Sunshine Group | Economic Development | March 4, 2013

Lorenz Curve & Gini Coefficient

THEORY & APPLICATION
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Table of Contents
INTRODUCTION ................................................................................. 3
Lorenz curve ......................................................................................... 4
Gini coefficient ..................................................................................... 4
THEORY ................................................................................................ 7
I. Overview of Inequality Metrics ...................................................... 7
Defining Income ................................................................................ 7
Some common metrics of measuring inequality ............................... 8
Properties of Inequality Metrics as in Lorenz Curve and Gini
coefficient ........................................................................................ 12
II. Lorenz Curve ............................................................................. 14
Definition: ....................................................................................... 14
How to construct a Lorenz Curve? .................................................. 14
Calculation ...................................................................................... 16
Properties......................................................................................... 18
Advantages ...................................................................................... 18
Limitations ....................................................................................... 19
III. Gini Coefficient ......................................................................... 21
Definition......................................................................................... 21
Ways to present Gini coefficient ...................................................... 21
Calculation ...................................................................................... 23
Advantages ...................................................................................... 23
Limitations ....................................................................................... 23
IV. Other uses of lorenz curve and gini coefficient .......................... 26
APPLICATION ................................................................................... 28
ZuXiang Wang and Russell Smyth ...................................................... 28
1. Structure of the article A hybrid method for creating Lorenz
Curve with an application to measuring world income inequality 28
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2. Findings from Lorenz Curves for selected years (1950, 1960,
1970, 1980, 1990, 2000 and 2005) ................................................... 29
3. Findings from the trend of AG, its decomposition and average
PPP of the world .............................................................................. 33
4. Density distribution function: ................................................... 37
Other authors findings: ...................................................................... 37
1. A World Bank working paper by Branko Milanovic (2012) ....... 38
2. Branko Milanovic (2010b) ........................................................ 40
3. Solt (2010) ................................................................................. 41
4. Some discrepancies among economists all over the world: ...... 44
CONCLUSION .................................................................................... 46


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INTRODUCTION
In contemporary time, many issues arising in accordance with development
in all corners of life, one of them is inequality happening all around the
world. Inequality can happen when there are discrepancies between
countries or even among groups or individuals within a country. Exactly
appearing in almost every sectors of society (economics, human
development, wealth distribution, education, health care) with clear
indications, this issue receives a great concern from public.
A child born in Swaziland is nearly 30 times more likely to die before the
age of five than a child born in Sweden. A typical Somalia person can live
50 years before he dies while Japanese people are famous for their great
life expectancy of over 84 years. 40% of school-age children in Africa do
not attend primary school mainly because of poverty while the US
government spent $12,743 per public school student on average. 400
richest Americans worth more than the GDP of Canada or Mexico. There
are numerous example of inequalities happening around the world relating
to social, racial, sexual, educational aspects, among individuals and groups
within a society as well as between countries
However, it is clear that all those problems are brought about by
Economic differences between the rich and the poor, which is the main
cause for the inequality in many other aspects such as education and health
care etc. Economic inequality varies between societies, historical periods,
economic structures and systems (for example, capitalism or socialism),
and between individuals' abilities to create wealth. The term can refer to
cross sectional descriptions of the income or wealth at any particular
period, and to the lifetime income and wealth over longer periods of time.
To measure economic inequality, income distribution deserves a much
more attention and effort of economists to do research, investigate and
invent a tools to measure it. To calculate income inequality, it provides 2
methods to apply:
The first one is Size distribution of income or Personal distribution
of income: one of the two methods to measure inequality in income.
Under this method, income of individuals and household are collected and
arranged in ascending order. The data, is then, divided among groups. Most
common method is to divide data in quintiles or deciles in percentage
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form. Then it is determined that what percentage of total income is received
by each income group.
The second method is Functional distribution of income is a theory
explaining how income is divided between different groups involved in the
production process, specifically, the income earned by the "owners" of
various factors or steps in production. This income is determined by the
supply and demand for the end goods produced by each of them.
However, in reality, the Size distribution of income method is preferable
to use, and from it, the income inequality can be calculated and visualized
by Loren Curve and Gini coefficient which is the most prominent index
to measure the income inequality. In this assignment, we will only focus
on Lorenz Curve and Gini coefficient to measure inequality in income.
LORENZ CURVE
Inventor
Max Otto Lorenz (September 19, 1876 in Burlington, Iowa July 1, 1959
in Sunnyvale, California) was an American economist who developed
the Lorenz curve in 1905 to describe income inequalities. He published this
paper when he was a doctoral student at the University of Wisconsin
Madison. His doctorate (1906) was on 'The Economic Theory of Railroad
Rates' and made no reference to perhaps his most famous paper.
He was active in both publishing and teaching and was at various times
employed by the U.S. Census Bureau, the U.S. Bureau of Railway
Economics, the U.S. Bureau of Statistics and the U.S Interstate Commerce
Commission.
Publish time:
The term Lorenz curve seems first to have been used in 1912 in a
textbook The Elements of Statistical Method.
GINI COEFFICIENT
Author:
Corrado Gini (May 23, 1884 March 13, 1965) was an Italian statistician,
demographer and sociologist who developed the Gini coefficient, a
measure of the income inequality in a society. Gini's scientific work ran in
two directions: towards the social sciences and towards statistics. His
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interests ranged well beyond the formal aspects of statisticsto the laws
that govern biological and social phenomena.
He was the president of the International Federation of Eugenics Societies
in Latin-language Countries, president of the Italian Sociological Society,
president of the Italian Statistical Society and other important roles in the
economic societies.
Publish time:
In 1912 in paper "Variability and Mutability" (Italian: Variabilit e
mutabilit)
After Max Lorenz and Gini, there have been many other scientists and
economists have applied LC and Gini coefficient for their business model
to measure inequality in income coming along with greater concern for
society matter. In contemporary time, the source or information as well as
techniques to do research make a big improvement in the quantity and
quality mutually, so existing other models with higher accuracy that done
by other researchers base on these theories. One of them is a research of
ZuXiang Wang and Russell Smyth namely A hybrid method for
creating Lorenz Curves with an application to measuring world
income inequality published in Department of Economics, Monash
University, Australia to act as a discussion topic for students.
In this article, a hybrid method is introduced by the two authors to create
efficient functional models for the Lorenz curve from the single-parameter
functional forms. A set of models are created and first tested using income
distribution data from the United States. The test show that the models
perform well. Then as an application, one of their best models is then used
to study world income inequality between 1950 and 2006.
To be more specific, they show clearly step by step with the beginning of
how to set up models to draw Lorenz Curve. Then, the authors used one of
this models, served it on the U.S. data to calculate the residuals for the
model and prove that is their models are better compared to the old ones in
criteria of accuracy. From that, they took the best model to measure the
inequality of the world. Finally, the results for the research are quite
interesting and at the same time they also proves that model they are
consistent with the original theory of the density distribution of Lorenz
Curve.
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In this report, our group would like to summarize as much as possible the
basic knowledge of the theory, as well as show our outcome after
investigating the complementary article: A hybrid method for creating
Lorenz Curve with an application to measuring world income inequality
of Wang and Smyth in 2013.

