AMANDA BELLUCCO-CHATHAM

What Is the Gini Index?

The Gini index, or Gini coefficient, measures income distribution across a population. Developed by
the Italian statistician Corrado Gini in 1912, it often serves as a gauge of economic inequality,
measuring income distribution or, less commonly, wealth distribution among a population. 1 2
The coefficient ranges from 0 (or 0%) to 1 (or 100%), with 0 representing perfect equality
and 1 representing perfect inequality. Values over 1 are theoretically possible due to negative
income or wealth.2
KEY TAKEAWAYS
 The Gini index is a measure of the distribution of income across a population.
 A higher Gini index indicates greater inequality, with high-income individuals receiving much
larger percentages of the total income of the population.
 Global inequality, as measured by the Gini index, has steadily increased over the past few
centuries and spiked during the COVID-19 pandemic.
 Because of data and other limitations, the Gini index may overstate income inequality and
can obscure important information about income distribution.
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Understanding the Gini Index
A country in which every resident has the same income would have an income Gini
coefficient of 0. Conversely, a country in which one resident earned all the income, while
everyone else earned nothing, would have an income Gini coefficient of 1.
The same analysis can apply to wealth distribution (the "wealth Gini coefficient"), but
because wealth is more difficult to measure than income, Gini coefficients usually refer to
income and appear simply as the "Gini coefficient" or "Gini index," without specifying that
they refer to income. Wealth Gini coefficients tend to be much higher than those for income.
The Gini coefficient is an important tool for analyzing income or wealth distribution within a
country or region, but it should not be mistaken for an absolute measurement of income or
wealth. A high-income country and a low-income one can have the same Gini coefficient, as
long as incomes are distributed similarly within each: For instance, Turkey and the United
States both have income Gini coefficients of around 0.39-0.40, according to the Organisation
for Economic Co-operation and Development (OECD), despite Turkey's vastly lower gross
domestic product (GDP) per person.3 4
Graphical Representation of the Gini Index
The Gini index is often represented graphically through the Lorenz curve, which shows
income (or wealth) distribution by plotting the population percentile by income on the
horizontal axis and cumulative income on the vertical axis. The Gini coefficient is equal to
the area below the line of perfect equality (0.5 by definition) minus the area below the Lorenz
curve, divided by the area below the line of perfect equality. In other words, it is double the
area between the Lorenz curve and the line of perfect equality.5 2
In the graph below, the 47th percentile corresponds to 10.46% in Haiti and 17.42% in
Bolivia, meaning that the bottom 47% of Haitians take in 10.46% of their nation's total
income and the bottom 47% of Bolivians take in 17.42% of theirs. The straight line
represents a hypothetically equal society: The bottom 47% take in 47% of national income.
To estimate the income Gini coefficient for Haiti in 2012, we would find the area below its
Lorenz curve: around 0.2. Subtracting that figure from 0.5 (the area under the line of
equality), we get 0.3, which we then divide by 0.5. This yields an approximate Gini of 0.6 or
60%.
Another way of thinking about the Gini coefficient is as a measure of deviation from perfect
equality. The further a Lorenz curve deviates from the perfectly equal straight line (which
represents a Gini coefficient of 0), the higher the Gini coefficient and the less equal the
society. In the example above, Haiti is more unequal than Bolivia.
The Gini Index Around the World
Global Gini
The Gini coefficient experienced sustained growth during the 19th and 20th centuries. In
1820, the global Gini coefficient stood at 0.50, while in 1980 and 1992, the figure was 0.657.6

Source: World Bank.

COVID-19 is likely to have a further negative impact on income equality. According to
the World Bank, the Gini coefficient has historically increased about 1.5 points in the five
years following major epidemics, such as Ebola and Zika. Economists believe COVID-19
triggered an annual 1.2 to 1.9 percentage points increase in the Gini coefficient for 2020 and
2021.6 7
Gini within countries
Below are the income Gini coefficients of every country for which the CIA World
Factbook provides data:
Some of the world's poorest countries have some of the world's highest Gini coefficients,
while many of the lowest Gini coefficients are found in wealthier European countries.
However, the relationship between income inequality and GDP per capita is not one of
perfect negative correlation, and the relationship has varied over time.8
Michail Moatsos of Utrecht University and Joery Baten of Tuebingen University show that
from 1820 to 1929, inequality rose slightly—then tapered off—as GDP per capita increased.
From 1950 to 1970, inequality tended to fall off as GDP per capita rose above a certain
threshold. From 1980 to 2000, inequality fell with higher GDP per capita then curved back up
sharply.9
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Correlation between Gini coefficients and GDP per capita in three time periods. Source: Moatsos and
Baten.
Limitations of the Gini Index
Though useful for analyzing economic inequality, the Gini coefficient has some
shortcomings.
The metric's accuracy is dependent on reliable GDP and income data. Shadow economies and
informal economic activity are present in every country. Informal economic activity tends to
represent a larger portion of true economic production in developing countries and at the
lower end of the income distribution within countries. In both cases, this means that the Gini
index of measured incomes will overstate true income inequality. Accurate wealth data is
even more difficult to come by due to the popularity of tax havens.
Another flaw is that very different income distributions can result in identical Gini
coefficients. Because the Gini attempts to distill a two-dimensional area (the gap between the
Lorenz curve and the equality line) down to a single number, it obscures information about
the "shape" of inequality. In everyday terms, this would be similar to describing the contents
of a photo solely by its length along one edge, or the simple average brightness value of the
pixels.
Though using the Lorenz curve as a supplement can provide more information in this respect,
it also does not show demographic variations among subgroups within the distribution, such
as the distribution of incomes across age, race, or social groups. In that vein, understanding
demographics can be important for understanding what a given Gini coefficient represents.
For example, a large retired population pushes the Gini higher.
What Country Has the Highest Gini Index?
South Africa, with a Gini coefficient of 63.0, is currently recognized as the country with the
highest income inequality. The World Population Review attributes this massive inequality to
racial, gender, and geographic discrimination, with white males and urban workers in South

Lorenz Curve
 Definition: The Lorenz curve is a way of showing the
distribution of income (or wealth) within an economy. It was
developed by Max O. Lorenz in 1905 for representing wealth
distribution.
 The Lorenz curve shows the cumulative share of income
from different sections of the population.
 If there was perfect equality – if everyone had the same
salary – the poorest 20% of the population would gain 20% of
the total income. The poorest 60% of the population would get
60% of the income.
Diagram of Lorenz curve

In this Lorenz curve, the poorest 20% of households have 5% of the

nation’s total income.

The poorest 90% of the population holds 55% of the total income. That
means the richest 10% of income earners gain 45% of total income.
Shift in the Lorenz Curve

In this example, there has been a reduction in inequality – the Lorenz

curve has moved closer to the line of equality.

