Close the skill gap with the Financial Modeling & Valuation Analyst (FMVA)® Certification >> Enroll today and save!

Economic Inequality

Wealth and income disparities that may exist in certain societies

What is Economic Inequality?

Economic inequality most often refers to disparities in wealth and income that may exist in certain societies. Economic inequality is a metric that many jurisdictions and governments monitor in order to assess the impact of policy changes.

 

Economic Inequality

 

How can we measure income inequality?

There are many ways to measure income inequality, and expert economists continue to debate which metric is the best. However, relying solely on one individual metric to assess income inequality can leave out a lot of information and skew the analysis. Thus, it is important to refer to income inequality indexes that take into account a wide array of economic metrics before coming to a conclusion.

Nonetheless, a very useful and widespread metric is the Gini coefficient. To understand this, we must first understand the economic relationship between the people’s level of income and the total share of wealth. The relationship is explained by the Lorenz Curve, which states that as people’s income increase, their relative share of wealth increases by a disproportionately large factor.

Thus, the amount of wealth held by the richest 10% or individuals in a society would be disproportionately larger than the wealth held by the bottom 10%. The graphic below illustrates this principle:

 

Lorenz Curve

 

Using the information above, we can calculate the Gini coefficient using the following formula:

Gini Coefficient = Area A / (Area A + Area B)

 

The higher the coefficient, the smaller area B is, meaning the lower the economic inequality is. A very low Gini coefficient would mean that area B is very large, which implies a greater degree of economic inequality.

 

Shortcomings of the Lorenz Curve

While the Lorenz Curve works very well in theory, it relies upon the magnitude of positive earned income to deliver accurate results. However, in many situations, individuals may show negative net worth due to being in debt.

In the US, there are over 16 million households with a negative net worth as a result of the phenomenon. If the fact is not taken into account when examining statistics about the levels of economic inequality, erroneous conclusions may be drawn.

For example, when we hear that the richest 20% of individuals hold over 90% of a nation’s wealth, there may cases where someone earns a large salary but is considered to be poorer than someone with a small salary due to debt.

 

Income inequality around the world

According to the Gini index, the top five countries with the lowest income inequality are:

  • Ukraine
  • Slovenia
  • Norway
  • Slovak Republic
  • Czech Republic

 

Conversely, the top five countries with the highest level of income inequality are:

  • The Central African Republic
  • Botswana
  • Haiti
  • Namibia
  • South Africa

 

Using the Gini coefficient

A Gini coefficient does not hold a lot of value and cannot be leveraged to draw conclusions by itself. In order to see useful insights, a Gini coefficient must:

  • Be compared to other Gini coefficients for nations that are of similar economic size and state, as it will enable us to rank countries. Such a process will provide us with a reference point that determines what a “High” or “Low” relative coefficient would be.
  • Be calculated using the same methodology – as differences in methodology may skew the results of the analysis. For instance, some researchers might compute the Gini coefficient using the Lorenz Curve approach, while others may use the extended Gini formula.
  • Be compared across a wide time horizon in order to observe how the level of economic inequality changed over time. It will also help establish reference points that will allow us to determine whether an economy is doing a good job of combatting income inequality.

 

More resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Fiscal Policy
  • Inflation
  • Purchasing Power Parity
  • Scarcity

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!