Income Inequality and Its Measurement - Essay Example

Income Inequality of Institute Income Inequality and its Measurement Introduction Income inequality refers to the disparities that exist in terms of income between different groups of people or households in an economy. The Gini coefficient together with the Lorenz curve make up the two measurements applicable to the measurement of income inequality. The inequality is a problem that faces not only developing countries but also developed countries. There are several factors that cause income inequality in developed countries. Such factors are important for any country to consider in policy making. In terms of income, there is a growing gap between the rich and the poor in any individual country. The rich tend to earn more income than the poor, and so more wealth seems to fall majorly in the hands of a few rich people while the majority earn very little. One’s earnings depend on several factors such as the demand and supply for the person’s skills. As the factors influence wages, they end up affecting the distribution of a country’s income. With income inequality, the rich tend to earn higher income while the poor earn low incomes. That differentiates the poor from the rich. Such inequality has several impacts on the economy and the population. To measure inequality, economists use some measures. Through one such measure, they compare household incomes through surveys. The process involves a comparison of the sources of income and the consumption patterns of the households that participate in the survey. To rank individuals in accordance to per capita income for each household, economists subtract direct taxes from the total income for the household. They then divide the amount by the number of individuals in the household. The calculation and the ranking give the Gini coefficient. The Gini coefficient is a method applicable to the measurement of inequality. The Gini coefficient has a range of 0 to 100 whereby 0 represents a period when everyone has the same income (Milanovic, 2011 p.7). The income inequality in a country would generally range between 25 and 60 in the Gini range. In the assessment of income inequality, household surveys come out as the best instruments. However, they have some drawbacks. At times, the rich may refuse to participate in interviews or at times they may understate their incomes. Another useful measure of income inequality is the Lorenz curve. With this measure, economists seek to determine how cumulative percentage of households links to cumulative percentage of income (Mankiw and Taylor, 2014 p.386). By plotting the cumulative percentage of income against the cumulative percentage of households, the Lorenz curve shows the degree of a county’s income inequality. The households form quintiles as per their income levels from the bottom to the top. The cumulative income should add up to 100 percent. Lorenz Curve A Lorenz Curve B Where each quintile has the same percentage in terms of cumulative income, then that would be the achievement of perfect equality. A 45-degree line would represent such perfect equality on a graph of cumulative percentage income against the cumulative percentage of households. The bow of the Lorenz curve reflects the degree of inequality (Mankiw and Taylor, 2014 p.387). A more bowed Lorenz curve this represents a higher degree of income inequality. From the Diagrams above, there is a higher degree of inequality in curve B as compared to curve A. One can derive the Gini coefficient given the Lorenz curve. It is the ratio of the area encompassed by the line of perfect inequality and the Lorenz curve to the total area under the perfect income equality line. The formula for the Gini Coefficient is as follows: Gini Coefficient = Using curve A, Gini coefficient = Conclusion Although the measurements are quite helpful in determining income inequality, they may also give biased of inaccurate estimations. That is a result of the subjectivity of the measurements to the correspondence from households that participate in the surveys. Therefore, there should be some consideration on such drawbacks. Causes and Consequences of Increased Income Inequality Introduction There are several possible causes and consequences of income inequality in developed countries. Some of the causes include technology, policies and institutional framework, globalization and changing social norms. All that leads to economic, social and political consequences. According to some economists, changes in technology are the reason for the rise in income inequality in developed countries. With new technology, there is increased demand for highly skilled and educated labor force. Since the society is not able to produce the high number of skilled workers that the economy requires, the wages of this category of workers have continuously risen. That is in comparison with the unskilled workers whose incomes have remained stagnant over time (Milanovic, 2011 p.8). For example, the supply of skilled labor has remained the same in the US for the last three decades. The stagnation in terms of supply has led to the income inequalities in the US as demand has risen over time with supply remaining the same. However, other factors may also have played a role in the inequalities. One such factor is the ability of trade unions to negotiate for better pay for their members. Policies and institutional framework in a country may also contribute to income inequality. The use of high taxes and social transfers by governments may redistribute incomes within the economy. Some countries show a reluctance to apply such