Kingfisher School of Business and Finance

ECON 25: Economic Development

Chapter 4 Poverty, Inequality and Development

Distribution and Development: Eight Critical Questions

1. How can we best measure inequality and poverty?
2. What is the extent of relative inequality in developing countries, and how is this related to the extent of
absolute poverty?
3. Who are the poor, and what are their economic characteristics?
4. What determines the nature of economic growth—that is, who benefits from economic growth, and why?
5. Are rapid economic growth and more equal distributions of income compatible or conflicting objectives for
low-income countries? Top put it another way, is rapid growth achievable only at the cost of greater
inequalities in the distribution of income, or can a lessening of income disparities contribute to higher
growth rates?
6. Do the poor benefit from growth, and does this depend on the type of growth a developing country
experiences? What might be done to help the poor benefit more?
7. What is so bad about extreme inequality?
8. What kinds of policies are required to reduce the magnitude and extent of absolute poverty?

Measuring Inequality
A. Size Distributions
 Personal distribution of income (size distribution of income) – the distribution of income
according to size class of persons—for example, the share of total income accruing to the
poorest specific percentage of a population—without regard to the sources of that income.
 Common methods to arrange all individuals by ascending personal incomes and then divide the
total population into distinct groups or sizes are by dividing the population into:
 Quintile (fifths) – a 20% proportion of any numerical quantity. A population divided into
quintiles would be divided into five groups of equal sizes.
 Deciles (tenths) – a 10% portion of any numerical quantity; a population divided into
deciles would be divided into ten numerical groups.
 Income inequality – the disproportionate distribution of total national income among households.
It can be derived from the ratio of incomes received by the top 20% and bottom 40% of the
population, also called as Kuznets ratio. Kuznets ration has been used as a measure of the
degree of inequality between high- and low-income groups in a country.
B. Lorenz Curve – a graph depicting the variance of the size distribution of income from perfect
equality. It was developed by Max O. Lorenz in 1905 for representing inequality of the wealth
distribution.
 The more Lorenz line curves away from the diagonal (perfect equality), the greater degree of
inequality presented. The greater the degree of inequality, the greater the bend and the closer
to the bottom horizontal axis the Lorenz curve will be.

C. Gini Coefficients and Aggregate Measures of Inequality

 Gini Coefficient (Gini concentration ratio) – 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 is, the
higher the inequality of income distribution; the lower it is, the more equal the distribution of
income.

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Ms. Maybelle Ann S. Lopez, MBA
Instructor, ECON 25
Kingfisher School of Business and Finance – ECON 25

 Four possible Lorenz curve presented in the figure above:

 In the Lorenz criterion of income distribution, whenever one Lorenz curve lies above another
Lorenz curve, the economy corresponding to the upper Lorenz curve is more equal than that
of lower curve. Thus, economy A may unambiguously be said to be more equal than
economy D.
 Whenever two Lorenz curves cross, such as curves B and C, the Lorenz criterion states that
we “need more information” or additional assumptions before we can determine which of the
underlying economies is more equal. For example, we might argue on the ground of priority
of addressing the problems of poverty that curve B represents a more equal economy, since
the poorest are richer, even though the richest are also richer (and hence the middle class
is “squeezed”).
 But others might also start with the assumption that an economy with a stronger middle class
is inherently more equal, and those observers might select economy C.
 Gini coefficient satisfies four desirable properties (discussed below); so does the
coefficient of variation (CV), and some others
1. Anonymity principle – measure of inequality should not depend on who has the higher
income; for example, it should not depend whether we believe the rich or the poor be good or bad
people
2. Scale independence principle – measure of inequality should not depend on the size of
the economy or the way we measure its income; for example, our inequality measure should not
depend whether we measure income in dollars or in cents or in rupees or rupiahs or for that matter
on whether the economy is rich on average or poor on average—because if we are interested in
inequality, we want a measure of the dispersion of income, not its magnitude (note: MAGNITUDES
are very important in poverty measures).
3. Population independence principle – the measure of inequality should not be based on
the number of income recipients; for example, the economy of China should be considered no
more or less equal than the economy of Vietnam simply because China has a larger population than
Vietnam.
4. Transfer principle (Pigou-Dalton principle) – holding all other incomes constant, if we
transfer some income from a richer person to a poorer person, the resulting new income
distribute on is more equal.
D. 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.
 Factors of Production – resources or inputs required to produce a good or a service, such as
land, labor, and capital.
E. The Ahluwalia-Chenery Welfare Index (ACWI) – final approach to accounting for the distribution
of income in assessing the quality of growth is to value increases in income for all individuals but to
assign a higher weight to income gains by lower-income individuals than to gains by higher-income
individuals.

