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Poverty and Inequality

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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 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

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.

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. 

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

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.

Yes, corruption increases income inequality and thus poverty.

Yes, globalization increases poverty and inequality.

Final Poverty and Inequality Quiz

Question

What is a firm’s main objective?

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Answer

Profit maximisation.

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Who are the customers of a firm?


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Individual customers, businesses, or governments.

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What are the financial goals of a firm?


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Profit maximisation, market share expansion.

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What is a firm's profit?


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The difference between the total costs and revenues.

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How to maximise a firm’s profit?


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 Profit is maximised when marginal costs equal marginal revenues.

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What are some non-financial objectives of a firm?


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Customer satisfaction, job satisfaction, corporate social responsibility.

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How to improve employees’ job satisfaction?


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Activities to boost job satisfaction can be taking care of employees’ well-being, offering incentives for good performance, providing an opportunity to learn, and communicating.

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Why is corporate social responsibility important?


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Corporate social responsibility (CSR) includes activities taken by companies to create a positive impact on the society and environment.

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Define government intervention.

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Government intervention is when a government is involved in the marketplace.

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Why do governments intervene in the marketplace?


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To overcome market failure.

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What are the types of government intervention?


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Taxes 

Subsidies 

Minimum and maximum prices 

Regulations

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What are subsidies?


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Subsidies are financial support to products with positive externalities.

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What are minimum prices?


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Setting a lower limit for prices by the government.

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What are the disadvantages of setting minimum prices?


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It can be costly for the government and force it to put tariffs on cheap imports – which damages the welfare of farmers in other countries.

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Give an example of maximum prices.


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The price for bread cannot be higher than 80p/100g.

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What can create a shortage?


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maximum prices

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What are regulations?


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Regulations include non-market based ways of intervention in markets.

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Give an example of regulations.


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Minimum age laws on alcohol, maximum CO2 emissions for vehicles, ban on diesel cars.

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What are the advantages of government intervention?


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The advantages of government intervention are equality, fighting monopolies, public goods, consumer behaviour and environmental protection.

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What are the disadvantages of government intervention?


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The disadvantages of government intervention are worsening the situation, limited choice of products, pressure and dicrimination.

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What are public goods?


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Some goods and services are not provided in a free market because they do not give any financial benefits. Instead, they can be provided by the government.

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What is government failure?


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Government failure is an economic inefficiency caused by government intervention. It is when the government intervenes in the market with good intentions, but in result, creates even more problems by either deepening the market failure or causing a new failure.

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What is monopolistic competition?

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Monopolistic competition is the market structure in which many firms compete to sell slightly differentiated products.

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What are the characteristics of monopolistic competition? 


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The characteristics are:

  • A large number of firms.
  • Slightly differentiated products.
  • No barriers to entry.
  • Firms are price makers. 

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What does the demand curve for individual firms in monopolistic competition look like?


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It is more elastic than the demand curve in monopoly, though not perfectly elastic as in perfect competition.

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Are firms in monopolistic competition price-takers or price-makers? 


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Price makers, though they have limited market power.

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How is the barrier to entry for a new firm in a monopolistic competition market?

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Low or no barrier to entry. Firms can enter and exit the market any time.

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How can firms in monopolistic competition differentiate their products? 


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Products in monopolistic competition can be differentiated with physical attributes such as taste, smell, and sizes, or intangible attributes such as brand reputation, and eco-friendly image.

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When does profit optimization happen in monopolistic competition? 


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At output Q where MC = MR.

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How can firms in monopolistic competition enjoy abnormal profit? 


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In the short-run, companies in a monopolistic market are able to earn abnormal profits at the output where marginal costs equal marginal revenues. 

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Do the abnormal profits in monopolistic competition last in the long run? 


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In the long, due to the increase in the number of firms, the price of the product will drop. Thus, the firms will only make normal profits. 

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What are some examples of fixed costs?

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Some examples of fixed costs include the maintenance costs of an office building, rent, salaries, interest on loans, advertising, and business rates.

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What are some examples of variable costs?

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 Some examples of variable costs include wage costs, basic raw materials (wood, metal, iron), energy costs, fuel costs, and packaging costs.

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What are total costs?

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The total costs (TC) of a company are the fixed costs (FC) and variable costs (VC) added together.

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What are average costs?


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The average cost (AC) or unit cost is calculated by dividing the firm’s total cost of production by the quantity (Q) of output produced.

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 What is the definition of market failure?

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Market failure is an economic term that describes the situation in which the markets perform inequitably (unfairly or unjustly) or inefficiently.

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What causes market failure?

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Market failure is caused by an inefficient allocation of resources which prevents supply and demand curves from meeting at the equilibrium point.

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Give an example of a market failure.

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The free-rider problem. This occurs when there are too many non-paying consumers using goods and services. For example, if too many non-paying consumers listen to the public radio station without giving a donation, the radio station should rely on other funds such as the government, to survive. 

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What does non-rival goods mean?


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The non-rival goods category means that if one person consumes this good it does not prevent another person from consuming it.

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What is the difference between exclusive and non-exclusive goods?


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Exclusive goods prevent non-paying customers from consuming this good. Non-exclusive goods do not prevent non-paying customers from consuming this good or service.

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What is the difference between pure and impure public goods?


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Pure public goods have both characteristics non-rival and non-exclusive while impure public goods have only one of those characteristics.

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What are the main types of market failure?


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  • Complete
  • Partial


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What does complete market failure mean?


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Complete market failure means that there are no goods supplied in the market at all.

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Give an example of a 'missing market'.


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If consumers would like to buy pink shoes, but there are no businesses that supply them. These results in missing markets for this good.

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What does a partial market failure mean?


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In this situation, the market still functions. However, the number of goods demanded does not equal the supply. This results in a shortage or excess supply and inefficient pricing of the goods.

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What are the main causes of market failure?


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  • Public goods

  • Negative externalities

  • Positive externalities 

  • Merit goods

  • Demerit goods

  • monopoly

  • Inequalities in the distribution of income and wealth 

  • Environmental concerns

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Give an example of how negative externalities cause market failure.

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Negative externalities are referred to as indirect costs to individuals. For example, production factories may be releasing dangerous chemicals into the air that may be harmful to people's health to lower the cost of production. This will cause market failure as due to lower production costs there will be excessive production that does not reflect the true product's price and an over-polluted environment.

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Give an example of how demerit goods cause a market failure.

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Demerit goods are harmful to society, such as alcohol and cigarettes. Market failure happens as smokers do not realize the effect that they have on society such as passing the smell and negatively impacting second-hand smokers. They can also cause long-term health problems for themselves and for others. This is all due to overconsumption of this demerit good.

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What does monopoly mean?


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Monopoly means that there is a single or only a few producers in the market which own a vast majority of the market share.


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Give an example of how unequal distribution of income and wealth causes market failure.


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The market failure can be caused by the unequal allocation of income and wealth. For example, due to technology someone receives an extremely high salary in comparison to average workers.

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