Absolute vs Relative Change

Absolute changes in price and quantity are measured in terms of the original
units whereas relative changes are not based on units of measurement. They
are calculated as percentage changes in price and quantity.
Absolute vs. Comparative Advantage: An Overview
Absolute advantage and comparative advantage are two important concepts in economics
and international trade. They largely influence how and why nations and businesses devote
resources to the production of particular goods and services. Absolute advantage describes a
scenario in which one entity can manufacture a product at a higher quality and a faster rate
for a greater profit than another competing business or country can accomplish. Comparative
advantage, on the other hand, takes into consideration the opportunity costs involved when
choosing to manufacture multiple types of goods with limited resources.

 Absolute advantage and comparative advantage are two concepts in

economics and international trade.
 Absolute advantage refers to the uncontested superiority of a country or
business to produce a particular good better.
 Comparative advantage introduces opportunity cost as a factor for analysis in
choosing between different options for production diversification.
 Economist Adam Smith helped develop the concepts, suggesting that
countries can specialize in goods they can produce efficiently and trade with
others for goods they can't produce nearly as well.
 David Ricardo built on Smith's concepts by introducing comparative
advantage, saying countries can benefit from trade even when they have
absolute advantage in producing everything.
Absolute Advantage
The differentiation between the varying abilities of companies and nations to produce goods
efficiently is the basis for the concept of absolute advantage. As such, absolute advantage
looks at the efficiency of producing a single product. It also looks at how to produce goods
and services at a lower cost by using fewer inputs during the production process when
compared to the competition.

This analysis helps countries avoid producing goods and services that would yield little to
no demand, which would ultimately lead to losses. A country’s absolute advantage (or
disadvantage) in a particular industry can play an important role in the types of products it
chooses to produce. Some of the factors that can lead an entity to absolute advantage
include:

 Lower labor costs

 Access to an abundant supply of (natural) resources
 A larger pool of available capital

As an example, if Japan and Italy can both produce automobiles, but Italy can produce sports
cars of a higher quality and at a faster rate with greater profit, then Italy is said to have
an absolute advantage in that particular industry. On the other hand, Japan may be better
served to devote limited resources and labor to other types of vehicles (such as electric cars)
or another industry altogether. This may help the country enjoy an absolute advantage rather
than trying to compete with Italy's efficiency.
While absolute advantage refers to the superior production capabilities of one entity
versus another in a single area, comparative advantage introduces the concept
of opportunity cost.
Comparative Advantage
Comparative advantage takes a more holistic view of production. In this case, the perspective
lies in the fact that a country or business has the resources to produce a variety of goods and
services rather than focus on just one product

The opportunity cost of a given option is equal to the forfeited benefits that could have been
achieved by choosing an available alternative in comparison. In general, when the profit from
two products is identified, analysts would calculate the opportunity cost of choosing one
option over the other.

For example, let's assume that China has enough resources to produce either smartphones
or computers such that China can produce either 10 computers or 10 smartphones.
Computers generate a higher profit. The opportunity cost is the difference in value lost from
producing a smartphone rather than a computer. If China earns $100 for a computer and $50
for a smartphone then the opportunity cost is $50. If China has to choose between producing
computers over smartphones it will probably select computers because the chance of profit is
higher.

Adam Smith is often considered to be the father of modern economics.

History of Absolute Advantage and Comparative Advantage
Scottish economist Adam Smith helped originate the concepts of absolute and comparative
advantage in his book, The Wealth of Nations. Smith argued that countries should specialize
in the goods they can produce most efficiently and trade for any products they can't produce
as well.1

Smith described specialization and international trade as they relate to absolute advantage.
He suggested that England can produce more textiles per labor hour and Spain can produce
more wine per labor hour so England should export textiles and import wine and Spain should
do the opposite.1

Smith made a number of basic assumptions in order for his theory to work, including:

 No change to the factors of production between different countries

 The lack of trade barriers
 An equal balance of exports and imports
 No economies of scale2

British economist David Ricardo later built on Smith's concepts by more broadly introducing
comparative advantage in the early 19th century. He became well-known throughout history
for his musings on comparative advantage. According to Ricardo, nations can benefit from
trading even if one of them has an absolute advantage in producing everything. 3 In other
words, countries must choose to diversify the goods and services they produce which
requires them to consider opportunity costs.