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THEORY
I. OVERVIEW OF INEQUALITY METRICS
The concept of inequality is distinct from that of poverty and fairness.
Income inequality metrics or income distribution metrics are used by social
scientists to measure the distribution of income, and economic inequality
among the participants in a particular economy, such as that of a specific
country or of the world in general. While different theories may try to
explain how income inequality comes about, income inequality metrics
simply provide a system of measurement used to determine the dispersion
of incomes.
Income distribution has always been a central concern of economic theory
and economic policy. Classical economists such as Adam Smith, Thomas
Malthus and David Ricardo were mainly concerned with factor income
distribution, that is, the distribution of income between the main factors of
production, land, labor and capital. It is often related to wealth distribution
although separate factors influence wealth inequality.
Defining Income
All of the metrics described below are applicable to evaluating the
distributional inequality of various kinds of resources. Here the focus is on
income as a resource. As there are various forms of "income", the
investigated kind of income has to be clearly described.
One form of income is the total amount of goods and services that a person
receives, and thus there is not necessarily money or cash involved. If a
subsistence farmer in Uganda grows his own grain, it will count as income.
Services like public health and education are also counted in. Often
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expenditure or consumption (which is the same in an economic sense) is
used to measure income. The World Bank uses the so-called "living
standard measurement surveys" to measure income. These consist of
questionnaires with more than 200 questions. Surveys have been
completed in most developing countries.
Applied to the analysis of income inequality within countries, "income"
often stands for the taxed income per individual or per household. Here
income inequality measures also can be used to compare the income
distributions before and after taxation in order to measure the effects of
progressive tax rates.
Some common metrics of measuring inequality
Among the most common metrics used to measure inequality are the Gini
index (also known as Gini coefficient), the Theil index, and the Hoover
index.
Gini index
The range of the Gini index is between 0 and 1 (0% and 100%), where 0
indicates perfect equality and 1 (100%) indicates maximum inequality.
The Gini index is the most frequently used inequality index. The reason for
its popularity is that it is easy to understand how to compute the Gini index
as a ratio of two areas in Lorenz curve diagrams. As a disadvantage, the
Gini index only maps a number to the properties of a diagram, but the
diagram itself is not based on any model of a distribution process. The
"meaning" of the Gini index only can be understood empirically.
Additionally the Gini does not capture where in the distribution the
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inequality occurs. As a result two very different distributions of income
can have the same Gini index.
20:20 Ratio
The 20:20 or 20/20 ratio compares how much richer the top 20% of
populations are to the bottom 20% of a given population, this can be more
revealing of the actual impact of inequality in a population, as it reduces
the effect on the statistics of outliers at the top and bottom and prevents the
middle 60% statistically obscuring inequality that is otherwise obvious in
the field. The measure is used for the United Nations Development
Program Human Development Indicators. The 20:20 ratio for example
shows that Japan and Sweden have a low equality gap, where the richest
20% only earn 4 times the poorest 20%, whereas in the UK the ratio is 7
times and in the US 8 times. Some believe the 20:20 ratio is a more useful
measure as it correlates well with measures of human development and
social stability including the index of child well-being, index of health and
social problems, population in prison, physical health, mental health and
many others.
Palma ratio
The Palma ratio is defined as the ratio of the richest 10% of the population's
share of gross national income divided by the poorest 40%'s share. It is
based on the work of Chilean economist Gabriel Palma who found that
middle class incomes almost always represent about half of gross national
income while the other half is split between the richest 10% and poorest
40%, but the share of those two groups varies considerably across
countries.
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The Palma ratio addresses the Gini index's over-sensitivity to changes in
the middle of the distribution and insensitivity to changes at the top and
bottom, and therefore more accurately reflects income inequality's
economic impacts on society as a whole. Palma has suggested that
distributional politics pertains mainly to the struggle between the rich and
poor, and who the middle classes side with.
Hoover index
The Hoover index is the simplest of all inequality measures to calculate: It
is the proportion of all income which would have to be redistributed to
achieve a state of perfect equality.
In a perfectly equal world, no resources would need to be redistributed to
achieve equal distribution: a Hoover index of 0. In a world in which all
income was received by just one family, almost 100% of that income would
need to be redistributed (i.e., taken and given to other families) in order to
achieve equality. The Hoover index then ranges between 0 and 1 (0% and
100%), where 0 indicates perfect equality and 1 (100%) indicates
maximum inequality.
Theil index
A Theil index of 0 indicates perfect equality. A Theil index of 1 indicates
that the distributional entropy of the system under investigation is almost
similar to a system with an 82:18 distribution. This is slightly more unequal
than the inequality in a system to which the "80:20 Pareto principle"
applies. The Theil index can be transformed into an Atkinson index, which
has a range between 0 and 1 (0% and 100%), where 0 indicates perfect
equality and 1 (100%) indicates maximum inequality.
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The Theil index is an entropy measure. As for any resource distribution
and with reference to information theory, "maximum entropy" occurs once
income earners cannot be distinguished by their resources, i.e. when there
is perfect equality. In real societies people can be distinguished by their
different resources, with the resources being incomes. The more
"distinguishable" they are, the lower is the "actual entropy" of a system
consisting of income and income earners. Also based on information
theory, the gap between these two entropies can be called "redundancy". It
behaves like negative entropy.
For the Theil index also the term "Theil entropy" had been used. This
caused confusion. As an example, Amartya Sen commented on the Theil
index: "given the association of doom with entropy in the context of
thermodynamics, it may take a little time to get used to entropy as a good
