We often assume that residents of countries with high average incomes lead better lives. But skewed distribution of income may produce its own complexities. A situation that could be described as a small band of Gullivers cherry-picking the best fruit, leaving behind a big army of Lilliputians jumping, well, fruitlessly. To measure inequality of income distribution, we use what is known as the Gini index.
Johnny: I think the economic health of any country will suffer if only a few enjoy the riches. But first tell me, what exactly is the Gini index?
Jinny: The Gini index, or Gini coefficient, was developed by an Italian statistician called Corrado Gini in 1921, and it can be used to measure the inequality of any distribution, but economists most commonly use it for measuring the inequality of income distribution.
The index measures the inequality of income distribution on a scale of 0-1. A reading of 1 on the index is a sign of perfect inequality, whereas a reading of 0 is a sign of perfect equality. In other words, the index would show a value of 1 if all income goes to a single individual and a value of 0 if income is equally distributed among all individuals.
In reality, we do not come across either extreme, and are more likely to find the Gini index showing different values such as 0.25 or 0.60 for different countries. In the Gini index, a low number is more desirable as it indicates less inequality in income distribution.
Illustration: Jayachandran / Mint
Johnny: Nice to see all countries trying to score 0. I think a value closer to 0 would be a sign of good economic health. What do you say, Jinny?
Jinny: A reading closer to 0 in the Gini index can’t blindly be taken as a sign of good economic health. The Gini index simply measures inequality of distribution. It does not really tell us anything about the overall economic health of any country.
Think of it like this—even poor countries may show a lower index value if all its residents equally receive lower income. Some countries may not be good in distributing riches equally, but they show terrible efficiency in distributing misery.
Further, the Gini index merely measures the distribution of net income; it does not take into account the overall net worth of individuals. So, if the majority of non-income generating assets, such as self-occupied homes, are concentrated in a few hands, then that will not get reflected in the Gini index. The Gini index would continue to show a low value as long as incomes are being distributed equally, even though the income generating assets may still be owned by a few.
Johnny: So, a low value on the Gini index should be interpreted with caution. I was just wondering, how is the Gini index actually calculated?
Jinny: To understand that, you would need to close your eyes and think about a graph in which the X-axis represents the distribution of income in percentage terms, and the Y-axis represents the number of families from the poorest to the richest, also in percentage. Different points on the X axis may read something like this: 10% of total income, 20% of total income, 30% of total income, and so on. The points on the Y-axis may read something like this: the bottom 10% of all households, the bottom 20% of all households, and so on. To calculate the Gini index, we plot the distribution of percentage of income against the percentage of households, which in effect tells us what percentage of the total income is distributed among, say, 10% of households.
This kind of plotting gives us what is known as the Lorenz curve, which was developed by Max O. Lorenz in 1905 to present income distribution in graphical form. Every point on the Lorenz curve tells us about the distribution of income. Say, for instance, the bottom 30% of households get 10% of the total income. If the income distribution had been perfectly equal, your Lorenz curve would have been a perfectly straight line at 45 degrees to both the X and Y axes. In such a situation, the bottom 10% of households would have 10% of total income, the bottom 20% of households would have 20% of total income, and so on.
The Gini index just tells us how far our actual Lorenz curve is from the perfect 45-degree line denoting perfect equality. The index is measured by taking a ratio of the area between the actual Lorenz curve and the perfect line to the entire triangular area made by the perfect line. The closer the actual Lorenz curve is to the perfect line, the less would be the area between the Lorenz curve and the perfect line and, hence, the lower would be the ratio.
Johnny: Well, thanks Jinny. I think we need to develop a “Jinny index” for measuring how far this complicated stuff has been made real simple. What do you say?
What: The Gini index is used to measure inequality of income distribution.
Who: The Gini index was developed by Italian statistician Corrado Gini in 1921.
Why: The Gini index is not an indicator of overall economic health because countries may be poor but may have equality in income distribution.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com