What Is Adam Smith's Theory of Absolute Advantage?

Scottish economist Adam Smith is credited with developing the theory behind
absolute and creative advantage. He wrote about them in his book, The Wealth of
Nations. According to Smith, countries should focus on goods they can produce
efficiently and should use trade as a way to acquire anything they aren't able to
make themselves.

What Is an Example of Absolute Advantage?

There are many examples of absolute advantage, especially in the real world. For
instance, Saudi Arabia's oil reserves are abundant, giving it an absolute advantage.
That's one reason why it exports the commodity to other nations around the world.

How Do You Calculate Absolute Advantage?

In order to calculate absolute advantage, examine the output of the product in
question between two entities. The one with the larger output has the absolute
advantage. To demonstrate, let's use this example. Let's say Worker A produces 60
glue sticks and 25 large foam pads per hour and Worker B produces 20 glue sticks
and 35 foam pads per hour. Worker A has the absolute advantage for glue sticks
while Worker B has the absolute advantage for foam pads.

How Do You Define Comparative Advantage?

Comparative advantage is often contrasted with absolute advantage. Where
absolute advantage refers to the ability of an entity to produce a greater quantity of
a product or service, comparative advantage refers to the ability to produce goods
and services at a lower opportunity cost compared to the competition.

What Is the Benefit of Reaching Absolute Advantage in the Production of One

Good?
The benefit of reaching absolute advantage when it comes to producing a single
good or service boils down to pure economics and profit. Making a product that
others need (and can't produce themselves) allows you can initiate a trade
relationship for goods and services that you need but can't produce yourself. This
allows you to profit from the sale of your (specialized) good and still be able to
enjoy the goods you import from your trading partner(s).

The Bottom Line

The idea of absolute advantage was developed by Scottish economist Adam Smith, who
explained how countries can profit by only specializing in the goods and services they can
produce efficiently. Smith suggested that countries can open up trade with others for products
they can't make efficiently on their own. The concept is often contrasted with comparative
advantage, which was explored after Smith by economists like David Ricardo. He suggested
that countries produce goods and services not necessarily at a greater volume or quality but
at lower opportunity costs. Although these ideas have evolved since they were first
developed, the fundamental basis is still prevalent in production and international trade today.

Relative change shows the change of a value of an indicator in the first period
and in percentage terms, i.e., Relative change is calculated by subtracting the
value of the indicator in the first period from the value of the indicator in the
second period which is then divided by the value of the indicator in the first
period and the result is taken out in percentage terms.
Home » Financial Modeling Guides » Excel Modeling » Relative Change

Relative Change

Article byShivam Gupta

Reviewed byDheeraj Vaidya, CFA, FRM

What is Relative Change?

Relative change shows the change of a value of an indicator in the first period
and in percentage terms, i.e., Relative change is calculated by subtracting the
value of the indicator in the first period from the value of the indicator in the
second period which is then divided by the value of the indicator in the first
period and the result is taken out in percentage terms.
The formula for relative change is very simple, and it is derived by initially
deducting the initial value of the variable from the final value, then dividing
the result by the initial value, and then finally multiplying by 100% to
express in terms of percentage. Mathematically, it is represented as,

Relative Change = (Final value – Initial value) / Initial value * 100%

Calculation of the Relative Change (Step by Step)

The formula for relative change can be derived by using the following steps:

1. Firstly, determine the initial value of the variable. For instance, the revenue earned
by a company in the previous year can be an example of an initial value of the revenue.
2. Next, determine the final value of the variable. In the above
example, the revenue earned in the following year can be
regarded as the final value of the revenue.
3. Next, deduct the initial value from the final value to derive the
absolute change in the variable. In the example, the increase in
revenue in the following year.
 Absolute change = Final value – Initial value