thing." It is important to understand that an increasing Theil index does not
indicate increasing entropy, instead it indicates an increasing redundancy
(decreasing entropy).
High inequality yields high Theil redundancies. High redundancy means
low entropy. But this does not necessarily imply that a very high inequality
is "good", because very low entropies also can lead to explosive
compensation processes. Neither does using the Theil index necessarily
imply that a very low inequality (low redundancy, high entropy) is "good",
because high entropy is associated with slow, weak and inefficient resource
allocation processes.
There are three variants of the Theil index. When applied to income
distributions, the first Theil index relates to systems within which incomes
are stochastically distributed to income earners, whereas the second Theil
index relates to systems within which income earners are stochastically
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distributed to incomes. A third "symmetrized" Theil index is the arithmetic
average of the two previous indices. Interestingly, the formula of the third
Theil index has some similarity with the Hoover index (as explained in the
related articles). As in case of the Hoover index, the symmetrized Theil
index does not change when swapping the incomes with the income
earners. How to generate that third Theil index by means of a spreadsheet
computation directly from distribution data is shown below.
An important property of the Theil index which makes its application
popular is its decomposability into the between-group and within-group
component. For example, the Theil index of overall income inequality can
be decomposed in the between-region and within region components of
inequality, while the relative share attributable to the between-region
component suggests the relative importance of spatial dimension of income
inequality.
However, to the extent of this report, we just analyze the two main
inequality metrics: Lorenz Curve and Gini coefficient, which are presented
in the following parts.
Properties of Inequality Metrics as in Lorenz Curve and Gini
coefficient
In the economic literature on inequality four properties are generally
postulated that any measure of inequality should satisfy. These four
properties could be considered the major characteristics of them including
Lorenz Curve and Gini Coefficient.
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Anonymity
This assumption states that an inequality metric does not depend on the
"labeling" of individuals in an economy and all that matters is the
distribution of income. For example, in an economy composed of two
people, Mr. Smith and Mrs. Jones, where one of them has 60% of the
income and the other 40%, the inequality metric should be the same
whether it is Mr. Smith or Mrs. Jones who has the 40% share. This property
distinguishes the concept of inequality from that of fairness where who
owns a particular level of income and how it has been acquired is of central
importance. An inequality metric is a statement simply about how income
is distributed, not about who the particular people in the economy are or
what kind of income they "deserve".
Scale independence
This property says that richer economies should not be automatically
considered more unequal by construction. In other words, if every person's
income in an economy is doubled (or multiplied by any positive constant)
then the overall metric of inequality should not change. Of course the same
thing applies to poorer economies. The inequality income metric should be
independent of the aggregate level of income.
Population independence
Similarly, the income inequality metric should not depend on whether an
economy has a large or small population. An economy with only a few
people should not be automatically judged by the metric as being more
equal than a large economy with lots of people. This means that the metric
should be independent of the level of population.
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Transfer principle
The PigouDalton, or transfer principle, is the assumption that makes an
inequality metric actually a measure of inequality. In its weak form it says
that if some income is transferred from a rich person to a poor person, while
still preserving the order of income ranks, then the measured inequality
should not increase. In its strong form, the measured level of inequality
should decrease.
II. LORENZ CURVE
Definition:
Lorenz Curve is a graph depicting the variance of the size distribution of
income from perfect equality.
How to construct a Lorenz Curve?
The standard framework can be built up in four stages.
First, we draw a set of axes in which the number of income recipients are
plotted on the horizontal axis (or the x-axis), not in absolute terms but in
cumulative percentage while the vertical axis (or the y-axis) shows the
cumulative share of total income received by each percentage of
population. Usually, the graphs axes are closed off to form a square.
The second stage requires us to order the distribution from the smallest
through to the largest, thereby enabling us to answer the following
sequential questions:
(a) What proportion of income is owned by the poorest 10 percent of the
population?
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(b) What proportion of income is owned by the poorest 20 percent of the
population?
(c) What proportion of income is owned by the poorest 30 percent of the
population?
This process continues until we reach the point where 100 per cent of
wealth is owned by 100 per cent of the population. The third step is to
assume that we live in a truly equal society. If this were to be the case, the
relationship would be such that the percentage of income received is
exactly equal to the percentage of income recipients. For example, as we
move along the x-axis, each 10 per cent increment of population would
own an additional 10 per cent of income. In this case, the diagonal line that
is drawn from the lower left corner (the origin) of the square to the upper
right corner is known as the line of absolute equality and will have a slope
of 45 degrees.
Finally, the most important step is to draw the Curve. We can insert a line
that is based on the data set available to us. In this case, the line will bow
away from the line of absolute equality. This line is known as the Lorenz
Curve. With increasing inequality, the Lorenz Curve starts to fall below the
diagonal in a loop that is always bowed out to the right of the diagram; it
cannot curve to the other way. The slope of the curve at any point is simply
the contribution of the population at that point to the cumulative share of
income. Because we have ordered income recipients from poorest to
richest, this marginal contribution cannot ever fall. This is the same as
saying that the Lorenz Curve can never get flatter as we move from left to
right. The overall distance between the diagonal line (the 450 line) and
the Lorenz Curve is indicative of the amount of inequality present in the
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society that it represents. The greater the extent of the inequality, the
further the Lorenz Curve will be from the diagonal line.