 The poorest 20% of the population now gain 9% of total

income
 The richest 10% of the population used to gain 45% of
total income but now only get 25% of total income.
The Lorenz Curve and the Gini Coefficient

The Lorenz Curve can be used to calculate the Gini coefficient – another
measure of inequality.
The Gini coefficient is area A/A+B

The closer the Lorenz curve is to the line of equality, the smaller area A is.
And the Gini coefficient will be low.

If there is a high degree of inequality, then area A will be a bigger

percentage of the total area.

A rise in the Gini coefficient shows a rise in inequality – it shows the Lorenz
curve is further away from the line of equality.
Lorenz Curve and wealth

Wealth Inequality and Lorenz curve

The Lorenz curve shows the cumulative wealth of each wealth decile. It
shows that the lowest 38% of individuals have zero property wealth. The
top 10% own nearly 50% of property wealth.

With financial wealth, inequality is even greater with 60% of the

population in debt and negative wealth. The top 10% have 80% of the
nations financial wealth.

Source:
 Wealth in Great Britain ONS, published July 2012
Gini Coefficient in the UK

This shows that since 1979, the UK has seen a rise in inequality – especially
during the 1980s.
Measuring income inequality
Summary measures of inequality differ from one another and give
different pictures of the evolution of economic inequality over
time

Ija Trapeznikova
Royal Holloway University of London, UK
ONE-PAGERFULL ARTICLE
Elevator pitch
Economists use various metrics for measuring income inequality. Here, the most commonly
used measures—the Lorenz curve, the Gini coefficient, decile ratios, the Palma ratio, and the
Theil index—are discussed in relation to their benefits and limitations. Equally important is
the choice of what to measure: pre-tax and after-tax income, consumption, and wealth are
useful indicators; and different sources of income such as wages, capital gains, taxes, and
benefits can be examined. Understanding the dimensions of economic inequality is a key first
step toward choosing the right policies to address it.
Key findings
Pros

The Lorenz curve is a commonly used metric that allows for the quick and visual comparison
of inequality across countries.

The Gini coefficient uses information from the entire income distribution and is independent
of the size of a country’s economy and population.

Percentile ratios are easy to calculate and focus on a specific region of the distribution.

The Theil index can decompose inequality into within- and between-group inequality.

These commonly used measures are generally in agreement when comparing inequality
across countries.

Cons

If Lorenz curves cross they cannot provide a conclusive ranking between distributions.

The Gini coefficient values change depending on what is measured—wages, before-or after-
tax income, wealth, or consumption.

Percentile ratios fail to use all information since they ignore incomes between percentiles.

The Theil index is less intuitive and not directly comparable across populations with different
sizes or group structures.

The evolution of inequality within a country can appear different depending on the metric
used.

Author's main message

Despite the relative strengths and weaknesses of the available measures, empirical studies
show that they are mainly in agreement when comparing inequality differences across
countries. However, the evolution of inequality within a country or the effectiveness of a
specific policy can be perceived differently depending on the specific metric under
consideration, as well as what variable is being measured. For instance, if policymakers care
more about what happens to the poor they should use the Palma ratio instead of the Gini
coefficient as their inequality measure and focus on consumption instead of income data.

Motivation
There are many reasons why policymakers and researchers alike are concerned with a
country's degree of economic inequality. Recent studies show that persistent income
disparities among individuals are associated with poverty and deprivation, mental illness,
social unrest, and crime, as well as lower levels of education, employment, and life
expectancy [1]. Many public policies such as taxes, welfare benefits, provision of education
and health services, price, and competition regulations have distributional implications for
income.
How equally is income distributed across individuals in countries with different social
institutions, education systems, capital, and labor markets? How has inequality evolved over
time? How have income distributions changed after tax reforms or financial crises? To be
able to answer these important questions, a consistent measure of inequality is needed.

Discussion of pros and cons

Dimensions of economic inequality

Before choosing a particular metric, a decision must be made about the dimension of
economic inequality to be measured. This choice is important, not only from a conceptual
point of view, but also because it determines what instruments are available to policymakers
trying to correct a given distribution. The discussion in this article focuses on inequality in
outcomes, as opposed to inequality of opportunities (such as access to education, skills, and
other limitations imposed by parental circumstances or belonging to a low socio-economic
class). While the latter is undoubtedly important for understanding the factors behind
economic inequality, especially in the context of social mobility, this article relies on more
readily observable indicators of living standards, such as income and wealth. Many of the
measuring techniques described below, however, can be applied to inequality in education,
health, happiness, and life satisfaction in general.

When looking at disparities in income among individuals, it is necessary to distinguish

between income, wealth, and pay inequality. “Pay inequality” refers to differences in wages
paid to different people. This inequality can reflect differences in productivity of workers
(e.g. between low- or high-skilled workers), labor market discrimination between groups, or
differences in the nature of the job (e.g. miners and sales assistants).

“Income inequality” is the extent to which income is distributed unevenly across people or
across households. Income encompasses labor earnings (such as wages, salaries, and
bonuses), capital income derived from dividends, interest on savings accounts, rent from real
estate, as well as welfare benefits, state pensions, and other government transfers. In addition,
it is possible to distinguish between individual versus family income, pre-tax versus after-tax
(disposable) income, and labor earnings versus capital income.

The third dimension of economic inequality is differences in “wealth” distribution. While

income refers to the flow of money over a given period (say, a year or a month), an
individual's wealth represents the stock of all assets that a person holds. These include
financial assets, such as bonds and stocks, property, and savings. Income and wealth are not
perfectly correlated. For instance, a high earner might be in the upper end of the income
distribution while being relatively poor in terms of assets; likewise, an elderly worker might
have accumulated substantial wealth (e.g. owning a house) but have low labor earnings.
Different policies ranging from income and inheritance taxes to government schemes for
first-time home buyers will affect different groups of individuals and might have opposing
effects on wealth and income distributions.

Consumption versus income inequality

Some economists argue that “consumption” is a more appropriate indicator of persistent

inequality as it is closely related to permanent income [2]. Consumption inequality is
typically lower than income inequality because individuals can smooth temporary shocks to
income (such as a temporary layoff or the end of a seasonal job) through saving and
borrowing. Disparities in consumption better reflect differences across individuals in the
accumulation of assets, access to credit, or the social safety net. Recent studies use the link
between income and consumption variation to quantify the role of assets, taxes, transfers, and
family labor supply in insuring against permanent income shocks [3], [4].
In practice, the choice between income or consumption measures is often determined by data
availability. Advanced economies tend to collect high-quality income data, especially those
drawn from administrative tax records. Consumption data are particularly relevant for
developing countries, where it is difficult to obtain reliable estimates of income because a
large part of the population is self-employed, producing for their own consumption
(especially in agriculture), or being paid in kind. For this reason, World Bank Development
Indicators on inequality for the least developed countries are typically estimated on
household consumption expenditures.

