Income inequality metrics

Economists have developed numerous ways of measuring income inequality, and by extension income equality. The varioustechniques are typically categorized as either absolute measures or relative measures.

Table of contents

1 Absolute income criteria

2 Relative income criteria

3 Criticisms of income inequality metrics

4 See also

Absolute income criteria

Absolute measures define a minimum standard, then calculate the number (or percent) of individuals below this threshold. Thesemethods are most useful when determining the amount of poverty in a society. Examples include:

Poverty line - This is a measure of the level of income necessary to subsist in a society and varies fromplace-to-place and from time-to-time depending on the cost of living and peoples' expectations. It is usually defined bygovernments and calculated as that level of income at which a household will devote two-thirds (to three-quarters) of its incometo basic necessities such as food, water, shelter, and clothing. See povertyline for details.
Poverty index - This measure was developed by Amartya Sen and uses an index numbers approach. The indextakes into account both the number of poor and the extent of their poverty. Sen defined the index as:

           I=(P/N)((B-A)/A)

        where:              P=number of people below the poverty line             N=total number of people in society             B=poverty line income             A=average income of those people below the poverty line

Relative income criteria

Relative income measures compare the income of one individual (or group) with the income of another individual (or group).These measures are most useful when analyzing the scope and distribution of income inequality. Examples include:

Percentile distributions - One percentile is compared toanother. For example, it might be determined that the income of the top ten-percentile is only slightly more than the bottomforty-percentile. Or it might be determined that the top quartile earns 45% of the society's income while the bottom quartile has10% of society's income .
Lorenz curve - This is a graphic device used to display the relative inequality in a distribution of incomevalues. A society's total income is ordered according to income level and the cumulative total graphed. See Lorenz curve for details.
Gini coefficient - This is a summary statistic used to quantify the extent of income inequality depicted ina particular Lorenz curve. See Gini coefficient for details.
Standard deviation of income - This measures income dispersion by assessing the squared variance from the mean. This metric is seldom seen, its use limitedto occasional reference in academic journals.
Relative poverty line - This is a measure of the number or proportion of people or households whose level ofincome is less than some give fraction of typical incomes. This form of poverty measurement tends to concentrate concern on thebottom half of the income distribution and pay less attention to ineqalities in the top half. See poverty line for details.

Criticisms of income inequality metrics

It is not clear how income should be defined. Should it include capital gains, imputed house rents from home ownership, andgifts? If these income sources are ignored (as they often are), how might this bias the analysis? How should non-paid work (suchas parental childcare) be handled? Wealth or consumption may be more appropriate measures in some situations. Broader metrics of human well-being might be useful.
Should the basic unit of measurement be households or individuals? The Gini value for households is always lower than forindividuals because of income pooling and intra-family transfers. The metrics will be biased either upward or downward dependingon which unit of measurement is used.
These income inequality metrics ignore life cycle effects. An individual tends to start life with little or no income,gradually increase income till about age 50, after which incomes will decline, eventually becoming negative. This will have theeffect of significantly overstating inequality. It has been estimated (by A.S. Blinder in The Decomposition ofInequality, MIT press) that 30% of measured income inequality is due to the inequality an individual experiences as they gothrough the stages of life.
Absolute measures often give very different results than relative measures. For example, in measuring inequality changes dueto the development of less developed countries, absolute measures typically show improvements as the general income level rises,but it is also common for relative measures to deteriorate as the new wealth becomes concentrated in the hands of the upperpercentiles. The diverging results can be a problem is they are used inappropriately or interpreted incorrectly.
Should real or nominal income distributions be used? What effect will inflation have on absolute measures? Do some groups(eg., pensioners) feel the effect of inflation more than others?
How do we allocate the benefits of government spending? How does the existence of a social security safety net influence thedefinition of absolute measures of poverty. Do government programs support some income groups more than others?
Income inequality metrics are seldom used to quantify and examine the causes of income inequality. The main causes are: lifecycle effects (age), inherited characteristics (IQ, talent), willingness to take chances (risk aversion), theleisure/industriousness choice, inherited wealth, economic circumstances, education and training, discrimination, and marketimperfections.