Relative change Formula = (Final value – Initial value) / Initial value *

100%

A Collection of Keywords and Phrases

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A Collection of Financial Keywords and Phrases
A Collection of Keywords and Phrases for Decision Making

Absolute minimum: The output value of the lowest point on a graph over a given input
interval or over all possible input values. An absolute minimum point is a local minimum
point and occurs at an endpoint of the given input interval.
Absolute vs. Relative Price: Absolute price is the number of dollars that can be exchanged
for a specified quantity of a given good. Relative price is the quantity of some other good
that can be exchanged for a specified quantity of a given good. Suppose we have two goods
A and B. The absolute price of good A is the number of dollars necessary to purchase a unit
of good A. The relative price of good A in terms of B is the amount of good B necessary to
purchase a unit of good A. The change in relative prices is not the same thing as changes in
absolute prices. Sometimes, the absolute prices of goods may change but relative prices may
remain constant. In general, we measure absolute prices in terms of dollars and relative
prices in terms of units of some other good. However, many times we measure relative
prices in terms of dollars also keeping in mind that the word dollar is being used to refer not
to a piece of green paper but to a basket of goods. In microeconomics, the word prices
always refer to relative prices.
Angle: The amount of rotation in a turn. An angle can be thought of as the counterclockwise
rotation of its initial side into its terminal side. The size of an angle is the measure of this
rotation, and a negative sign in front of the size indicates clockwise rotation.
Antiderivative: A function F is an antiderivative of another function f if the derivative of F
is f. If F is an antiderivative of f, where both F and f have input x and C is an arbitrary
constant, then y = F(x) + C is called a general antiderivative of f .
Annual percentage rate (APR): The percentage used in calculating interest each
compounding period. In an investment context, the annual percentage rate (or nominal rate)
is the advertised rate of interest, 100r%.
Annual percentage yield (APY): A percentage by which an investment grows over one
year. Unlike APR, APY indicates the affect of the compounding periods. APY will be larger
than APR any time interest is compounded more frequently than once a year.
Approximate change in a function: The rate of change of the function times a small
change in the input of the function. That is, for the function f with input variable x, the
approximate change in f is f ' (x).h where h represents the small change in x. The exact
change is f(x + h) - f(x).
Autocorrelation: A correlation between a component of a stochastic process and itself
lagged a certain period of time.
Average cost : The total production cost divided by the number of units produced.
Average rate of change: The amount that a quantity changes over an interval divided by the
length of the interval. That is, if a quantity changes from a value of m to a value of n over a
certain interval, the average rate of change equals n - m length of interval. The average rate
of change is the slope of the secant line. Average rates of change have labels of output units
per input unit.

Beta: A measure of systematic risk.

Bias: Bias is the difference between the parameter and the expected value of the estimator of
the parameter.
Black-Scholes Theory: Another name for option pricing theory. Differential equations
approach is an informal name for derivatives pricing models based upon the original Black-
Scholes methodology.
Bootstrapping: Bootstrapping method is to obtain an estimate by combining estimators to
each of many sub-samples of a data set. Often M randomly drawn samples of T observations
are drawn from the original data set of size n with replacement, where T is less than n.
Break-even point: The number of units (produced or sold) for which revenue equals cost so
that profit is zero.
Business Cycle Frequency: The business cycle frequency is often considered to be three to
five periods.
Buyer's Market: A buyer's market is a market for a good (stocks, housing, etc.) where
prices are falling and there are more parties interested in selling than in buying.
Business risk: Exposure to uncertainty in economic value that cannot be marked-to-market.

Calculus: The branch of mathematics involving derivatives and integrals.