Figure 1: How to construct a Lorenz Curve?
Calculation
The Lorenz curve can usually be represented by a function L(F), where F,
the cumulative portion of the population, is represented by the horizontal
axis, and L, the cumulative portion of the total wealth or income, is
represented by the vertical axis.
For a population of size n, with a sequence of values y
i
, i = 1 to n, that are
indexed in non-decreasing order (y
i
y
i
+1), the Lorenz curve is
the continuous piecewise linear function connecting the points (Fi, Li), i =
0to n, where F0 = 0, L0 = 0, and for i = 1to n:

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Note that the statement that the Lorenz curve gives the portion of the wealth
or income held by a given portion of the population is only strictly true at
the points defined above, but not at the points on the line segments between
these points. For instance, in a population of 10 households, it doesn't make
sense to say that 45% of them earn a certain portion of the total. If the
population is modeled as a continuum then this subtlety disappears.
For a discrete probability function f(y), let yi, i = 1to n, be the points with
non-zero probabilities indexed in increasing order (y
i
< y
i
+1).
The Lorenz curve is the continuous piecewise linear function connecting
the points (Fi, Li), i = 0to n, where F0 = 0, L0 = 0, and for i = 1to n:

For a probability density function f(x) with the cumulative distribution
function F(x), the Lorenz curve L(F(x)) is given by:

For a cumulative distribution function F(x) with inverse x(F), the Lorenz
curve L(F) is given by:

The previous formula can still apply by generalizing the definition of x(F):
x(F1) = inf {y : F(y) F1}
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Properties
A Lorenz curve always starts at (0,0) and ends at (1,1).
The Lorenz curve is not defined if the mean of the probability distribution
is zero or infinite.
The Lorenz curve for a probability distribution is a continuous function.
However, Lorenz curves representing discontinuous functions can be
constructed as the limit of Lorenz curves of probability distributions, the
line of perfect inequality being an example.
The information in a Lorenz curve may be summarized by the Gini
coefficient and the Lorenz asymmetry coefficient.
The Lorenz curve cannot rise above the line of perfect equality. If the
variable being measured cannot take negative values, the Lorenz curve:
- cannot sink below the line of perfect inequality,
- increasing and convex.
Advantages
First, the Lorenz Curve provides a visual presentation of the information
we wish to consider, in this case the inequality of the income distribution
prevailing in the society.
Second, we could superimpose the Lorenz Curves onto the same diagram
to show changes in the way in which income has been distributed across
society at various points in time.
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In general, the advantage of using Lorenz Curve to show income inequality
is that the shape and the position of the curve can indicate the income
inequality well.
Limitations
Lorenz Curve is not a quantitative measure of inequality in income
distribution:
Despite the Lorenz Curves visual presentation in order to point out the
inequality of income, Lorenz Curve is not a quantitative measure of
inequality in income distribution. On the other hand, even when comparing
the Lorenz Curves between countries in a visual way, in many cases, we
cannot conclude which country has a higher level of inequality. If the
Lorenz Curves do not intersect, the curve that is further from the diagonal
line shows a higher level of income distribution inequality. However, in
case the Lorenz Curves intersect, it would be difficult to judge the
difference of income distribution. As shown in Figure 2, when the two
Lorenz Curves B and C cross, we need more information or additional
assumptions before we can determine which of the underlying economies
is more equal.

