals their real wage.
 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 DL in Figure 5.5. With a
traditional neoclassical upward-sloping labor supply curve SL, the equilibrium wage will be
equal to WE and the equilibrium level of employment will be LE.

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 Total national output (which equals total national income) will be represented by the area
0RELE.
 This national in-come will be distributed in two shares: 0WEELE going to workers in the
form of wages and WERE remaining as capitalist profits (the return to owners of capital).
 Hence in a competitive market economy with constant-returns-to-scale 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.
 Model of income distribution is at the core of the Lewis theory of modern-sector growth
based on the reinvestment of rising capitalist profits.
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5.2.1. Approaches to Measures of Absolute Poverty

What is Poverty?
“No society can surely be flourishing and happy, of which by far the greater
part of the numbers are poor and miserable.” Adam Smith, 1776

Poverty has many aspects. It is:

Hunger, lack of shelter, being sick and not being able to see a doctor, not having
access to school and not knowing how to read & write, not having a job, fear for
the future & living one day at a time
Poverty is also losing a child to illness brought about by unclean water.
Poverty is powerlessness, lack of representation and lack of freedom
Poverty is lack of basic necessities that all human beings must have: food and
water, shelter, education, medical care, security, etc.
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 Poverty is a multi-dimensional issue; it exceeds all social, economic, and
political boundaries.
 As such, efforts to alleviate poverty must be informed of a variety of different
factors.
The UN provides a broader definition of poverty:
 A human condition characterized by the sustained or chronic deprivation of the
resources, capabilities, choices, security and power necessary for the enjoyment
of an adequate standard of living and other civil, cultural, economic, political
and social rights.’
Why estimate poverty?
 Because poverty estimates are vital input to design, monitor and implement
appropriate anti-poverty policies.

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 Absolute poverty: The situation of being unable or only barely able to meet the
subsistence essentials of food, clothing, and shelter.
Measuring Absolute Poverty
1.Headcount index: This shows proportions of a country’s population living below the poverty
line.
HCI=H/N
 Where H is the number of persons who are poor and N is the total number of people in the
economy
2.Total poverty gap: The sum of the difference between the poverty line(Yp) and actual
income(Yi) levels of all people living below that line.

TPG   (Yp  Yi )
H

i1
Measures the total amount of income necessary to raise everyone who is below the poverty
line up to that line.


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3. Average poverty gap (APG):on a per capita basis

TPG
APG 
N
 Where N is number of persons in the economy
 TPG is total poverty gap

Normalized poverty gap, NPG = APG/Yp
 This measure lies between 0 and 1 and so can be useful when we want a unitless measure of the gap for
easier comparisons.
4. Average income shortfall (AIS): tells us the average amount by which the income of a poor person falls below
the poverty line. TPG
AIS 
H
• Where H is number of poor persons
• TPG is total poverty gap

Normalized income shortfall, NIS = AIS/Yp

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5. The Foster-Greer-Thorbecke (FGT) index:

1 H  Yp  Yi 
P  
N i 1  Yp


Where,
– Pα = the weighted poverty index
– α = FGT index and takes on the values of 0, 1 and 2 for incidence, depth and severity of
poverty measures respectively
– Yp = the poverty line
– H = the number of individuals below the poverty line
– N = the total number of individuals in the reference population
– Yi = the per capita expenditure of household j in the sub-group i
– Yp - Yi = poverty gap of the ith household
– Yp – Yi/Yp = poverty gap ratio

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6. The Newly Introduced Multidimensional Poverty Index
 Identification of poverty status through a dual cutoff:
 First, cutoff levels within each dimension (analogous to falling below a
poverty line for example $1.25 per day for income poverty);
 Second, cutoff in the number of dimensions in which a person must be
deprived (below a line) to be deemed multidimensional poor.
 MPI focuses on deprivations in health, education, and standard of living; and
each receives equal (that is one-third of the overall total) weight.

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MPI Indicators
 Health - two indicators with equal weight - whether any child has died in the
family, and whether any adult or child in the family is malnourished –weighted
equally (each counts as 1/6 toward the maximum deprivation in the MPI)
 Education - two indicators with equal weight - whether no household member
completed 5 years of schooling, and whether any school-aged child is out of
school for grades 1 through 8 (each counts 1/6 toward the MPI).
 Standard of Living, equal weight on 6 deprivations (each counts as 1/18 toward
the maximum): lack of electricity; insufficiently safe drinking water;
inadequate sanitation; inadequate flooring; unimproved cooking fuel; lack
of more than one of 5 assets – telephone, radio, TV, bicycle, and motorbike.

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Interaction of the deprivations
 Building the index from household measures up to the aggregate measure (rather
than using already-aggregated statistics), MPI approach takes account of
multiplied or interactive harm (complementarity) done when multiple
deprivations are experienced by the same individual or family.
 The MPI approach assumes an individual’s lack of capability in one area can
only to a degree be made up by other capabilities – capabilities are treated as
substitutes up to a point but then as complements.