Studies that look at the joint analysis of consumption and income data suggest that, while the level
of inequality in consumption is typically lower than in disposable income, the overall ranking of
countries is similar under both measures [5]. At the same time, the question of whether
consumption inequality tracks income inequality over time has been a subject of debate, with mixed
empirical results that differ depending on the data sources and methodology used for a literature
survey based on US data).
Unit of measurement

Another important issue for inequality statistics is the unit of measurement—whether it is an

individual, a tax-paying unit, a family, or a household. Given that income is often shared within a
family or a household, it might be more appropriate to look at disparities in household income, as
opposed to individual income. Typically, earnings dispersion among households is lower than among
individuals because of income pooling within the household, as well as the fact that families can
provide insurance against individual risks (e.g. a worker increasing their labor supply in response to
the job loss of their partner). The role of this family insurance mechanism has increased over time
due to a rise in female labor force participation.

Recession Recession - Is a decline in total output (GDP) for a period of two quarters or more. Unlike
Depression (or crisis) - is a period of prolonged and severe recession.
Labour force - is the total of those in employment plus the unemployed. The rate of unemployment
expressed as a percentage
unemployment × 100 %
unemployment rate
The labour force participation rate is measured as a percentage of the total population of working
age (usually defined as population aged from 16 to the statutory retirement age):
labour force participation rate = labour force × 100 %
total working age population

Factors of production - are the inputs of land, labour and capital used by firms to engage in
production.
Gross National Income (GNI) - Is the total income received by all residents (including individuals,
institutions and firms) of a country. However, Gross National Income (GNI) in a closed economy,
income from abroad would be zero, and GNI would therefore be the same as GDP.
The expenditure approach - to measuring the economy uses sales data, and survey data on
expenditure by domestic consumers, by government and by consumers and firms overseas buying
exports. The expenditure totalled is final expenditure on goods and services to be used by
consumers, overseas buyers or government; it does not include expenditure on goods supplied by
one domestic firm

The output approach - measures total output by adding up the value added at each stage in the
production of all the goods and services in the economy. Value added is the additional value given
by a firm to its intermediate goods in producing its output.

How is value added is calculated at each stage-Is The farmer produces the primary product – the
grain (1). The miller buys the grain as an input and mills (2) it; the value of the grain is therefore
subtracted from the value of the flour to calculate the miller’s value added in milling flour (2)-(1).
The baker’s (3) value added is calculated by subtracting the cost of the flour and other intermediate
goods from the value of the bread(3)-(2). The caterer’s (4)-(3) value added is calculated by
subtracting the cost of bread (3) and fillings from the value of the sandwiches(4). Finally, the
supermarket’s (5)value added to the wholesale

The total value added by producers within the economy, including production of services such as
education by government, adds up to the Gross Value Added (GVA) and is used to calculate GDP.
The primary sector 3% (farming, mining), which produced the initial grain; the secondary sector
excluding manufacturing 10% (manufacturing, construction and energy), plus Manufacturing 10%,
which milled the flour and produced the sandwiches; and the tertiary or services sector 48% , which
distributed lunch. The rest is Business and financial services 29%.
The tertiary sector is nowadays the largest sector in terms of GVA.

The rate of inflation of a country is measured by the rate of change in its price level. The rate of
inflation is calculated as
Consumer Price CP level in inflation rate = CP current period - CP previous period × 100%
CP level in previous period
A second method of measuring inflation is the GDP deflator, calculated as
GDP in current prices in year t = GDP in current prices in year t × 100
GDP at constant prices from base year
The choice of measure of inflation therefore depends on your interests: to measure real changes in
standards of living, the prices of consumer goods are key and so the appropriate indicator is the CPI
rather than the GDP deflator. The two indices may not necessarily move together: consumer prices
may rise more quickly or more slowly than general prices of domestic output, (the GDP deflator).

There are three types of positive inflation that it is useful to distinguish when looking at inflation
over time. First, under constant inflation, the price level increases at a fixed rate. In the first example
above, constant inflation over a particular period of time requires inflation to remain stable at a
fixed level of 6% (P284).

GDP can be measured in two ways: current prices and constant prices
If output in a given year is added up at the prices prevailing in that year, this gives GDP in current
prices or nominal GDP The difference between total output in two years measured in current prices
will therefore be influenced by both output changes and price changes between the two years.
If however, you want to measure just the growth (or decline) in output, without the price change,
then you can measure the output in each year at the prices prevailing in a specified year, chosen as
the base year. This gives a measure of GDP in constant prices or real GDP.

Nominal value - Is expressed in terms of prices at the time of measurement (current). Unlike
Real value - expressed in terms of prices in a specified base year.

Inflation, real living standards and recession: Inflation creeps up on you, gradually eroding your
standard of living. One effect is akin to an acute disease; the other is more like a chronic illness. So,
to distinguish between nominal wage and their real wage.: The nominal wage is the money
received for paid work. The standard of living, however, depends on the cost of living (paid work ).
The real wage is a measure of the quantity of consumer goods and services that can be bought with
the nominal wage (whether up or down you have to pay for it).
To derive a general measure of real wages, economists use the CPI to deflate nominal wages:
real wage = Nominal wage × 100
CPI
This formula tells you that for real wages to remain constant, nominal wages must grow in line with
the rate of inflation. If the growth in nominal wages lags behind the rate of inflation, then real wages
fall; conversely, if nominal wages rise ahead of inflation, then real wages rise.

Comparing GDP and standards of living across national economies

PPP holds when price levels in two countries are equal when expressed in a common currency. To
adjust for such differences in living costs, economists often compare national incomes at purchasing
power parity (PPP). country’s PPP ratio:
(p53) PPP ratio of a country = cost of goods in the country (USD)
cost of same basket in USA (USD)

Investment is expenditure on machinery and equipment that adds to capital and increases the
productive capacity of an economy.

‘Gross’ investment means that it includes investment made to replace capital goods that have
worn out or become obsolete, as well as to purchase new items of capital. (Note that gross
investment is often denoted as ‘gross fixed capital formation’ in statistical reports and accounts.)

A firm is technically efficient - if it is using the minimum quantity of inputs required to produce a
given output for each technique of production.

Stocks and flows: some general principles

Flow Flows (Water flowing)- are the movement of income or goods and
services between sectors that occur within a period of time:
GDP is a flow: it usually measures the output produced by an economy in a year
Investment is also a flow – the amount spent on new plant and equipment in a
period of time.

Stocks (Already collected Water) measure the total amount of capital, savings or some
other quantity in each sector at a given moment in time. The size of a stock changes if there
is a net inflow or outflow (e.g. of investment or saving). Measured at a point in time and
refer to totals accumulated over previous periods up to that point.
Net flow – Is the overall outcome of two opposing flows(In &out), such as
inflows and outflows: e.g. there is no net flow if these exactly balance (Zero
balance flow).