Figure 2: Four possible Lorenz Curves
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The amount of inequality may be misleading:
If richer households are able to use their incomes more efficiently than
lower income households, the amount of inequality could be understated.
Lorenz curve ignores life cycle effects:
The measurement of income inequality with a Lorenz curve shows income
distribution only at a given time while an individuals income varies over
his lifetime, and this variation is not considered when analyzing inequality
using a Lorenz curve. For instance, the income of a sports man and of a
lecturer may be about the same over their lifetimes. But the income of the
lecturer may be spread over a number of years say for 40 years whereas
that of sports man may be realized in 10 years. Hence, the two incomes are
likely to be highly unequal in a given year
Not Based on Disposable Income:
The Lorenz curve is based on the data relating to money income rather than
disposable income. It does not take into consideration personal income
taxes, social security deductions, subsidies received by the poor families
etc. Moreover, the data are converted to a per capita basis to adjust for
differences in average family size within each quintile (5th) or decile (10th)
group of the population. As a consequence, smaller families may
sometimes be shown better off than large ones with greater incomes.
Does not consider age Differences: The construction of a Lorenz curve
does not consider the ages of the persons, who receives income. The
income of a young individual who enters jobs recently those in mid-career
and of old people who have retired are not the same. But the Lorenz curve
does not distinguish incomes by ages and reflects inequalities across all
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ages. It is therefore not correct to group the incomes of the people
belonging to different age groups for measuring income inequality.
III. GINI COEFFICIENT
Definition
Gini coefficient is an aggregate numerical measure of income inequality
ranging from 0 (perfect equality, everyone in the society has exactly the
same amount of wealth) to 1 (perfect inequality, one person has all the
wealth and everyone else has nothing). 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, the higher the inequality of income
distribution; the lower it is, the more equal the distribution of income.
Ways to present Gini coefficient
Gini coefficient is a summary statistic. We can present Gini Coefficient in
2 main ways:
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Time series trend
The y-axis represents the percentage of Gini coefficient while the X-axis
represents the years the Gini index was calculated.

Cross section figures
The table gives Gini coefficient of 15 counties on different year base.

Figure 3: Time series trend
Figure 4 Cross section figures
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Calculation
The Gini index is defined as a ratio of the areas on the Lorenz curve
diagram. The Gini index can be calculated through various mathematic
methods such as: integration, discrete probability function, cumulative
distribution function, relative mean difference, lognormal distribution, a
combination of techniques for interpolation, trapezoid estimation, or a
trick regression model (Ogwang 2000) and of course the hybrid method
of the two author Zuxiang Wang and Russell Smyth 2013.
Advantages
Gini coefficient has features that make it useful as a measure of dispersion
in a population, and inequalities in particular. It is a ratio analysis method
making it easier to interpret. It also avoids references to a statistical average
or position unrepresentative of most of the population, such as per capita
income or gross domestic product. For a given time interval, Gini
coefficient can therefore be used to compare diverse countries and different
regions or groups within a country; for example states, counties, urban
versus rural areas, gender and ethnic groups. Gini coefficients can be used
to compare income distribution over time, thus it is possible to see if
inequality is increasing or decreasing independent of absolute incomes.
Limitations
Although Gini coefficient quantifies the degree of inequality of income
distribution, but economists found that the Gini coefficient reflects only the
most general aspects of the distribution of income, in some cases, not
assess specific issues.
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Different income distributions with the same Gini coefficient
Even when the total income of a population is the same, in certain
situations two countries with different income distributions can have the
same Gini index (e.g. cases when income Lorenz Curves cross).
Economies with similar incomes and Gini coefficients can have very
different income distributions
Extreme wealth inequality, yet low income Gini coefficient
A Gini index does not contain information about absolute national or
personal incomes. Populations can have very low income Gini indices, yet
simultaneously very high wealth Gini index. By measuring inequality in
income, the Gini ignores the differential efficiency of use of household
income. By ignoring wealth (except as it contributes to income) the Gini
can create the appearance of inequality when the people compared are at
different stages in their life.
Small sample bias sparsely populated regions more likely to have
low Gini coefficient
Gini index has a downward-bias for small populations. Counties or states
or countries with small populations and less diverse economies will tend to
report small Gini coefficients. For economically diverse large population
groups, a much higher coefficient is expected than for each of its regions.
The Gini coefficient measure gives different results when applied to
individuals instead of households, for the same economy and same income
distributions. If household data is used, the measured value of income Gini
depends on how the household is defined. When different populations are
not measured with consistent definitions, comparison is not meaningful.
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Gini coefficient is unable to discern the effects of structural changes
in populations
Expanding on the importance of life-span measures, the Gini coefficient as
a point-estimate of equality at a certain time, ignores life-span changes in
income. Typically, increases in the proportion of young or old members of
a society will drive apparent changes in equality, simply because people
generally have lower incomes and wealth when they are young than when
they are old. Because of this, factors such as age distribution within a
population and mobility within income classes can create the appearance
of inequality when none exist taking into account demographic effects.
Thus a given economy may have a higher Gini coefficient at any one point
in time compared to another, while the Gini coefficient calculated over
individuals' lifetime income is actually lower than the apparently more
equal (at a given point in time) economy's. Essentially, what matters is not
just inequality in any particular year, but the composition of the distribution
over time.
Egalitarianism aspect:
Another limitation of Gini coefficient is that it is not a proper measure of
egalitarianism, as it is only measures income dispersion. For example, if
two equally egalitarian countries pursue different immigration policies, the
country accepting a higher proportion of low-income or impoverished
migrants will report a higher Gini coefficient and therefore may appear to
exhibit more income inequality.
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Gini coefficient falls yet the poor get poorer, Gini coefficient rises yet
everyone getting richer
The income of poorest fifth of households can be lower when Gini
coefficient is lower, than when the poorest income bracket is earning a
larger percentage of all income. This is counter-intuitive and Gini
coefficient cannot tell what is happening to each income bracket or the
absolute income.
Inability to value benefits and income from informal economy affects
Gini coefficient accuracy
Some countries distribute benefits that are difficult to value. Countries that
provide subsidized housing, medical care, education or other such services
are difficult to value objectively, as it depends on quality and extent of the
benefit. In absence of free markets, valuing these income transfers as
household income is subjective. The theoretical model of Gini coefficient
is limited to accepting correct or incorrect subjective assumptions.
IV. OTHER USES OF LORENZ CURVE AND GINI COEFFICIENT
The Lorenz Curve and Gini coefficient can in theory be applied in any field
of science that studies a distribution. For example, in ecology the Lorenz
Curve has been used as a measure of biodiversity, where the cumulative
proportion of species is plotted against cumulative proportion of
individuals. In health, it has been used as a measure of the inequality of
health related quality of life in a population. In education, it has been used
as a measure of the inequality of universities. In chemistry it has been used
to express the selectivity of protein kinase inhibitors against a panel of
kinases. In engineering, it has been used to evaluate the fairness achieved
by Internet routers in scheduling packet transmissions from different flows
PAGE 27
of traffic. In statistics, building decision trees, it is used to measure the
purity of possible child nodes, with the aim of maximizing the average
purity of two child nodes when splitting, and it has been compared with
other equality measures. The Gini coefficient is sometimes used for the
measurement of the discriminatory power of rating systems in credit risk
management.

