Poverty and Inequality

Poverty affects millions of people around the world. Poverty and inequality can lead to issues that prevent people from fully participating in society. In this explanation, we will look at what poverty and inequality mean in economic terms. You will see how they are measured and their relationship with economic growth. If you are ready to learn more about poverty and inequality then keep on reading!

Poverty and Inequality Poverty and Inequality

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Table of contents

    Poverty and inequality definition

    What are the definitions of poverty and income inequality? Are they different? Let's start from the beginning.

    Poverty can be measured in two different ways: absolute poverty and relative poverty.

    Absolute poverty is when people are unable to afford the sufficient necessities to sustain themselves. The World Bank defines absolute poverty as the percentage of the population in a country that lives on less than $1.90 a day.

    The United Nations (UN) define absolute poverty as

    A condition characterised by severe deprivation of basic human needs, including food, safe drinking water, proper sanitation facilities, health facilities, shelter and education.

    Relative poverty is the level of household income that is below a certain percentage of the median level of income of the particular country.

    In the UK, relative poverty is less than 60% of median income (£30,800 in 2020). In other words, relative poverty encompasses those who cannot afford to buy the goods they need to not be considered poor according to social norms. For example, if they can't afford a refrigerator or car.

    Inequality is the degree to which income or wealth are distributed unequally throughout a population.

    Income inequality and poverty

    Income inequality has been linked to poverty. Although it is unclear as to how exactly the two are correlated, research from LSE has found some correlation between the widening income inequality gap and poverty rates in the UK.1

    How can this be the case? Well, there may be many explanations. However, some of them include the fact that individuals with high incomes belonging to elite groups may be able to sway political interests in their favour. This means that households on low incomes are disregarded when it comes to such decision-making. Furthermore, early income earners may be finding themselves in situations where they cannot afford housing due to rising inflation and low credit availability, which causes them to be more entrenched into the lifestyle with very limited disposable income.1

    Inequality can be measured in two different ways: income inequality and wealth inequality.

    Income is a flow of earnings received at a certain rate in a given period, such as a salary or rental earnings.

    Wealth is the stock or monetary value of a person's marketable assets.

    Difference between poverty and income inequality

    So, what's the difference between poverty and income inequality?

    Income inequality is the degree to which income is distributed unequally throughout a population. Wealth inequality is how unequal the distribution of wealth is throughout a population.

    A population can be divided up in many different ways to study and understand how income and wealth are distributed.

    The population can be divided up by age to see how income is distributed between the old and the young.

    Poverty, on the other hand, as described in the previous section, is when people are unable to afford the sufficient necessities to sustain themselves.

    Measurements of income inequality

    Let's discuss some of the measurements of income inequality. Economists measure income inequality using a variety of criteria. The most generally used measures - the Lorenz curve, the Gini coefficient, decile ratios, the Palma ratio, and the Theil index - all have merits and limits.

    The choice of what to measure is also crucial: pre-tax and after-tax income, consumption, and wealth are helpful indicators, as are various sources of income such as wages, capital gains, taxes, and perks.

    Understanding the dimensions of economic inequality is a critical first step in determining the best solutions to combat it.

    Measurements of income inequality: The Lorenz curve

    The Lorenz curve is one measure of income inequality. It graphically depicts how income is distributed throughout a population.

    Poverty and Inequality Lorenz curve StudySmarterFig. 2 - Lorenz Curve

    As Figure 2 above shows, the cumulative percentage of the population is plotted against the cumulative percentage of the income of a population. The straight line of equality shows a perfectly equal society. The Lorenz curve is below the line of equality. The further away it is, the greater the income inequality.

    Our explanation on the Lorenz Curve discusses this graph further, how you can interpret it and some of its limitations.

    Measurements of income inequality: The Gini coefficient

    The Gini Coefficient is related to the Lorenz curve. It shows the ratio of the area between the 45-degree line of equality and the Lorenz curve.

    As it is a ratio, it can be calculated mathematically. Its values range between 0 and 1. A value of 0 means that income is perfectly shared equally across society. A value of 1 would mean that one single person has access to all the income in a country.

    Our explanation on the Gini Coefficient discusses this ratio further and how you can calculate it.

    Causes of poverty and income inequality

    There are many causes of both poverty and income inequality. Some causes are:

    • Wages. Unequal distribution of wages on grounds of higher educational achievements or longer working hours causes a disparity among the higher income earners and lower-income earners. A higher-income earner assures more savings, which build up more wealth compared to a lower-income earner whose basic needs take precedence.
    • Wealth levels. A higher level of wealth eventually leads to more wealth. With more wealth, people can undertake risky investments with a higher rate of return and therefore increased interest and income rates.
    • Chance. This is based on good decision making and luck of the people who either choose the right sort of job that increases their income or they invest in assets that increase their wealth.
    • Age. The age group of working adults at the peak of their career have a higher chance of increased incomes than the fresh starters, similar to the older ones who have had their chance to accumulate wealth and assets in their prime.
    • Socioeconomic status. This can explain the difference in how income and wealth are distributed between countries. Developing countries may be marginalised compared to developed countries that favor international trade and negotiations that help them in economic development.

