Income inequality utilizes the dispersion of capital to identify the way in which economic inequality is defined among a group of individuals in a given economy. Simply put, economics measures income levels and purchasing power across a society to identify averages and distributions to identify the extent of inequalities. Historically this problem was limited to the scope of differences of income and assets between people, creating separate social classes. However, as economists expand their understanding of markets, it has become increasingly clear that there is a relationship between income inequality and the potential for long-term sustainable economic growth. As a result, a wide array of income inequality scales and metrics have been generated in order to identify challenges.
Inequality Metrics
In pursuing an objective and comparable lens in which to measure income inequality, a variety of methods have been created. Models, ratios and indices include:
- Gini Index: One of the most commonly used income inequality metric is the Gini Index, which uses a straightforward 0-1 scale to illustrate deviance from perfect equality of income. A 1 on this scale is essentially socialism, or the perfect distribution of capital/goods. The derivation of the Gini ratio is found via Lorenz curves, or more specifically, the ratio of two areas in a Lorenz curve diagram. The downside to this method is that it does not specifically capture where the inequality occurs, simply the degree of severity in the income gap. This demonstrates the Gini ratio across the globe, with some interesting implications for advanced economies like the U.S.
- 20:20 Ratio:This name indicates the method; the top 20% and the bottom 20% of earners are used to derive a ratio. While this is a simple method of identifying how rich the rich are (and how poor the poor are), it unfortunately only captures these outliers (obscuring the middle 60%).
- Palma Ratio: Quite similar to the 20:20 ratio, the Palma ratio underlines the ratio between the richest 10% and the poorest 40% (dividing the former by the latter). The share of the overall economy occupied by these two groups demonstrates substantial variance from economy to economy, and serves as a strong method to identify how drastic the inequity is.
- Theil Index:The Theil Index takes a slightly different approach than the rest, identifying entropy within the system. Entropy in this context is different than that which is found in thermodynamics, primarily meaning the amount of noise or deviance from par. In this case, 0 indicates perfect equality, and 1 indicates perfect inequality. When there is perfect equality, maximum entropy occurs because earners cannot be distinguished by their incomes. The gaps between two entropies is called redundancy, which acts as a negative entropy measure in the system. Redundancy in some individuals implies scarcity of resources for others. Comparing these gaps and inequality levels (high entropy or high redundancy) is the basic premise behind the Theil Index.
- Hoover Index: Often touted as the simplest measurement to calculate, the Hoover Index derives the overall amount of income in a system and divides it by the population to create the perfect proportion of distribution in the system. In a perfectly equal economy this would equate to income levels, and the deviance from this (on a percentile scale) is representative of the inequality in the system.
To simplify the information above, the basic concept behind measuring inequality is identifying an ideal and tracking any deviance from that ideal (which would be deemed the inequality of a given system). Minimizing this inequality is the sign of a mature and advanced society with high standards of living across the board, while substantial income gaps are indicative of a developing or struggling economy. Some powerful economies, like the United States and China, demonstrate high inequality despite high economic power while others, like Switzerland or Norway, demonstrate high equality despite lower economic output. This is a critical consideration in economic policy (from a political perspective). Minimizing inequality is a central step towards an advanced society.