Surplus and deficit - Surplus occurs when incoming flows are larger than outgoing
flows. When the opposite is true, there is a deficit.

The current account deals with transactions between a country and the rest of
the world that are part of the country’s net income. Exports are the main
component bringing income into the country, while imports are the main flow of
income out of the country to the rest of the world.

Assets Stocks of accumulated wealth owned by firms, households or governments. The

income account represents flows generated by firms, households and government, as
owners of assets or as workers.

The capital account records transactions between a country and the rest of the world that
represent a change in ownership of assets.

Foreign direct investment (FDI) - Cross-border investment arising when a company creates,
acquires or expands an operation abroad. Direct investment, a much larger component of
the capital account, arises from the formation, acquisition or expansion of firms by parent
companies based elsewhere . A country is a net importer of goods and services when its
total imports exceed its total exports. A current account deficit results from more being
spent abroad than received from abroad,

Aggregate demand Is the planned demand across the whole economy for goods and
services. It is also known as planned expenditure.
Economic model Is an image or representation that isolates and examines the key ways in
which an economy, or part of an economy, works. Economic quantities are captured by
variables: letters or other symbols that can represent any of a number of different values.

Consumption (C), on the other hand, is an endogenous component of aggregate demand,

its value is set inside the model.

Marginal propensity to consume Is the fraction of an extra unit of income that households
plan to spend on consumption, and this is done by letting consumption depend on income.

Endogenous variable - A variable is endogenous when its value is set inside the model.
Exogenous variable (like intercept) A variable is exogenous when its value is set outside the
model.
Involuntary unemployment -occurs when workers looking for work are unable to find work.

Paradox of thrift Is that individuals deciding to save more does not lead to an increase in
aggregate savings for the economy as a whole, where where an individual decides to save
more (be more thrifty).
There are two key functions of money that can be introduced here. First, money acts as a
measure of value, known also as a ‘unit of account’ ; and Second, money acts as a medium
of exchange, acting as a go-between when individuals exchange commodities.

Money as a measure of value Is a standard unit of measurement for comparing the prices
of commodities.

Money as a medium of exchange – Is an intermediary that facilitates exchange between

circulating commodities. It is also known as a ‘medium of circulation’.

A final key function of money that applies to both these forms of money is its role as a
store of value. Is a vehicle for holding and retrieving value at a future point in time.

A transfer payment Is usually provided by the government Fiscal to individuals not in

exchange for services,

Short run – Is a firm operating in the short run when it is unable to change the quantity that it uses
of at least one of its factors of production, but we can change the number of people employed to
produce goods and services. Unlike Long run, when a firm is able to change the quantity of all of its
factors of production.

The long run = Is a period of time in which the capital stock can change

The multiplier is a ratio capturing the change in aggregate income associated with an exogenous
change in aggregate spending, since the impact of the fiscal stimulus is multiplied throughout the
economy. Multiplier = ΔY
ΔG
The size of the multiplier depends on the marginal propensity to consume, as explored in the box
below. It has a simple formula: multiplier = 1
1−b
Direct taxes - are paid directly out of income, gains or profits by individuals or firms, People who
work for an employer have Income Tax deducted directly from their pay each month; for the self-
employed, two advance payments are usually made each financial year, and Corporation Tax, which
makes up 2.4% of GDP, is a direct tax paid by companies directly out of their income, as are Capital
taxes.

Indirect taxes are levied as part of economic transactions and so are paid via an intermediary, as can
fuel excise duties, paid via your garage when you buy petrol.

A tax-modified multiplier - explore how taxation works as a fiscal policy tool, a modification can be
made to the aggregate demand model and multiplier. Hence the total revenue received by the
government from tax (T) is T = tY (p154).

Capitalist economies enjoyed continued growth and mild business cycle fluctuations, Business cycle
Repeated phases of high and low growth.

A discretionary stabiliser - Is a fiscal policy tool (spending or taxation) that the government uses to
actively smooth out fluctuations in economic activity, governments can use discretionary stabilisers,
actively adjusting fiscal policy in response to boom or slowdown in economic activity. If the economy
is overheating (growing too fast).
An automatic stabiliser - Is a fiscal response (of transfer payments or taxation) that smoothes out
fluctuations in economic activity without active government intervention. Governments, of course,
have to choose to keep the system in place to facilitate this automatic spending, but they do not
have to actively direct the spending from day to day.

Primary budget deficit - Is the excess of government expenditure over tax receipts, in a given time
period, usually one year – so it is a flow. The national debt will increase.

A balanced budget - Is when government spending is exactly matched by tax receipts.

The total government deficit Is the primary deficit (government spending minus taxation) plus these
debt interest payments. This is the total government deficit that economists and policymakers
usually worry about. In a more compact notation, The total deficit is = G − T + iD.

Funding capital expenditure Is usually included in the calculation of government debt and deficits. In
response to this constraint in the UK, governments have introduced schemes such as the Public
Finance Initiative (PFI), in order to classify funding public infrastructure spending as private debt.

Capital expenditure - refers to purchases that generate future long-run benefits, is usually included
in the calculation of government debt and deficits.

A further criticism levelled at the Keynesian fiscal policy is the risk of crowding out.
Crowding out - Is a squeezing out of consumption and investment in the private sector by
government spending, A key proponent of the idea that government spending may crowd out
consumption is the economist Roger Farmer (Farmer and Plotnikov, 2012). The alternative is based
on an approach developed by Milton Friedman called the permanent income hypothesis (Friedman,
1957, pp. 21–2). (page 174).

Monetary policy - The control of money and/or interest rates in an economy in order to influence a
specified variable, such as aggregate demand or inflation. (p185). The manipulation of interest rates
and quantitative easing both attempt to influence economic activity by changing the terms under
which people finance their spending.

A key function of the Bank of England, therefore, is to be the sole supplier of legal tender (pounds
and pence) in the UK.

Bank liabilities Is the amount that a bank owes. This includes the amount of cash that a bank owes
to its depositors, potentially repayable in cash .

Bank assets - Is the amount that a bank owns or is owed. This includes loans and financial assets,
cash reserves, and balances held at the central bank.

Customer A deposits two £50 notes(100) into her bank account at the DueWest bank. Is this an
asset or a liability for the bank? The answer is both. The two banknotes are an asset to the bank,
but also a liability, since the bank owes the money to customer A. The bank now holds an asset of
£100 (the cash reserves)

Cash reserves Is Legal tender notes held in bank vaults.

The liabilities that money can be created by commercial banks represent an additional type of
money, referred to as bank money. commercial bank liabilities may be quite different from the
amounts deposited as cash. In fact, commercial banks’ liabilities – in other words, bank money – are
by far the larger part of the money.