Measuring Absolute Poverty

Absolute Poverty – the situation of being unable or only barely able to meet the subsistence essentials
of food, clothing, and shelter. The number of people in the world who are absolutely poor is closest to 1.5 billion.
 May be measured by the number or “headcount”, H, of those whose incomes fall below the
absolute poverty line, Y(P). When the headcount is taken as a fraction of the total population,
N.
 Headcount index (P0) – measures the proportion of the population that is poor. It is popular
because it is easy to understand and measure. But it does not indicate how poor the poor are.
 Poverty line – is set at a level that remain constant in real terms that we can chart our progress.

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Ms. Maybelle Ann S. Lopez, MBA
Instructor, ECON 25
Kingfisher School of Business and Finance – ECON 25

 Total Poverty Gap (TGP) – the sum of the difference between the poverty line and actual
income levels of all people living below that line. It measures the total amount of income
necessary to raise everyone who is below the poverty line up to that line
𝐻

TPG = ∑(𝑌𝑝 − 𝑌𝑖 )
𝑖=1

On a per capita basis, the average poverty gap (APG) is found by dividing the TPG by the total population:
TPG
APG =
𝑁
Normalized poverty gap (NPG): 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.

Average income shortfall (AIS), the total poverty gap divided by the headcount of the poor: AIS=TPG/H.
The AIS tells us the average amount by which the income of a poor person falls below the poverty line.
This measure can also be divided by the poverty line to yield a fractional measure, the normalized income
shortfall (NIS): NIS=AIS/Yp.

 Poverty Gap Index (P1) – measures the extent to which individuals fall below the poverty line
(the poverty gaps) as a proportion of the poverty line. The sum of these poverty gaps gives the
minimum cost of eliminating poverty, if transfers were perfectly targeted. The measure does not
reflect changes in inequality among the poor.
 Criteria for a desirable poverty measure that are widely accepted by development economists:
1. Anonymity principle
2. Population independence principle
3. Monotonicity principle – if you add income to someone below the poverty line, all other
incomes held constant, poverty can be no greater than it was
4. Distributional sensitivity principle – other things being equal, if you transfer income from a
poor person to a richer person, the resulting economy should be deemed strictly poorer.
 The headcount ratio measure satisfies anonymity, population independence, and monotonicity,
but it fails on distributional sensitivity. The simple headcount fails even to satisfy the population
independence principle.
The Foster-Greer-Thorbecke Index (Pα class of poverty measures)– a class measures of the level
of absolute poverty. FGT class is based on the normalized gap of a poor person, which is the income
shortfall expressed as a share of the poverty line.
𝐻
1 𝑌𝑝 − 𝑌𝑖
𝑃𝛼 = ∑( )𝛼
𝑁 𝑌𝑝
𝑖=1
 Squared Poverty Gap (poverty severity) Index (P2) – averages the squares of the poverty
gaps relative to the poverty line. It has become a standard of income poverty measure used by
the World Bank and other agencies, and it is used in empirical work on income poverty because
of its sensitivity to the depth and severity of poverty. Another reason to prefer P2 (or at least P1)
over P0 is that standard headcount measures also have the perverse property of creating
incentives for officials to focus efforts on the poor who are closest to the poverty line—because
that is the easiest and cheapest way for them to demonstrate progress.
Pearson-Equivalent Headcounts. Given a political need to feature “headline” headcount measures, a
partial improvement is to convert changes in the poverty gap into its headcount-equivalent (based on
the initial average income shortfall). If aid agencies featured a supplementary headcount-equivalent,
they could report in terms of numbers of people while accounting for changes in poverty depth.