PAGE 28
APPLICATION
ZUXIANG WANG AND RUSSELL SMYTH
1. Structure of the article A hybrid method for creating
Lorenz Curve with an application to measuring world
income inequality
ZuXiang Wang and Russell Smyth has written a discussion paper
proposing a new method to create Lorenz Curves. They believe that their
method not also provide acceptable accuracy but also satisfies the
condition of the Lorenz Curve in terms of its density distribution.
First, in their paper, they suggest, propose and introduce the hybrid method
for building convex combination models for the Lorenz Curve and
demonstrate how to build Lorenz models from the forms generated.
Then, to test the performance of their proposed models, they use the data
of the US income distribution which previously also used by several other
economists for easier comparison. The results showed that their models
perform well with less residuals than other methods.
After that, they use one of their best models to apply on studying global
income inequality. Their results are investigated by our groups and will be
presented hereafter.

PAGE 29
2. Findings from Lorenz Curves for selected years (1950,
1960, 1970, 1980, 1990, 2000 and 2005)

Figure 5: Lorenz curves for selected year
a) Comparing global inequality while two Aggregate Lorenz curves
separate (do not intersect each other)
As we can see from the chart above, from 1950 to 2005, there are many
fluctuations in the inequality all over the World. Normally, based on two
different Lorenz Curves, we can compare the inequality in different years.
PAGE 30
For example, we can conclude from the graph that inequality in 1960 is
more than in 1950 (1960> 1950), 2005> 1950, 1960> 1970, 2000> 1980,
1960> 1990, 1960> 2005.
Take an example of the year 1950-1960: the inequality increases rapidly

Figure 6: Lorenz Curves for 1950 and 1960 (by Wang and Smyth)
Explanation: The vast majority of developing countries had lower
growth rates than high income OECD countries since high-income
countries became richer for the achievements from Industrial
Revolution while the poor remained poor. In some African countries
researched, there were even crisis in their political and economic
environment.
PAGE 31
b) Comparing global inequality while two Aggregate Lorenz curves
intersect each other
However, there are some situations in which the two Lorenz Curves
intersect each other. In these cases, though we may be able to rank some
subsets contained in the entire set of all the aggregate Lorenz curves, we
cannot rank the entire set itself.
Take an example of the year 2000-2005:

Figure 7: Lorenz Curves for 2000 and 2005 (by Wang and Smyth)

- Increase in the proportion of Income in the poorest 40% of the
population (0-40
th
percentile)
Explanation: Improvement in global economic environment with
developing regions adopting macro economies and social policies.
Most developing and transition economies got high rapid GDP
growth and benefited from rapid expansion of World Trade and
PAGE 32
also, easier access to global finance and rising migrant
remittances. More developing and transition economies began and
resumed the catching process.
- Increase in the proportion of Income in the richest 30% of the
population (70-100
th
percentile)
Explanation: In most OECD countries, the household income of the
top decile was growing faster than that of the bottom decile and the
total population due to an under-proportional increase of the real
wages compared to productivity, the over-proportional increase of
top management and superstar wages, and the unevenly distributed
capital income.
The accumulative Income increases in both the rich and the poor, so we
cannot conclude how the inequality changes from 2000-2005 by just
comparing the two Lorenz Curve as stated. Therefore, we will need another
component in order to find conclusion for this situation and that is the
Aggregate Gini Coefficient.

PAGE 33
3. Findings from the trend of AG, its decomposition and
average PPP of the world

Figure 8: The trend of AG, its decomposition and average PPP of the
world.

