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Measuring Poverty and Inequality

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There are several kinds of poverty and inequality measuring tools, here are three ways to measure poverty and two measures of income inequality.

The World Bank defines poverty as inability to attain minimum standard of living.  The first way to measure poverty is by defining poverty line or poverty threshold which measures minimum living standards based on per capita income that is sufficient to provide a minimum acceptable level of consumption. The way to set consumption based poverty line is by PPP method and the food energy method. The PPP method reflects the cost to individuals to buy goods or services in the domestic market as a dollar in US. The PPP does not deal with intercountry differences in nutrition; because the composition of consumption is very likely differ in different countries. To handle this problem, the food energy method is used which defines minimum calorie intake using nutritional values of consumption goods. However, it’s still problematic as people in different countries may choose different combination of foods which require different incomes to meet nutritional requirements.

In practice, the World Bank assigned poverty line $1.251 which means the minimum level of income deemed necessary to achieve standard of living. This value comes from income or consumption data survey, estimation of PPP level, and World Bank comparison program. From the value of poverty line, the number of people under the poverty line can be measured using head count index.  The head count index ignores the extent to which the poor fall below the poverty line.  The third way to measure poverty is poverty gap index which measures the depth or intensity of poverty, how far the poor are below the poverty line.

The most used inequality measure is Gini index as a ratio of two areas in Lorenz curve2 diagrams values between 0 and 1.  A low Gini coefficient indicates more equal income or wealth distribution, while high Gini coefficient indicates more unequal distribution. 0 corresponds to perfect equality and 1 corresponds to perfect inequality. The problem with Gini index are: the measure will give different result when applied to individuals instead of households; it measures in certain time, ignores life-span changes in income; in some societies people may have significant income in other forms than money as in subsistence farming, the value of these incomes is difficult to quantify, thus will yield different Gini index.

Another inequality measurement is Theil index which is a weighted average of inequality within subgroups, plus inequality among those subgroups, means that Theil index has decomposability that Gini index doesn’t have. The Theil index is always positive, individual contributions to the Theil index may be negative or positive. But Gini index is more popular than Theil for it’s depicted on Lorenz curve which is more intuitive to understand.

1 The latest update, announced in March 2008 is $1.25 per day based on the latest available international PPP comparison for the year 2005. For further information in World Bank Report 1990, 2008.

2 The Lorenz curve is a graphical representation of the cumulative distribution function of a probability distribution; It is often used to represent income distribution, where it shows for the bottom x% of households, what percentage y% of the total income they have. It was developed by Max O. Lorenz in 1905 for representing income distribution.