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Ms. Maybelle Ann S. Lopez, MBA
Instructor, ECON 25
Kingfisher School of Business and Finance – ECON 25

Estimates using this approach show progress against poverty in many countries is significantly greater
than revealed using conventional headcount measures alone.
Multidimensional Poverty Measurement. Sabina Alkire and James Foster filled the gap on which
poverty cannot be adequately measured with income alone by extending the FGT index to multiple
dimensions.
 A poor person is identified as poor through what is called the “dual cutoff method”: 1) 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); 2) the cutoff of the number of dimensions in
which a person must be deprived (below the line) to be deemed multidimensionally poor.
 Multidimensional headcount ration HM – fraction of the population in multidimensional poverty
 M0 (adjusted headcount ratio) –uses ordinal data and is similar conceptually to the poverty
gap P1 (which again can be expressed as the headcount ratio times the normalized income
shortfall). It may be represented by the product of the multidimensional headcount ratio times
the average fraction of dimensions in which the poor are deprived (or “average intensity of
poverty” A, that is, M0 = HM * A. The adjusted multidimensional headcount ratio satisfies the
desirable property (dimensional monotonicity) that if average fraction of deprivations increases,
so does M0.

Poverty, Inequality, and Social Welfare

What’s So Bad about Extreme Inequality?
1. Extreme income inequality leads to economic inefficiency.
 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.
 Relative poverty – lack of collateral. When low-income individuals cannot borrow money, they
generally cannot adequately educate their children or start and expand a business.
 With high income 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 to
the nation’s productive resources; in fact, they represent substantial drains on these resources. The
rich do not generally save and invest significantly larger proportions of their incomes than the middle
class or even the poor.
2. Extreme income disparities undermine social stability and solidarity.
 High inequality strengthens the political power if the rich and hence their economic bargaining power.
 High income inequalities facilitates rent seeking, including actions such as excessive lobbying, large
political donations, bribery, and cronyism.
 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.
 High inequality may also lead the poor to support populist policies that can be self-defeating.
Countries with extreme inequality, El Salvador and Iran, have undergone upheavals or extended civil
strife that have cost countless lives and set back development progress by decades.
 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.
3. Extreme inequality is generally viewed as unfair.
 veil of ignorance – a hypothetical state, advanced by the US political philosopher John
Rawls, in which decisions about social justice and the allocation of resources would be made
fairly, as if by a person who must decide on society’s rules and economic structures without
knowing what position he or she will occupy in that society.

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Ms. Maybelle Ann S. Lopez, MBA
Instructor, ECON 25
Kingfisher School of Business and Finance – ECON 25

Dualistic Development and Shifting Lorenz Curves: Some Stylized Typologies

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. 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.
Latin America 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. Sri Lanka and the state of Kerala in
Southwestern India.

Kuznet’s Inverted-U Hypothesis

 Kuznets curve – a graph reflecting the
relationship between a country’s income
per capita and its inequality of income
distribution.
 The inverted-U is consistent
with modern sector
enlargement growth, but not
traditional or modern sector
enrichment growth.