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Computing the MPI
 The MPI for the country (or region or group) is then computed
 A convenient way to express the resulting value is H*A, i.e.,
 The product of the headcount ratio H (the percent of people living in
multidimensional poverty), and the average intensity of deprivation A (the % of
weighted indicators for which poor households are deprived on average).
 The adjusted headcount ratio HA is readily calculated
 HA satisfies some desirable properties. Important example -Dimensional
monotonicity: If a person already identified as poor becomes deprived in
another indicator she is measured as even poorer - not the case using a simple
headcount ratio.

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Table 5.2 MPI Rankings and Poverty Headcounts for Selected Countries

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 Multidimensional poverty tells a different story than income poverty
 The UNDP reports the MPI for 104 developing countries, based on the currently available data;
some examples are given in Table 5.5.
 The index can range from 0 to 1. Slovenia and Slovakia receive an MPI of 0, the lowest
possible value, indicating the least poverty, while the world’s most impoverished country for
which data were available to compute a ranking, Niger, ranks 104th, with an MPI value of
0.642.
 Nearly 1.7 billion people living in what was termed “acute” poverty
 Several hundred million more than the estimated number living on income of less than $1.25
per day.
 Sub-Saharan Africa has the highest proportion of people living in poverty, and South Asia has
the largest number of people living in poverty (almost twice as many as in Africa).
 Only Niger had an MPI higher than 0.6.
 Seven other countries had an MPI higher than 0.5, all in sub-Saharan Africa: Ethiopia, Mali,
Burkina Faso, Burundi, Somalia, Central African Republic, and Guinea.
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 A further eight countries had MPIs between 0.4 and 0.5; all of these were African nations as
well.
 The severity of poverty in Africa is also brought home by some of the findings.
– In Guinea, Mali, and Niger, more than 50% are poor and live in a household in which at least
one child has died.
– In Mozambique, Guinea, Burundi, Mali, Ethiopia, Burkina Faso, and Niger, more than 50%
live in a poor household where no one has completed five years of education.
 The poorest non-African countries were Nepal (with an MPI of 0.350), Haiti (0.306), India
(0.296), Bangladesh (0.291), Yemen (0.283), and Pakistan (0.275). But these six countries
have a combined population of about 1.6 billion people. And 39% in India and 37% in
Bangladesh live in a poor household where at least one child or woman is undernourished.

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 5.3. Poverty, Inequality and Social Welfare
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
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 saving in the economy tends to be lower, because the highest rate of
marginal savings is usually found among the middle classes.
Second: Extreme income disparities undermine social stability and solidarity.
• High inequality facilitates rent seeking, including actions such as excessive lobbying and
bribery.
• High inequality also makes poor institutions very difficult to improve.
 Third: Extreme inequality is generally viewed as unfair.
Generally, our assumption is that social welfare depends positively on the level of
income per capita but negatively on poverty and negatively on the level of inequality.

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 Inequality and Economic Growth
Kuznets’ 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 it will improve. Why?
 This is because of the nature of structural change undertaking in a country.
 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.
Alternatively, returns to education may first rise as the emerging modern sector demands
skills and then fall as the supply of educated workers increases and the supply of unskilled
workers falls.
It was in his 1963 Study that Kuznets developed his inverted U-shaped hypothesis by taking
the data of 18 countries by size distribution of income.
On their basis, he constructed different Lorenz curves for DCs and LDCs and derived their
Gini coefficients.
It was 0.37 for DCs and 0.44 for LDCs.
It showed that income inequalities were higher in LDCs than in DCs. 36
Figure 5.6 The “Inverted-U” Kuznets Curve

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 Factors Driving Higher Income Inequality
 Technological change
 Eliminating many jobs through automation
 Financial development could benefit the rich in the early stages of
development
 Changes in labor market institutions.
 A decline in trade union membership could reduce the relative bargaining
power of labor
 Redistributive policies
 False Progressive taxation & social transfers