policies and hence cause the gap between the rich and the poor to widen. For example, due to social transfers and direct taxes, the Gini in Germany reduced by nine points but fell by six points in the US. That demonstrates how a government’s decisions and policies may influence the level of Income inequality. It may also show the political influence the rich have to influence policy decisions in their favor. Recent models of political economy show that due to the political influence of the rich, political systems have shifted from “one person, one vote” to “one dollar, one vote” (Milanovic, 2011 p.9) The changing social norms in society may also offer an explanation to income inequality (Milanovic, 2011 p.9). Previously, people felt that it was not right to have huge gaps between the salaries of the chief executive officer of a company and the other workers. However, presently, such gaps seem to be encouraged. As the management of a company falls in the category of skilled labor, they tend to earn much more than those below them in the company structure. That furthers the gap between the rich and the poor in terms of income. Another cause for income inequality is globalization. Globalization necessitates specialization. As specialization aims at producing high skilled exports, it requires high skilled labor thus increasing the demand for such labor. In the end, the wages for skilled labor rise thus increasing the gap between the wages of the skilled and unskilled. Also, with globalization, the rich in developed countries are able to take advantage of low cost of material and labor, and less stringent laws in other countries to make more profits from their operations (Salman, 2014 p.202). A good example is Inditex, which is a clothing company with several stores worldwide. Its founder is worth US $57 billion while the monthly salary of a worker of the company in Bangladesh is US $38. Such use of globalization further increases inequality as it may increase unemployment, which reduces the income of the poor. Income inequality has adverse consequences socially, economically and politically. With increased inequality, the rich wield the biggest share of both wealth and power. They are thus able to influence policy-making. It thus becomes easy for them to manipulate systems to come up with rules that favor them such as lower taxes higher income brackets. That is in contrast to the poor who have no say in such policies that have an impact on their lives (Oxfam, 2014 p.3). Also, there is increased tax evasion as the rich take advantages of tax havens. Estimates show that the rich account for about £5.2 billion of tax evasion every year (Oxfam, 2014 p.2). If the amount were to be distributed to the population, it would amount to £200 per household every year. Increased income inequality has led to a deterioration of living standards. More people are living in poverty as incomes fall while the costs of basics such as food rise. Cuts in public services as well as social security further worsen the situation making life a struggle for the poor (Oxfam, 2014 p.3. Unemployment may be on the decrease, but the wages are not sufficient for households to get by. For example, statistics show that in 2012, of the 13 million people living in poverty in UK, half of them came from families in employment. That shows how the income inequality affects the living standards. Inequality may demotivate individuals as they feel that no matter how talented they are or the amount of effort they put, it is impossible for them to climb the economic ladder (Salman, 2014 p.203). Such a feeling may be a cause for psychosocial stress, which may affect ones health. That leads to a lack of determination to work hard and hence there is reduced labor productivity. That would result in the economic growth slowing down. A decrease in social cohesion is another possible consequence of income inequality. As the wealthy feel superior and above the masses, the poor resent them and view them with contempt. The poor may perceive the rich corrupt people who engage in illegal activities to increase their wealth. Lack of social cohesion within a society is detrimental to development. Increase income inequality establishes a harmful cycle in society. The rich can access quality education and health care among other facilities while the poor have to contend with services of a lower quality. That also applies to their children. In the end, due to the difference in the services they can access, children from affluent households end up developing skills that help them get well-paying jobs. On the other hand, due to the financial strains, children from poor households fail to develop such skills and form the unskilled labor category. The cycle continues and worsens the inequality further as the rich get richer while the poor get poorer. Conclusion It is thus necessary to manage income inequality for there to be some economic balance. The management of the causes of such inequalities would ensure the economy does not face adverse effects of such inequalities. A country that manages to close the gap between the rich and the poor would have favorable economic development. References Mankiw, N. and Taylor, M., 2014. Economics, 3rd edition. Boston: Cengage Leaning. Milanovic, B., 2011. More or Less. Finance and Development, September 2011, p.6-11. Oxfam, 2014. A Tale of Two Britains. Oxfam Media Briefing. Available through: oxfamilibrary database (Accessed 1 March 2015). Salman, S., 2014. The Ninety-Nine Percent and the One Percent. Research in Applied Economics, 6(3), p.196-219. (Total Word count = 1530 words) Read More