Income, wealth and the Lorenz curve

Two things that students constantly confuse:

• Income is a FLOW — money received per period: wages, rent, interest, profit, benefits.
• Wealth is a STOCK — the value of assets held at a point in time: property, pensions, shares, savings.

Wealth is always far more unequally distributed than income, because wealth accumulates: it is inherited, and it earns a return which is itself reinvested. In the UK the richest 10% of households own roughly half of all wealth.

The Lorenz curve plots the cumulative percentage of income (vertical axis) against the cumulative percentage of the population, ranked poorest first (horizontal axis).

• The 45° line is perfect equality: the poorest 20% of people receive exactly 20% of income, and so on.
• The actual Lorenz curve sags below it. The further it sags, the more unequal the distribution.

• Gini = 0 → perfect equality. Gini = 1 → perfect inequality (one person has everything). The UK's Gini for disposable income is around 0.35; Scandinavian countries are near 0.25; South Africa is above 0.6.

Your turn — the Gini coefficient

Your turn — cumulative shares

Your turn — the quintile ratio

Reading the Gini

Absolute and relative poverty

• Absolute poverty — income below the level needed to afford the basic necessities of life: food, safe water, shelter, sanitation. The World Bank's international line is a fixed real amount per day. It is a measure of survival and, in principle, it can be eliminated. Globally it has fallen dramatically over forty years, driven mainly by growth in China and India.
• Relative poverty — income below a given proportion of the national median (the UK uses 60% of median household income). It measures exclusion from the normal life of your own society. Note the consequence: relative poverty can only be eliminated by reducing inequality, not by growth alone — if everyone's income doubled, the median would double too and relative poverty would be unchanged.

Causes of poverty and inequality: unemployment and worklessness; low pay and low skills; the wage premium to education (skill-biased technological change); regressive taxes; regional decline; discrimination; poor health; inherited wealth; and the return on capital exceeding the growth rate (Piketty's r > g).

Consequences: lower living standards and health; the poverty trap (withdrawn benefits plus tax mean a very high effective marginal deduction rate, so working more barely pays); reduced social mobility; lost human capital and hence lower LRAS; higher crime; and reduced AD, since the poor have the highest MPC.

The equity-efficiency trade-off. Redistribution through progressive tax and benefits reduces inequality — but very high marginal rates may blunt incentives to work, save, invest and take entrepreneurial risk, and may drive high earners abroad. The counter-argument: extreme inequality is itself inefficient, because it wastes the talent of children who never get the chance to develop it. Some inequality is a necessary incentive; the argument is about how much.

Your turn — the relative poverty line

Growth and relative poverty

Measuring development: HDI and beyond

Economic growth is a rise in real output. Economic development is broader: a sustained improvement in living standards, capabilities and freedoms (Amartya Sen). A country can grow without developing — an oil boom that enriches an elite while schools and clinics crumble.

The Human Development Index (HDI), published by the UN, is a composite of three dimensions:

• A long and healthy life — life expectancy at birth.
• Knowledge — mean years of schooling and expected years of schooling.
• A decent standard of living — GNI per capita (PPP-adjusted, and logged, because an extra dollar matters far less to a rich country).

Each dimension is converted into an index between 0 and 1, then combined. The dimension index is:

Strengths of HDI: it captures more than income; it is comparable across countries and over time; it embarrassed governments into caring about health and education.

Limitations: it ignores inequality (a country can have a decent average HDI and terrible deprivation — hence the inequality-adjusted IHDI); it ignores the environment, political freedom, human rights and gender equality; the three components are weighted equally, which is an arbitrary value judgement; and the data can be unreliable in the poorest countries. Alternatives include the Multidimensional Poverty Index, the Genuine Progress Indicator and measures of subjective wellbeing.

Sustainable development (the Brundtland definition) meets the needs of the present without compromising the ability of future generations to meet their own. That is the direct conflict between the growth objective and the environmental objective: growth that depletes natural capital and loads the atmosphere with carbon borrows from the future.

Your turn — an HDI dimension index

HDI limitations

Policies to reduce poverty and inequality

• Progressive taxation — the average tax rate rises with income (UK income tax). Regressive taxes take a larger share of a poor person's income (VAT, duties on tobacco and fuel — regressive precisely because the poor spend a larger share of their income). Proportional (flat) taxes take the same percentage from all.
• Benefits and transfer payments — the most direct and effective way to cut relative poverty. But they cost money, and a badly designed system creates the poverty trap: if benefits are withdrawn at 55p for every extra £1 earned, and income tax and NI take another 30p, the effective marginal deduction rate can exceed 80% — a punishing disincentive. Universal Credit's taper was designed to attack exactly this.
• The National Living Wage — raises the pay of the low-paid, though it does nothing for the workless and risks job losses in competitive labour markets.
• Education, training and childcare — the long-run answer: it raises the human capital, MRP and hence the earnings of the low-skilled, and it simultaneously shifts LRAS right. It attacks the cause rather than the symptom — but it takes a generation to work.
• State provision of merit goods — free healthcare and schooling redistribute in kind, raising the real living standards of the poor without a cash transfer.
• Wealth, inheritance and capital taxes — attack the accumulation of inequality at source, but are politically hard and can prompt avoidance and capital flight.

Evaluation: always weigh the equity gain against the efficiency cost (incentives, avoidance, administration, opportunity cost of the spending), and distinguish symptom policies (benefits — fast, effective, expensive) from cause policies (education — slow, cheap per head, and permanent).

Progressive or regressive?

The poverty trap

Absolute poverty, relative poverty, or a measure?

Tap a card, then tap where it belongs.

Match the concept to its meaning

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered income distribution, welfare and development from the OCR A-level Economics (H460) specification. Press Finish to see your score.