Money supply – Is the stock of whatever counts as money in an economy, including for example
legal tender and bank money. Money supply in modern economies, with legal tender deposits
being only a small fraction.

Commercial banks hold balances at the Bank of England that can be drawn as legal tender notes on
demand. In addition, the Bank of England, as the sole supplier of legal tender, has a key role as the
lender of last resort to replenish a commercial bank’s reserves to stave off a general loss of
confidence. (page 191).

Money markets – are Numerous electronic marketplaces in which organisations and people lend to
each other for short periods (from a few hours up to a year).

Base rate, referred to as bank rate - The interest rate at which a central bank makes short-term
loans to commercial banks (sometimes called the ‘official rate’ or ‘policy rate’).

Open market operations - Purchases and sales of government bonds by a central bank in order to
adjust the amount of funds in the banking system and so influence interest rates.

A prospective rate of return - Is the return that a firm expects to get in future if it invests today in
the capital goods needed to start or increase production. Prospective return will be uncertain and
based on estimates of, for example, future sales and profit margins. Keynes (1973) called the
investment return on the marginal unit of capital the marginal efficiency of capital (MEC)
(for different investment projects).

Transmission mechanism - Is a process by which interest rates determine aggregate

demand AD (and other economic targets)

Market interest rates - are interest rates in the economy that are determined by the actions of
lenders and borrowers. These include rates in the money markets (where the central bank typically
intervenes to influence rates) and markets where firms raise finance to fund investment projects
(p213).
There are a number of reasons why market interest rates may vary independently of base rate.
First, the banking system may increase its preference for liquid assets,
Liquidity preference - Is the extent to which economic agents prefer to hold cash (or other very
liquid assets). This could be because of fears that depositors may withdraw their instant access
funds, which must be paid in cash,
Second, banks and other financial organisations may change their view about the risks facing the
firms to which they are lending; if they have suffered from the consequences of widespread
bankruptcies, as is likely to occur in the aftermath of a significant recession.

Bank overdrafts and loans are not the only source of funds for firms. Firms may also engage in
raising finance by issuing bonds and other forms of commercial paper. Bonds pay a fixed interest
rate, the coupon (c), on their nominal or par value (N). But the effective interest rate on a bond (or
other financial instrument having a similar structure) – called its yield (y) – is the coupon relative to
the price (P) at which the holder bought the bond. yield is therefore: y = c × N
P
Zero lower bound Is a situation where monetary policy in the form of a reduction in base rate (a
nominal interest rate) ceases to be an option because the rate is already at or close to zero.

Central banks have responded to the limitations of traditional monetary policy (Base rate) by
devising new ways of stimulating demand. These have been christened ‘quantitative easing when
base rate can no longer be used due to Zero bound.

Quantitative easing - involves the central bank buying assets, often bypassing the commercial
banks, in order to put downward pressure on interest rates and inject money directly into the
economy in order to stimulate aggregate demand. The main transmission mechanism for
quantitative easing (p220). The IS curve with quantitative easing (p221).

Open economy -Is one where agents (such as households and firms) are able to trade with other
countries, Marginal propensity to import m, Is the proportion of extra income (after saving and tax
have been deducted) that households plan to spend on imported goods and services.

Just like a higher tax rate, a higher propensity to import also swings the consumption function
downwards. This is mirrored by a leftward swing of the IS curve with an associated fall in output. The
higher consumers’ propensity to import, the lower the equilibrium level of output will be. (p242
deriving formula).

Relative prices and exchange rates formula - A floating exchange rate describes the situation where
a government leaves the country’s exchange rate to be determined by market forces, through the
interaction of buyers and sellers of the currency. A general formula Pf = Ph × e
where Pf is the price in the foreign currency, Ph is the price in the home currency, and e is the
exchange rate.

Hedge fund - Is a type of investment fund that uses a wide range of tactics to make profits from
buying and selling assets, currencies and other sophisticated financial products. Typically, a hedge
fund may use borrowed money to increase its asset purchases when it expects prices to rise, and
short-selling (selling borrowed assets with the aim of buying them back later when they are cheaper)
to back its hunches that asset prices may fall.

Capital flight - typically refers to the sudden flow of money out of a sector or country because of
fears that its bonds or other assets no longer offer a safe store of value. As a result, investors move
their money to other, less risky assets.

Activity 6.4 (p250)

If you were deciding between saving in an account in the UK or an account in, say, the USA or India,
what factors would sway your choice?
Answer: You might be motivated by the interest rate that you could get, how much that would be
worth converted back into pounds, and whether the account would provide a secure store of value.
The same considerations influence international financial flows. The agents – such as investment
banks, pension funds, hedge funds and investment managers – who control these flows will seek out
the highest returns taking into account the interest rates being offered by different countries,
exchange rates against their home currency, and expectations about how these may change. If
lending to governments or firms in a particular country looks risky, the interest rate offered may
have to be high to compensate for this risk, or alternatively lending may suddenly dry up as the
agents involved seek less risky returns elsewhere – the phenomenon called capital flight.

The alternative to a floating exchange rate is a fixed exchange rate, where the government decides
on a particular level of exchange rate.
A fixed exchange rate – also called a pegged exchange rate – describes the situation where a
government chooses to tie its exchange rate to the currency of another country. With a fixed
exchange rate, pegged to the currency of another country, the home country in effect loses its
ability to use monetary policy to manage aggregate demand. Because, a change in interest rate
affects international financial flows that put pressure on the exchange rate to change.

Currency union -Is an agreement between two or more countries (or regions) to use the same
currency, which means giving up the ability individually to set their own interest rate or exchange
rate.
Policy constraints in an open economy - In theory, borrowing enables a government to spend
without limit, provided that it can fund its total deficit: G − T + iD. You met this equation for the total
deficit in Chapter 4, Section 5.3: i is the rate of interest that the government must pay on its
outstanding debt, D. However, this freedom to borrow relies on there being people willing to buy
the debt. This in turn depends on investors’ confidence that the government will honour its
commitments to pay the interest and capital repayments when they fall due.

Labour productivity The output produced per unit of labour. Unit cost Unit cost is the total cost
incurred per unit of output produced. Mark up A mark up is the amount that a firm adds to the price
of a commodity in addition to its unit costs.
Defining the unit cost as C, the mark up rule is P = (100% + ε) × C

Activity 7.3 Imagine that the mark up is 50% and, as above, a shoe costs £2 to produce. What will
be the unit price of output?
Answer Applying the mark up rule as in the above equation, the price of each unit of output will be
P = 150% × £2 = 1.5 × £2 = £3. In the aggregate, output supplied is priced at 50% more than the cost
of inputs used to produce it.
Assume that the price level P is represented by the index 300, which is three times higher than the
base year index of 100. Assume also that the hourly nominal wage W is £30. The real wage is
calculated using the formula = W = GBP 30 = × 100 = GBP 10
P 300
Given the nominal wage of £30, and using a deflator, firms are able to earn a 50% mark up on their
unit costs by setting a price of £3 and a real wage of £10 per hour for all workers.