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 Poverty and Economic Growth
• Are the reduction of poverty and the acceleration of economic growth in conflict? Or are they
complementary?
1) Traditional Argument
 A body of opinion held that rapid growth is bad for the poor because they would
be disregarded by the structural changes of modern growth.
 There had also been considerable concern in policy circles that the public
expenditures required for the reduction of poverty would involve a reduction in
the rate of growth.
 This arguments conclude that countries with lower inequality would experience
slower growth.
 In particular, if there were redistribution of income from rich to poor, even
through progressive taxation, the concern was expressed that savings would fall.
 Therefore, this argument concludes that reduction of poverty and the
acceleration of economic growth goes in conflict.
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2) Counter-arguments
 According to counter arguments, the marginal savings rates of the poor, when
viewed from a general perspective, are not small.
 In addition to financial savings, the poor tend to spend additional income on
improved nutrition, education for their children, improvements in housing
conditions, and other expenditures that, especially at poverty levels, represent
investments rather than consumption.
 Arguments in favor of complementarity of poverty reduction strategy and
economic growth provides five reasons why policies focused toward reducing
poverty levels do not lead to a slower rate of growth.
 First, widespread poverty creates conditions in which the poor have no access to
credit.
 Second, a wealth of empirical data bears witness to the fact that the rich in many
contemporary poor countries are generally not noted for their frugality or for their
desire to save and invest substantial proportions of their incomes in the local
economy.
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 Third, the low incomes and low levels of living for the poor, which are
manifested in poor health, nutrition, and education, can lower their economic
productivity and thereby lead directly and indirectly to a slower-growing
economy.
 Fourth, raising the income levels of the poor will stimulate an overall increase in
the demand for locally produced necessity products like food and clothing.
• Rising demand for local goods provides a greater stimulus to local
production, local employment, and local investment. Such demand thus
creates the conditions for rapid economic growth.
 Fifth, a reduction of mass poverty can stimulate healthy economic expansion by
acting as a powerful material and psychological incentive to widespread public
participation in the development process.
 It can be concluded, therefore, that promoting rapid economic growth and
reducing poverty are not mutually conflicting objectives.

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 Economic Characteristics of High-Poverty Groups
 May be the most valid generalizations about the poor are that:
 They are exceptionally located in rural areas and engaged in agricultural and
associated activities;
 For example, in Africa and Asia, studies shows that about 80% of all target
poverty groups are located in the rural areas, and these are about 50% in
Latin America.
 They are more likely to be women & children than adult males; and
 They are often concentrated among ethnic minorities & indigenous peoples.

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 Causes of poverty in third world countries (LDCs)
Trade
Third world countries lose out through unfair trade agreements, lack of technology and
investment, and rapidly changing prices for their goods.
Work and globalisation
Better communications and transport have led to a “globalised” economy. Companies look
for low-cost countries to invest in. This can mean that, though there are jobs, they are low-
paid.
War or conflict
When a country is at war (including civil war) basic services like education are disrupted.
People leave their homes as refugees. Crops are destroyed.
Debt
Third world countries have to pay interest on their debts.
This means they cannot afford to spend enough on basic services like health and education;
nor on things like transport or communications that might attract investment.
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Land
If you have land you can grow your own food.
But many people in the Third World have had their land taken over by large businesses, often
to grow crops for export.
Health
Affordable or free health care is necessary for development.
In poor countries the percentage of children who die under the age of five is much higher than
in rich countries.
HIV/AIDS is having a devastating effect on the Third World.
Food and education
Affordable, secure food supplies are vital.
Malnutrition causes severe health problems, and can also affect education.
• Without education it is difficult to escape from poverty.
• This becomes a vicious circle – people who live in poverty cannot afford to send their
children to school.

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Gender
When we measure poverty we find differences between the level experienced by men or boys,
and women or girls.
• Women may be disadvantaged through lack of access to education; in some countries they
are not allowed to own or inherit land; they are less well paid than men.
Environment
A child born in an industrialized country will add more to pollution over his or her lifetime than
30-50 children born in the Third World.
However, the third world child is likely to experience the consequences of pollution in a much
more devastating way.
• For example, annual carbon dioxide emissions have quadrupled in the last 50 years.
• This contributes to global warming, leading to devastating changes in weather patterns.
• Bangladesh could lose up to 17% of its land area as water levels rise.

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 Policy Options on Income Inequality and Poverty:
Some Basic Considerations
 Areas of intervention: Four broad areas of possible government policy intervention can
be identified:
1) Altering the functional distribution
 Through Changing relative factor prices.
• It is argued that measures designed to reduce the price of labor relative to capital (e.g.,
through public wage subsidies to employers) will cause employers to substitute labor for
capital in their production activities
• Such factor substitution increases the overall level of employment and ultimately raises the
incomes of the poor.
2) Mitigating the size distribution
 Through progressive redistribution of asset ownership.

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3) Moderating (reducing) the size distribution at upper levels
 Through progressive taxation of personal income and wealth.
 Progressive income tax is a tax whose rate increases with increasing personal incomes.
 Such taxation increases government revenues that decrease the share of disposable income of the very
rich.
4) Moderating (increasing) the size distribution at lower levels
Through transfer payments and public provision of goods and services. Generally:
 Providing social protection to disadvantaged and vulnerable households through Productive Safety Net
Programme (PSNP).
 This Programme, however, should not be always funded by aid money but it should be a good way of
redistributing the proceeds of growth in the country.
 Removing gender inequality goes beyond closing the gender pay gap and should include legislative
measures that improve the situation of women.
 There should be industrial decentralization to achieve shared prosperity in different regional states.

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