Absolute Poverty: Extent and Magnitude

 Poor health, nutrition, and education lowers economic productivity of people in poverty, leading
directly and indirectly to slower growth
 Higher income for the poor raises demand for locally produced goods

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Instructor, ECON 25
Kingfisher School of Business and Finance – ECON 25

 Often, the poor lack access to credit, which constrains entrepreneurship, children’s education, and
fertility reduction
 Social exclusion/injustice associated with poverty also leads to bad government policies that can
reduce growth
Multidimensional Poverty Index (MPI) – a poverty measure that identifies the poor using dual cutoffs
for levels and numbers of deprivations, and then multiplies the percentage of people living in poverty
times the percent of weighted indicators for which poor households are deprived on average. It takes
into account that there are negative interaction effects when people have multiple deprivations—worse poverty
than can be seen by simply adding up separate deprivations for the whole country, then taking averages, and only
then combining them.
 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 multidimensionally poor.
 MPI focuses on deprivations in health, education, and standard of living; and each
receives equal (i.e., one-third of the overall total) weight. MPI indicators are as follows:
1. 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 one-sixth toward the maximum deprivation in the MPI)
2. 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 to 8 (each counts one-sixth toward the MPI).
3. 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 of 5 assets—
telephone, radio, TV, bicycle, and motorbike.
 Interaction of the deprivations:
o 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
o The MPI approach assumes an individual’s lack of capability in one area can only
to degree be made up by other capabilities – capabilities are treated as
substitutes up to a point but then as complements.
 Computing the MPI
o The MPI for the country (or region or group) is then computed
o 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 percent of weighted indicators for
which poor households are deprived on average).
o The adjusted headcount ratio HA is readily calculated
o HA satisfies some desirable properties. Dimensionally 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.
 Multidimensional poverty tells a different story than income poverty
o The results showed that knowing income poverty is not enough if our concern is
with multidimensional poverty.
o Multidimensionally, Bangladesh is substantially less poor – but Pakistan
substantially poorer – than would be predicted by income poverty
o Ethiopia is far more multidimensionally poor, and Tanzania much less so, than
predicted by income poverty.
o Most Latin American countries e.g. Brazil rank worse on multidimensional poverty
than on income poverty; but Colombia’s income and MPI poverty ranks are about
same. (refer Table 5.5 Income Poverty Indicated in Selected Countries)

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Instructor, ECON 25
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Growth and Poverty

Five reasons why policies focused toward reducing poverty levels need not lead to a slower rate of
growth—and indeed could help to accelerate growth:
1. Widespread poverty creates conditions in which the poor have no access to credit, are unable
to finance their children’s education, and, in the absence of physical or monetary investment
opportunities, have many children as a source of old-age financial security.
2. A wealth of empirical data bears witness to the fact that unlike the historical experience of the
now developed countries, the rich in many contemporary poor countries are generally not noted
for frugality or for their desire to save and invest substantial proportions of their incomes in the
local economy.
3. 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.
4. Raising the income levels of the poor will stimulate an overall increase in the demand for locally
produced necessity products like food and clothing, whereas the rich tend to spend more of their
additional incomes on imported luxury goods.
5. 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.

Economic Characteristics of High-Poverty Groups

Rural Poverty
 The most valid generalizations about the poor are that they are disproportionately located in
rural areas, that they are primarily engaged in agricultural and associated activities, that they
are more likely to be women and children than adult males, and that they are often concentrated
among minority ethnic groups and indigenous peoples.
 Some of the one-third are also located in rural areas but engaged in petty services, and others
are located on the fringes and in marginal areas of urban centers, where they engage in various
forms of self-employment such as street hawking, trading, petty services, and small-scale
commerce.

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Instructor, ECON 25
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 On the average, in Africa and Asia, about 80% of all target poverty groups are located in the
rural areas, as are about 50% in Latin America. (see Table 5.7 for the data of specific countries in
relation to poverty in rural vs urban)