Factors influencing costs of production are Cost push inflation occurs where prices are driven up by
increases in the costs of imported goods and services and Labour.

Activity 7.4 Consider the impact on the PS line, as represented in Figure 7.12, of an increase in the
money wage.
Answer The PS line does not move at all. An increase in the money wage would increase the unit
cost of each good produced; but with the manufacturers adding a fixed profit mark up, the price
level P would increase by the same amount as the increase in the wage. The real wage would
therefore remain the same, so the PS line remains fixed. All that would change is an increase in the
nominal wage and an increase in the price. You can see where this is leading – the makings of a story
as to how inflation gets going. Workers are able to increase the nominal wage; firms respond by
marking up this new cost with a new price. This wage and price setting process forms the basis for
our supply-side model of inflation.

This attempt to stimulate the economy was therefore successful in increasing output and
employment, but unsuccessful at increasing real wages permanently. In summary, the demand
stimulus has given an increase in output at the cost of an increase in the inflation rate. This is the
trade-off summarised in the Phillips curve.(p310).

The output gap Is the difference between the actual and equilibrium levels of output. When there is
a positive output gap (i.e. Y > Ye ). In empirical work the output gap is sometimes measured as a
percentage of GDP. When inflation is constant and this is because there is no output gap and
expectations are stable and With a zero output gap, inflation remains unchanged. And
expectations of future inflation match actual future inflation.

We can now summarise our theory or model of inflation in a very simple way, as π = π L + α(Y − Ye ).
By changing the value of α, we can change the importance of the output gap. We have set α = 1.
When πL changes, the inflation equation shows that the Phillips curve will shift in a parallel way.
Higher values of πL will shift the Phillips curve upwards, and lower values of πL will shift the Phillips
curve downwards. But the slope of the Phillips curve can also change, mostly because of factors
that influence equilibrium in the labour market.

The limits to demand-side policies: the vertical Phillips curve: Critically, the
macroeconomy will not self-stabilise once output is higher than the equilibrium level, and Inflation
will spiral in the absence of government intervention. Equilibrium can be reached only when output
returns to Y0 = Ye , the equilibrium level on the VPC.

At first sight, you may have thought that the upward-sloping Phillips curve in Chapter 7( p320)
would mean that a policymaker could trade off a level of output against a given rate of inflation.
But then you learned that the choice is in fact more constrained, because of the vertical Phillips
curve (VPC) .

If inflation has costs (It erodes PPP, how much can be bought), why is the target not set at
zero, instead of 2%? The answer lies principally in the dangers of deflation (falling prices). These may
sometimes reflect errors of judgement by the policymaker, but far more frequently they will be the
result of events, often called ‘shocks’, beyond the policymaker’s control. There are two main
types of shock that are handled by the inflation targeting model.

First, a demand shock provides a sudden disruption to aggregate demand, which in the inflation
targeting model leads to a shift of the IS curve, could be due forces such as change in government
fiscal policy, a change in exchange rates impacting on exports and imports; or due to a change in
private investment .

Second, a supply shock, disrupts the economy suddenly from the supply-side. This could have its
origins in the labour market – say a change in unionisation (impacting on the wage-setting curve) or
the profit mark up (impacting on the price-setting curve). Or it could have its origins in the goods
market, where say a change in the price of oil affects inputs, or a change in technology affects
outputs.
Time Lags - decisions taken today will have their full effect in up to two years’ time, and it leaves a
long period of time in which unexpected events can throw policy off course. If this happens, there is
virtually nothing that the policymaker can do to correct it immediately. So undershoots and
overshoots are a real possibility.

Imagine the prices of goods and services generally falling and expected to continue to fall. What
does this do to aggregate demand, output and employment? Answer If consumers and firms think
that prices will be lower in future than they are at present, then they will be tempted to delay
purchases until prices are lower. This means that aggregate demand falls. Output will be lower and
unemployment higher.

As a second threat, a fall in the general price level pushes up the real value of debts, since these
are usually fixed in their nominal (money) values. So every household with a mortgage, everyone
with a credit card debt, every firm with an overdraft, finds their debt burden growing. Once the
nominal rate i = r + π, falls to zero,(nominal rate of interest that cannot realistically be set below
zero – the so-called zero lower bound problem) it can go no further. But if prices are falling, the real
rate r = i − π will be rising and pushing down aggregate demand.

Since the money supply is endogenous, the quantity is determined by factors within the economic
system (bank loans create bank deposits. When a client borrows from a bank, the loan comes into
existence only when the funds are spent), and this is one of the reasons why policymakers today
conduct monetary policy by setting interest rates, rather than trying to control the quantity of
money directly. (A rise in interest rates discourages the demand for credit ).

A rise in interest rates not only contracts aggregate demand, as given by the IS curve, but also
contracts the money activity in an economy. however, changes in Rate are not instantaneous.
Some will happen faster than others, causing a change in the spread between rates.
Spread - Is the difference between market rates and the base rate, or between different market
rates. (particularly the London Interbank Offered Rate (LIBOR) ).

Base rate is a nominal rate of interest (i ). It refers to the amount that commercial banks and
money market participants pay on central bank loans in cash terms. But what matters to lenders
and borrowers (and therefore to the level of demand in the economy) is the real rate of interest (r).
as r = i − π, where π is the rate of inflation.

The transmission mechanism: linking the base rate to aggregate demand and
inflation:

Stage 1: from base rate to aggregate demand, the change in the rate of interest
moves the economy up and down the IS curve by changing planned spending.

Stage 2: from aggregate demand to inflation, the change in Y, resulting from the
change in aggregate demand in the IS diagram, is important to the Phillips curve because it
is responsible for the degree of inflationary pressure in the economy. This pressure depends
on the output gap (Y − Ye ) on the horizontal axis, and determines the rate of inflation (on
the vertical axis) of the Phillips curve (p348).

The inflation-targeting model: linking the IS and Phillips curve

So for a given rate of expected inflation (πL) , the larger the output gap (Y − Ye ), the
higher the current rate of inflation (π); and the smaller the output gap (Y − Ye ), the lower
the rate of inflation (π). This gives the upward slope of the Phillips curves.

It demonstrate that the output Y, in the output gap, is set by the IS curve, given the rate of
interest. Hence the output gap (Y − Ye ) is derived from the IS diagram. (p392).

How far Y moves to the left or right (and how far inflation falls or rise) depends, of course,
on the size of the shift of the IS curve, and this in turn depends on how sensitive aggregate
demand AD is to issues of ‘confidence’

(p384, Figure 9.5, Getting back to target inflation process)

Central bank preference -The degree to which a central bank is inflation averse

The medium run - Is a period of time during which the price level and wages change, and the capital
stock is fixed.

