Pareto index

# Pareto index

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In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

the Pareto index, named after the Italian economist and sociologist Vilfredo Pareto
Vilfredo Pareto
Vilfredo Federico Damaso Pareto , born Wilfried Fritz Pareto, was an Italian engineer, sociologist, economist, political scientist and philosopher. He made several important contributions to economics, particularly in the study of income distribution and in the analysis of individuals' choices....

, is a measure of the breadth of income or wealth distribution. It is one of the parameters specifying a Pareto distribution and embodies the Pareto principle
Pareto principle
The Pareto principle states that, for many events, roughly 80% of the effects come from 20% of the causes.Business-management consultant Joseph M...

. As applied to income, the Pareto principle is sometimes stated in popular expositions by saying 20% of the population has 80% of the income. In fact, Pareto's data on British income taxes in his Cours d'économie politique indicates that about 30% of the population had about 70% of the income.

One of the simplest characterizations of the Pareto distribution, when used to model the distribution of incomes, says that the proportion of the population whose income exceeds any positive number x > xm is

where xm is a positive number, the minimum of the support of this probability distribution
Probability distribution
In probability theory, a probability mass, probability density, or probability distribution is a function that describes the probability of a random variable taking certain values....

(the subscript m stands for minimum). The Pareto index is the parameter α. Since a proportion must be between 0 and 1, inclusive, the index α must be positive, but in order for the total income of the whole population to be finite, α must also be greater than 1. The larger the Pareto index, the smaller the proportion of very high-income people. (The 80-20 rule holds precisely when α = log(5)/log(4) ≈ 1.16 whereas the 70-30 result corresponds to α = log(0.3)/log(3/7) ≈ 1.42.)

Mathematically, the formula above entails that all incomes are at least the lower bound xm, which is positive. At this income the probability density suddenly jumps up from zero and then starts decreasing, which is clearly unrealistic. Economists therefore sometimes state that the Pareto law as stated here applies only to the upper tail of the distribution.