    Poverty and inequality example: the Kuznets hypothesis

    Let's take a look at an example of poverty and inequality by looking at the Kuznets curve.

    The Kuznets hypothesis helps us understand the Kuznets curve relationship.

    The Kuznets hypothesis suggest how economic growth and development initially lead to a worsening of poverty and inequality. But after a certain level of economic growth, poverty and inequality reduce.

    The Kuznets hypothesis is also known as the Kuznets curve. It can also be applied to show the relationship between economic growth/development and environmental degradation.

    Poverty and Inequality Kuznets curve StudySmarterFig. 4 - Kuznets Curve

    Figure 4 above shows the Kuznets curve. Initially, an economy is heavily reliant on the primary sector. This overdependence generates little economic growth.

    As the economy moves towards the manufacturing sector, economic growth starts to increase. Absolute poverty will decline, but there will be an increase in relative poverty as capital owners benefit more from the change to a manufacturing sector. They take advantage of cheap labour and this increases their wealth.

    The top of this curve is known as a turning point. Inequality and relative poverty will peak here. There is little pressure on wages to rise and a surplus of unskilled workers.

    After this point though, spare capacity in the economy has been used up and wages are rising. Higher incomes result in higher tax revenue which the government can use to improve in education, healthcare, etc. The government focuses now on creating a more equitable society because economic growth and development are sustainable now.

    China is a good example of this. China has shifted its economy to the manufacturing sector. The economy has experienced high levels of economic growth and many have been lifted out of absolute poverty. But relative poverty is on the rise, as capital owners benefit more from cheaper labour.

    Capitalism also explains the relationship between economic growth and inequality. Capitalism gives birth to income inequality because of wage differentials based on the demand and supply of different jobs. Individuals that own resources and wealth also differ based on their income levels.

    Hence, we could say that a capitalist economy can never achieve equality. In capitalism, it is important to encourage hard work and incentives without which the economy will not grow as the people will lose the motivation to work.

    This proves that a certain degree of inequality is necessary and desirable for economic growth but excessive inequality will result in social justice problems and inefficiency.

    Poverty and Inequality - Key takeaways

    • Absolute poverty is the situation where people can’t afford their basic needs to sustain a living.
    • Relative poverty is the income level that is lower than the median income of a given economy.
    • Income inequality can be measured using the Lorenz curve and the Gini coefficient.
    • Some causes of income and wealth inequality are: wages, wealth levels, chance, age, and socioeconomic status.
    • The Kuznets curve or hypothesis explains the relationship between economic growth, inequality and poverty.
    • Economic growth positively affects absolute poverty by raising the levels of income. However, it inversely affects relative poverty as the benefits from economic growth in the country may not be shared equally.

    References

    1. London School of Economics and Political Science, Higher inequality in the UK linked to higher poverty, 2017, https://www.lse.ac.uk/News/Latest-news-from-LSE/2017/11-November-2017/Higher-inequality-in-the-UK-linked-to-higher-poverty
    Frequently Asked Questions about Poverty and Inequality

    What is the difference between poverty and inequality?

    Poverty is when people don't have much to afford the sufficient necessities to sustain themselves. Inequality refers to the unequal distribution of income or wealth which results in some people having more than others.

    What is the relationship between economic growth, poverty, and inequality?

    Economic growth positively affects absolute poverty by raising the levels of income. However, it inversely affects relative poverty as the benefits from economic growth in the country may not be shared equally. 

    How is inequality measured?

    Inequality can be measured through the Lorenz curve or the Gini Coefficient.

    What is inequality and poverty?

    Inequality is the degree to which income or wealth are distributed unequally throughout a population. 

    Poverty can be measured in two different ways: absolute poverty and relative poverty.

    Absolute poverty is when people are unable to afford the sufficient necessities to sustain themselves.

    Relative poverty is the level of household income that is below a certain percentage of the median level of income of the particular country.

    Does corruption affect income inequality and poverty?

    Yes, corruption increases income inequality and thus poverty.

    Does globalization increase poverty and inequality?

    Yes, globalization increases poverty and inequality.

    Test your knowledge with multiple choice flashcards

    Economic growth positively affects absolute poverty.

    What is the Gini coefficient?

    What are some limitations of using the Lorenz curve?

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