A variable that has played an important role at times is the rate of growth of the money
supply. This idea of targeting the money supply is associated with the school of economic
thought known as monetarism.

Monetarism - Is a school of economic thought that argues that inflation can be controlled
by targeting the money supply.

Inflation aversion Is the extent to which a policymaker will prioritise reducing inflation over
sustaining output (and employment).

In my economist toolkit I have the IS curve, which links the interest rate to aggregate
demand and output. I also have the Phillips curve that links demand pressure to inflation.
In this section I look at the MR curve, where MR stands for ‘monetary rule’ – the rule
followed by the central bank when it sets the monetary policy instrument.
The MR curve – Is a line showing the policymaker’s chosen path of adjustment to the
target rate of inflation.

Inflation bias - occurs where the policymaker has a tendency to generate inflation by
maintaining output above its equilibrium rate.

Time inconsistency - occurs where policy in a particular time period is not suitable for a
different time period.

Qualitative easing - is an attempt to lower market rates of interest by improving the

quality of commercial bank balance sheets. It is achieved by the central bank exchanging
highquality, liquid, assets for the less liquid (and sometimes high-risk) assets that
commercial banks were previously holding. By improving the quality of assets on banks’
balance sheets, the Bank of England was hoping to encourage interbank lending once
again.
As was stressed that the conventional policy instrument was the base rate and that
policymakers could not hope to control the quantity of money directly. Nevertheless,
quantitative easing does just that, except that it is an attempt to increase the quantity of
money in the economy rather than restrict it.

Learning-by-doing - refers to a fall in unit costs as cumulative output increases over time. Once a
worker has practised a task, he will make fewer mistakes, reduce wastage and incrementally modify
or improve processes, such that average cost falls as output per worker increases.

Returns to labour – Is based on firms short run production and recruitments, an additional worker
at the start of every week and measures the increase in weekly output, would expect the output to
rise by the same amount each week.
Thus, when firm has very few employees, adding additional workers may mean that the production
and assembly line can run faster and, up to a point, extra workers can share equipment initially, as
the firm adds more employees, each employee contributes progressively more to total output. One
worker producing 4 units, adding a second may increase total output by 5 units and adding a third
labour may increase total output by more than 5 units. The firm would then be said to be
experiencing increasing returns to labour.
This is an example of marginal analysis on short-run constraints.

Marginal product of labour - Is defined as the additional units of output gained from the input of
one more unit of labour.

Marginal cost - Is the increase in total costs as a result of producing one additional unit of output.
marginal cost = change in total costs
change in quantity of output

The price elasticity of supply - measures the responsiveness of supply to a change in price. In the
short run, as price rises firms may only be able to increase the quantity supplied to a limited extent
using stocks of goods or spare capacity. At some point, capacity constraints will be hit until new
capacity can be installed. In the longer term, therefore, price elasticity of supply will be greater as
existing firms expand and new firms enter the market.

The price elasticity of demand measures the responsiveness of demand to a change in price, which
indicates how much the quantity demanded in the market changes when the market price changes.
Price elasticity of demand in the formula = proportionate change in quantity demanded
proportionate change in price

The government’s tax revenue partly depends on the price elasticity of demand. If the
government’s objective is simply to raise tax revenue, then it should target commodities that are
price inelastic in demand. If it targets commodities with highly price elastic demand, then tax
imposition or tax rises will lead to a large fall in quantity demanded and therefore a low tax yield .
Why is it a good idea to tax goods and services with inelastic demand . PERIOD !

These are the essential building blocks of the neoclassical competitive market analysis states.
Consumers formulate their demands by making choices, on the basis of their income, preferences
and the prices of commodities. Firms decide on a level of output given their technology, input prices,
and the price at which they can sell their goods
Market share – Is when a firm is its share of total industry output. It is usually expressed as a
percentage. Situations in which a seller has a large market share, with output a very large proportion
of the total industry output so that it could arbitrarily raise its price without losing much of its
business.

Profit-maximising rule - A firm maximises its profit when marginal revenue is equal to marginal
cost. MR = MC .

Shut-down rule - A firm will close down production when the price is below the minimum average
variable cost.

Utility maximising rule in perfect competition – Is when a consumer maximises her utility when
marginal utility is equal to the price paid: MU = P. Implying, when firm’s marginal cost (MC = P ).
Hence marginal utility and marginal cost will be the same: MU = P = MC.

Utility - Is a numerical representation of the amount of satisfaction derived from consumption.

Consumers will spend their income in such a way that they maximise their satisfaction, or utility.
Marginal utility - Is the additional utility gained when an additional unit of a good is consumed, it
utility decreases as consumption increases known as diminishing marginal utility.

Market power - Is when a firm has market power (also referred to as monopoly power) if it has
some choice in setting the price of its product,

Natural monopoly - exists if, as a result of economies of scale, a single firm can supply the market at
a lower average cost than can be achieved by a number of smaller firms, it is cost-efficient to have a
single firm supplying the market.

However, for most firms there are limits to economies of scale. As the firm’s output increases from
a low level, average cost (planning curve) decreases because of economies of scale. As output
continues to increase, the curve flattens; average cost remains constant as output increases. The
flattening of the curve indicates that economies of scale have been exhausted; increasing output
will not reduce the unit cost, but constant as output increases. The level of output at which the
curve becomes flat, is known as the minimum efficient scale (MES).

The MES marks - refers to the output at which long-run average cost first reaches its minimum
level as output rises, and the size of the firm beyond which there are no cost advantages to be
reaped from operating at a larger scale; it is the point at which all economies of scale have been
taken up, and the major sources of diseconomies of scale are coordination problems that beset
management in large bureaucratic organisations. Or Industries of firms producing a broadly related
range of goods using similar technologies.

Diseconomies of scale - arise firm produces higher levels of output, average cost starts to rise in the
long-run as average cost rises as output increases too,

Pure monopoly - exists when a single firm is the sole supplier in a market. But, not all pure
monopolies are ‘natural’, that is, arising because of cost conditions. Some firms are innovators,
discovering and selling new products that create new markets, and therefore they are the only
sellers, at least until imitators enter the market, without necessarily having economies of scale (the
iPad is a good example of this – in the early years of the tablet market, analysts used to say that
there was no market for tablets, but only the iPad).

Patent - Is the legal right of an inventor to exclude others from using a particular invention for a
fixed period in time.

Strategic competition - Is different from both perfect competition (firms take the market price and
technology as given and set their output without considering the behaviour of other firms) and
monopolistic (firms typically compete through product differentiation). competition,

Implicit collusion Implicit collusion occurs when firms behave as if they are colluding but there is no
agreement to do so.
Contestable market A market is perfectly contestable if entry and exit are costless.