Figure 8 graphs the trend in world inequality over the period 1950 to 2006. This
figure also represents the link between AG (Aggregate Gini) and the between
contribution, the within contribution plus residual and the average PPP income
per capita. The between contribution is the income inequality between different
countries; the within contribution expresses the economic inequality between
individuals or households in one country.
- The AG is high for almost all the years considered. There are 19, out of
57 years in which the AG was larger than 0.6. There are 36 years in which
PAGE 34
AG was larger than 0.55 and there are 13 years in which the AG was less
than 0.5: this means the total inequality of the world (including the
inequality among individuals in a country and the inequality among
countries) is very high. The world as a whole has been suffering from high
inequality for a long time.
- The contribution of the between contribution is the main component of
the AG. There are 42 years in which the within contribution is less than
0.1 and 22 years in which the value is less than 0.05. The average within-
contribution across the period studied is only about 18% while the average
between contribution is about 64%. Therefore, the reason for the large
AG is not the within contribution, but the large income disparity between
countries. This means the inequality among countries are more visible
and contributes more to the total inequality of the world than the
inequality across individuals within each country does.
- From 1960 to 1966: Though it is larger than 0.2 for most of the 1
st
decade
considered, the within contribution (the intra-country income inequality)
falls in 1960 and kept low since then until 1966 at the expense of the rise
of inter-country income inequality during this period. There are several
reasons for this: First, from 1960, the vast majority of developing
countries had lower growth rates than high income OECD countries,
high-income countries became richer for the achievements from
Industrial Revolution. Second, before 1960, the authors only examined 4-
6 countries while since 1960, the authors increased the sample size to 10
countries and most of them are poor countries which may lead to the over-
increase in the proportion of poor countries and make inter-country
inequality increase.
- From 1966 to 1978: the within contribution increased but the AG
decreased, meaning the between contribution decreased and the rate of
this decrease must be large enough to offset the increase in the within
contribution. This can be explained by the stagflation in high income
countries. 1970s is the time of great inflation and stagnation in
PAGE 35
industrialized countries. The first oil shock also happened in this period.
And also because of the break-down of the Bretton Woods fixed exchange
rate systems and the maturity in Japanese economy, high-income
countries became poorer and suffered from very low growth rates.
Therefore, the inter-country income inequality reduced during this
period. While in India, Indian people were enjoying their first
achievements after a long time being invaded by the English people and
having wars with their neighbor Pakistan.
- In 1978, the Aggregate Gini dropped from more than 0.5 to only 0.3 and
the within contribution (intra-country inequality) contributed more than
90% of this index. This happened not because of any social or political
reason but because of the sample size of the study. In this year, the authors
took only 4 countries into account and these countries are: Barbados,
Germany, Italy and UK. All these countries are medium to high income
countries in the West, there were hardly any income disparity between
these countries. The main component of the AG in this year was then the
inequality within each of 4 countries, which were also very low compared
to that of other developing countries.
- From 1978 to 1983, the between contribution (or inter-country income
inequality) was growing again, making the AG increase in total. This
period as we have known is the time of capital explosion with the freer
flows of capital around the world. The developed countries started to
grow fast and gained back what they lost during the stagflation period
thanks to the Keynesianism. On the other side of the world, there were the
sluggish growth performance in Latin America (following the debt crisis
and the neoliberal reforms), the decline in Eastern European/former
Soviet Union incomes (following the collapse of the Eastern Bloc and the
subsequent free market reform), and due to the disastrous economic
developments within many African economies.
- From 1983 to 2000, the Aggregate Gini index and its components
stabilized. It is because there were no significant economic shock during
PAGE 36
this period or because the growth of many countries all over the world has
offset each other (the China gained success in their economic reforms
while the high-income countries also grew steadily) so the inter-country
income inequality remain unchanged.
- From 2000, there were an upward trend of within contribution and a
downward trend of the between contribution. This happened because of
many reasons. First, the intra-country inequality increase significantly
because of wage dispersion, technological change, demographic
changes, returns on capital, inheritance and initial inequality differences
and changes in income distribution policies and taxation policies.
According to recent empirical results, the most important reason for the
increasing income inequality in OECD was that in most of these countries
the household income of the top decile was growing faster than that of the
bottom decile and the total population. This increase in top incomes can
be mainly explained by an under-proportional increase of the real wages
compared to productivity, the over-proportional increase of top
management and superstar wages, and the unevenly distributed capital
income. The redistributive policies became weaker and could not offset
the growth in income inequality in this period. The rise of the top income
shares was the increase in business profits (i.e. by the relative high
dividends for shareholders) and top management salaries (including
bonuses and stock options), which suggests that changes in the income at
the very top explain most of the increase in income inequality in OECD
countries.
The downward trend of the between inequality happened because
of many reasons also: Improvement in global economic environment,
developing regions adopting proper macro economies and social
policies. Most developing and transition economies got high rapid GDP
growth and benefited from rapid expansion of World Trade and also,
easier access to global finance and rising migrant remittances. More
PAGE 37
developing and transition economies began and resumed the catching
process.
4. Density distribution function:
The density distribution function explains why the 1960 Lorenz curve
represent the most inequality.

Figure 6 shows that the relationship of the corresponding densities is also
complex. The difference between the curves is attributable primarily to
the low-income portion of the distributions. The curve for 1960 is
different from the others, with a large population in the low-income
portion. The curve for 1950 has the most uniformly distributed population
among the seven distributions, and, therefore, suggests the least income
inequality. The curves for 1980 and 2000 can be regarded alike, and
similarly those for 1970, 1990 and 2005 can be seen as consisting of
another group. The curves in the latter group seem to have less positive
skew than those in the former.
OTHER AUTHORS FINDINGS:
Beside the application of Wang and Smyths method of measuring worlds
income inequality, many other economists have also conducted their own
PAGE 38
studies and produced different findings. There are findings that have
similar results, supporting our two authors figures, but there are others that
are quite different from previous findings. We would like to list some of
them here to bring you a wider perspective on this issue:
1. A World Bank working paper by Branko Milanovic (2012):

Figure 9: Global Gini coefficient compared to the Ginis of selected
countries
In this research, Milanovic and his team found out that the Gini index is of
about 0.7 during the period from 1990 to 2010. Though there are some
small oscillations around the 0.7 level, the general trend is rather flat and
stable. In our authors research, the trend of the Aggregate Gini of the
world stabilized after 1983 and there is no huge change since then, which
partly confirm the trend in world income inequality. The level of the Gini
index is quite different, while in Milanovics research, the index is around
0.7, the index in Wang and Smyth study is around 0.6. Knowing that the 2
PAGE 39
studies receive data from one source which is WIID version 2, but
according to Wang and Smyth, they do not use all the figures presented in
the WIID 2 for their accuracy adjustment purpose at the expense of taking
less countries into account, and this lead to quite a different result in the
two pieces of research. Despite all of that, we still come to a conclusion
that the level of inequality in income of the world since 1990 is high (0.6
or 0.7) and the trend is stabilizing.