Women and Poverty

 Women and children experience the harshest deprivation. They are more likely to be poor and
malnourished and less likely to receive medical services, clean water, sanitation, and other
benefits.
 Women have less access to education, formal-sector employment, social security, and
government employment programs.
 The earning potential of women is considerably below that of their male counterparts, women
are more likely to be among the very poor because in general, women in female-headed
households have less education and lower incomes. Furthermore, the larger the household is,
the greater the strain on the single parent and the lower the per capita food expenditure.
 In urban areas, women are much less likely to obtain formal employment in private companies
or public agencies and are frequently restricted to illegal, low-productivity jobs.
Ethnic Minorities, Indigenous Populations, and Poverty
 Data on the poverty of indigenous people in Latin America demonstrates that a majority of
indigenous groups live in extreme poverty and that being indigenous greatly increases the
chances that an individual will be malnourished, illiterate, in poor health, and unemployed.
 Research has shown that in Mexico, over 80% of the indigenous population is poor, compared
to 18% of the nonindigenous population. (Table 5.8 shows that similar situations exist in countries such
as Bolivia, Guatemala, and Peru)

Policy Options on Income Inequality and Poverty: Some Basic Considerations

Areas of Intervention
1. Altering the functional distribution – the returns to labor, land, and capital as determined
factor prices, utilization levels, and the consequent shares of national income that accrue to the
owners of each factor.
2. Mitigating the size of distribution – the functional income distribution if an economy translated
into a size distribution by knowledge of how ownership and control over productive assets and
labor skills are concentrated and distributed throughout the population.
 Asset Ownership – the ownership of land, physical capital (factories, buildings, machinery, etc.),
human capital, and financial resources that generate income for owners.

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Instructor, ECON 25
Kingfisher School of Business and Finance – ECON 25

 Redistribution policies – policies geared to reducing income inequality and expanding

economic opportunities in order to promote development, including income tax policies, rural
development policies, and publicly financed services.
 Land reform – a deliberate attempt to reorganize and transform existing agrarian systems within
the intention of improving the distribution of agricultural incomes and thus fostering rural
development.
3. Moderating (reducing) the size distribution at the upper levels through progressive taxation
of personal income and wealth. Disposable income—the income that is available to households for
spending and saving after personal income taxes have been deducted.
 Progressive income tax – a tax whose rate increases with increasing personal incomes.
 Regressive tax – a tax structure in which the ratio of taxes to income tends to decrease as
income increases.
 Indirect taxes – taxes levied on goods ultimately purchased by consumers, including customs
duties (tariffs), excise duties, sales taxes, and export duties.
4. Moderating (increasing) the size distribution at the lower levels through public expenditures
of tax revenues to raise the incomes of the poor either directly (e.g., by conditional or
unconditional cash transfers) or indirectly (e.g., through public employment creation such as
local infrastructure projects or the provision of primary education and health care).
 Public consumption – all current expenditures for purchases of goods and services by all levels
of government, including capital expenditures on national defense and security
 Subsidy – a payment by the government to producers or distributors in an industry to prevent the
decline of that industry, to reduce the prices of its products, or to encourage hiring.
 Workfare program – a poverty alleviation program that requires program beneficiaries to work in
exchange for benefits, as in a food-for-work program. It represents a better policy than welfare
when these criteria are met:
o The program does not reduce incentive for the poor to acquire human capital and other
assets
o There are greater net benefits of the program’s work output
o It is harder to screen the poor without a workfare requirement
o Poor workers have lower opportunity cost of time (so the economy loses little output when
they work in the program)
o Non-poor workers have higher opportunity cost of time (so they are unlikely to participate
to get the benefits)
o The fraction of the population living in poverty is smaller (so the extra costs of a universal
welfare scheme would be high)
o There is less social stigma attached to participating in a workfare program, so the poor
do not suffer humiliation or be deterred from needed work

Policy Options on Income Inequality and Poverty: Some Basic Considerations

Policy Options
 Changing relative factor prices
 Progressive redistribution of asset ownership
 Progressive taxation
 Transfer payments and public provision of goods and services

Summary and Conclusions: The Need for a Package of Policies

1. Policies to correct factor price distortions
2. Policies to change the distribution of assets, power, and access to education and associated
employment opportunities
3. Policies of progressive taxation and directed payments
4. Policies designed to build capabilities and human and social capital of the poor.

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Ms. Maybelle Ann S. Lopez, MBA
Instructor, ECON 25