Cartel A cartel is a group (of firms or countries) that makes joint decisions with a view to increasing
the combined profits of its members by suppressing competition between them.
Strategic competition characterised by interdependence is known as strategic competition. Strategic
competition means that firms need to take account of expected reactions from rivals when making
their plans.

Concentration ratio A concentration ratio measures the share of industry output produced by the
top few (usually three, four or five) firms.

Distributor agreements may also act as a barrier. Distributors of existing products may not want to
add a new product, and may have exclusive distribution agreements with a supplier.
In some cases, vertical integration of the supply chain, where a company extends ownership or
control to suppliers and customers, can prevent entry.

In predatory pricing, the incumbent sells at a loss (for example, temporarily).

Other approaches include increasing switching costs for consumers (which used to be common in
the UK telecommunications and utilities industries, but regulators have forbidden it), or creating
discount structures that make it unattractive for industrial customers to order from several suppliers
Another important barrier to entry is network effects. The example of a telephone service shows
that the utility people get from consuming such goods depends on the extent to which other people
also use these goods.

The Schumpeterian perspective therefore introduces a trade-off between the static perspective,
which focuses on the allocative inefficiency caused by the supernormal profits.

Or dynamic perspective that emphasises the improvements in productive efficiency generated by

the introduction of new technology.

Absolute advantage A country has an absolute advantage in the production of good X if production
of a unit of X requires fewer resources in that country than it does abroad. So absolute advantage is
determined by the productivity of labour: output per working person .

The high-income country has the absolute advantage in the production of both goods. To see this,
calculate the productivity of labour in each country. In the high-income country, 1000 workers can
produce 5000 tons of food, i.e. five tons per worker.
Alternatively, they can produce 25 000/ 1000 = 25 phones per worker. In the low-income country,
10 000 working people can produce 10 000 tons of food (i.e. one ton per worker) 10,000/ 10,000 =
1 , one ton per worker or 5000 phones (i.e. half (0.5) of a phone each). So the high-income country
is more efficient at producing both goods.
So the opportunity cost of each ton of food in the low income country is 5000/10 000 = 0.5 of a
phone.
The high-income country can produce 5000 tons of food or 25 000 phones. So the opportunity cost
of a ton of food is 25 000/5000 = 5 phones.

Comparative advantage A country has a comparative in the production of good X if the opportunity
cost of producing a unit of X is lower in that country than it is abroad.

Activity 15.3 So which country has the comparative advantage in producing phones? Work this out
for yourself, and make sure that you understand the answer.

Answer The opportunity cost of a phone is 2 tons of food in the low-income country, and 0.2 tons of
food in the high-income country. The high-income country therefore has the lower opportunity cost
of a phone and the comparative advantage in phone production.

Production possibility frontier (PPF) A PPF shows a country’s maximum output mixes: that is, at
each point along the PPF, more of one good cannot be produced without producing less of another.

The optimal tariff is the tariff rate that maximises the net gain, i.e. maximises G − (B + F).

Intra-Industry- Involves trade between countries of goods within the same industrial category, or
similar good in the same industry.
Inter-industry, Is however, specialise in different goods that belong to different industries. all trade
is inter-industry.

Dumping :-An imported product is dumped if its price is either below its producer’s price in its home
market or below its producer’s average cost of production. Firm that is a monopolist in its domestic
market may be able to maximise its profits by dumping part of its output into a competitive export
market, rather than selling only on its domestic market.

Equity Equity refers to a distribution of income (or assets) that a society deems to be fair and just.
Equivalised household income - Equivalised household income is household income adjusted to
account for household size and composition.

We can also construct decile groups, ten equally sized slices of the ranked population.
Quintile groups - when the ranked population is divided into five equally sized slices

Gini coefficient The Gini coefficient measures the extent to which the total distribution of income
among individuals or households within an economy deviates from a perfectly equal distribution.

Absolute poverty - Absolute poverty is defined as having a level of household income below that
needed to consume the basic necessities of life such as food, shelter, water and warmth.
In contrast, the concept of Relative poverty is concerned with people living in households whose
income is below that needed to participate fully in the society in which they live.

Regressive tax - For a regressive tax, the proportion of a person’s income paid as tax decreases as
their income increases.

Window Tax - Window Tax was introduced in 1696 in England and repealed in 1851. It was a
property tax based on the number of windows in a property.

Participation tax rate - The participation tax rate (PTR) is the proportion of earnings that are taken
away in tax or through lower benefit entitlements when an individual takes employment.

Formula for PTR is PTR = 1 − net income in employment - net income out of employment
gross earnings in employment

For example, consider an unemployed individual whose income after tax and benefits is £60. If he
got a job, his gross earnings would be £250, and he would need to pay £40 in income tax. The PTR is
calculated as 1 − 240(GBP) − 60(GBP)
300(GBP)
= 1 − 180(GBP)
300(GBP) = 40%

The lower the value of a person’s PTR, the greater his incentive to take employment, as he gets to
keep a higher proportion of his earnings. An unemployed person with a PTR that is too high can be
in an unemployment trap where it is not financially worthwhile taking a job.

Unemployment trap - An unemployment trap is a situation where the tax and benefit systems
combine to create disincentives to take up employment.

The effective marginal tax rate (EMTR) - measures the incentive for people already in paid
employment to earn more, when employed worker earns an extra unit of income. With an EMTR
of 0%, the household keeps all of the increased earnings, whereas with an EMTR of 100%, none of
the increased earnings would be retained. This means that she takes home only 20p for each extra
£1 that she earns. High EMTRs for low-income households lead to poverty traps.

Poverty trap - A poverty trap is a situation where the tax and benefit systems combine to make it
difficult to escape poverty through creating disincentives to earn more by taking a better-paid job.
If EMTR is 80%, means that she takes home only 20p for each extra £1 that she earns. It will
probably not be financially worth her working longer hours if she also has to pay for childcare. Marie
is in a poverty trap.

Pareto improvement - A change is a Pareto improvement if it makes someone better off and no one
worse off. Suppose, in a very unequal society, that a change makes the rich still richer – but does
not make anyone poorer. This is a Pareto improvement.

Pareto optimal - A situation is Pareto optimal if no one can be made better off without someone
being made worse off. The effectiveness of competition in markets in promoting welfare, where a
market equilibrium at which consumers equate their marginal utility MU to the price of the product P,
and producers equate their marginal cost MC to price, condition for optimal consumption can be
written as MC = P = MU.
Pigovian tax to reduce a polluting firm’s output, when a tax t is added to the firm’s marginal cost
at each level of output. This will shifts the firm’s marginal cost curve to MCP + t. The firm’s new
profit-maximising point, where MCP + t = world price (PW) with social output QS, the socially
optimum output is set to equal the gap between the marginal social cost and the marginal private
cost (MCP) at the optimum output QS. The tax has reduced production and consumption to the
optimum level. (Page 295).