Figure 10: Lorenz Curve for the global income distribution in 1988 and
2008 by Milanovic 2012

Milanovic from World Bank also presented his findings in Lorenz Curves
for the two years 1988 and 2008, and when compared to the Lorenz Curve
in 1990 and 2000 in Figure 5 of Wang and Smyth research, we can realize
some similarities: the Lorenz Curve of 1988 and 1990 are dominated by
the Curve of 2008 and 2000 in both studies. This again confirms the
discovery that the world income distribution is becoming more equal with
the significant rise in income of the middle portion.
PAGE 40
2. Branko Milanovic (2010b)
Same Branko Milanovic but back to the year 2010, this author also
published his study on income inequality of the world but with a different
source of data. Therefore, once again there are differences with the Wang
and Smyth findings in terms of figures, however, the trend is similar in
some way, especially in inter-country income inequality or the between
contribution as written in the two articles.

As in weighted Gini coefficient from this chart, we can see that there were
a significant decrease in the inter-country income inequality during the
period from 2000 afterwards. This also happened in Wang and Smyths
line graph where the AG stabilize and the within contribution increase
significantly leading to the huge drop in Between contribution Gini index.
In terms of the figures, again, in these 2 graphs, there are discrepancies
between the 2 levels but the general idea is that they (inter-country
inequality indexes) are both high (above 0.5). In other words, the inequality
happened cross countries are high in general but positively quickly
PAGE 41
reducing in recent years. The reasons for this have been mentioned above
in this report.
3. Solt (2010)
Solt dataset in 2010 gave certainly interesting findings in intra-country (or
inequality within each country) Gini index. Here are 6 graphs showing the
trends of intra-country income inequality Gini indexes. As can be seen
easily from these graphs, the intra-country inequality or the within
contribution Gini indexes increased in most parts of the world, from High-
income countries, European, Central Asian, East Asian, South Asian to
Caribbean developing countries while the Middle East and Africa are the
only two areas that has the within inequality reduced in the period from
1990 to 2005 but only with a slight reduction. When summing up these
data, we can conclude that the within contribution of the world Gini index
increased during this period. So, again the trend in Wang and Smyth
research consents with this findings: the income inequality happened
between groups/individuals within a country is increasing during the
period 1990 to 2005.
PAGE 42

PAGE 43




Before going to older findings from other economists, lets sum up what
we have known so far in this part. We have been looking at several papers
which all consent or at least support the trends in the Wang and Smyth
paper. Those similarities are:
- The Aggregate Gini index of the world income inequality is high and
stable since 1983.
- The income inequality across countries all over the word is high and since
2000 the index has decreased significantly.
- The income inequality happened within each country seems to increase
at the expense of the reduction in the inter-country income inequality from
1990 to 2005.
4. Some discrepancies among economists all over the world:
To be more objective, we would like to note that: Due to the differences in
methodologies and data sources, many other authors have produced
different findings, even contrary to these papers. The earlier the papers
were written, the more different they are from the pieces of study we have
mentioned above. There always be improvements in methodology and
quality of data sources. Since all papers we have mentioned above are
written recently (from 2010 to 2013), the availability of data sources are
hugely differ from what available therebefore.
PAGE 45

Here we would like to present the various pathways of global income
inequality that some other economists have published. As can be seen from
this chart, there are many trends proposed by different authors, some of
them even contrast to the others. So, before any solid evidence and
completely thorough further research are conducted, all trends and figures
are for your own reference.
However, one thing that is in common from all studies available: the
world Gini index are always high above 0.5, which means there are
undeniable global inequality in income.

PAGE 46
CONCLUSION
In the Introduction, we shortly reviewed the background of two theories of
Lorenz Curve and Gini coefficient on the inventors, the publish time and
the name of the paper.
In the Theory, we have reviewed the definitions, way to construct and
calculate the Lorenz Curve and Gini coefficient. It is important to know
that Gini coefficient is a very powerful tool in measuring income
inequality. While Lorenz Curve can show how the income is distributed
among individuals or among countries, the Gini coefficient can give a more
specific figure on the inequality, especially when it comes to the
comparison over time. There are ones limitations that are also the
advantages of the other. The two tools complete each other and help the
economists as well as the governments achieve the so-called income
equality.
The applications of two economists Wang and Smyth, though have some
limitations, still provide interesting and informative findings about the
trends and the degree of the global income inequality. We are happy to
have a chance to know more about Gini decomposition into inter- and intra-
country inequality and about the reasons behind the increase and decrease
of those contributions. Recent changes in the global income inequality
showed some positive signs though it still depends on the viewpoint of the
policy maker. Even though each economist has their own way to calculate
and conclude about the income inequality of the world, it is undeniable that
the inequality of the world is high and varies among countries.
The more time we spent with this topic, the more serious and important it
is that we realized. We hope that this small work beside helping us in our
own study, can show our eagerness to learn and our gratitude to our
beloved teacher.
Sunshine Group
K50CLC2
March 3, 2014.