Capital allocation: A process of choosing what ventures, deals or trades to engage in,
usually based upon some cost or risk-return analysis.
Capital asset pricing model: A model for valuing financial assets based upon their
systematic risk.
Cash instrument: An instrument whose value, unlike that of a derivative instrument, is
determined directly by the markets.
Change: If a quantity changes from a value of m to a value of n over a certain interval, then
the change in the quantity is n - m.
Changes in demand: A change in price does not lead to a change in demand. But a change
in a factor other than price such as income and prices of related goods etc, does lead to a
change in demand. In that case the change in demand leads to a shift in the demand curve. A
fall in demand shifts the demand curve to the left and a rise in demand shifts the curve to the
right. Other factors includes:

 Sales tax is a tax that is paid directly by consumers to the government. A sales tax
makes a good less desirable and as such it affects demand. It causes the demand
curve to shift towards the left parallel to itself by the amount of the tax.
 So far, we have been concerned with the demand by a single buyer. If there are N
buyers in the market, then market demand is the sum of the demand by all the N
buyers. The market demand curve is the horizontal summation of individual demand
curves.

Compound interest: A method of crediting interest in which interest is earned on interest.

Composition: A method of combining two functions in which the output of one function
(called the inside function) is used as the input of the other function (called the outside
function).
Compound interest formulas: Exponential formulas that are used to determine the amount
A(t) accumulated in an account after t years when P dollars are initially invested, if the
nominal interest rate is 100r% compounded n times a year.
Concavity: A description of the curvature of a graph. A graph is concave up at a point if the
tangent to that point lies below the graph near the point of tangency and concave down if
the line tangent to that point lies above the graph near the point of tangency. The point at
which the concavity changes to convexity is called an inflection point.
Constant dollars: Dollar values that have been adjusted for inflation by means of price
indexes to eliminate inflationary factors and allow direct comparison across years.
Conversion to constant dollars for a given year t may be calculated as the current dollar
value multiplied by the purchasing power of the dollar based on a dollar value of $1 in year
t.
Correlation: A parameter, related to covariance, that indicates the tendency for two
random variables to "move together" of "co-vary."
Correlation matrix: A symmetric matrix indicating all the correlations of a random vector.
Consumer Behavior: The behavior of consumers in general depends upon two major
factors:
1. Tastes (as represented by the concept called indifference curves)
2. Opportunities (as represented by the income or budget line)
Consumer price index (CPI): A measure that is 100 times the ratio obtained by comparing
the current cost of a specified group of goods and services to the cost of comparable items
determined at an earlier date. The consumer price index or CPI is a measure of the level of
inflation. CPI measures how much the price of a basket of consumer goods has changed
over a given time period.
Consumers' expenditure: The actual amount spent by consumers for a certain quantity of
goods or services. The consumers' expenditure equals the market price times the quantity
in demand.
Consumers' surplus: The amount that consumers are willing and able to spend but do not
actually spend for a certain quantity of goods or services.
Consumers' willingness and ability to spend: The maximum amount that consumers say
they will spend and/or actually spend for a certain quantity of goods or services.
Continuous graph/function: A continuous graph is an unbroken curve whose set of inputs
is assumed to fill up an entire interval of values along the horizontal axis. A continuous
graph can be drawn without lifting the writing instrument from the page. A smooth
continuous graph is one with no sharp points. A continuous function is a function whose
graph is continuous. When modeling real-life situations, continuous functions could be used
without restriction or could be discretely interpreted.
Continuous function used without restriction: A continuous function for which inputs of
any value make sense in context.
Continuous function with discrete interpretation: A continuous function whose
interpretation makes sense only at certain distinct points.
Continuous compound interest: A limiting form of compound interest where the frequency
with which interest is credited approaches infinity.
Contour curve: A two-dimensional outline of a three-dimensional graph at a given output
level. For a three-dimensional function f, the k-contour curve is the collection of all points
(x, y) for which f (x, y) = k, where k is a constant. Contour curves are also called level curves.
Contour graph: A graph of the contour curves f(x, y) = k for several values of a constant k.
Usually, the values of k are equally spaced.
Count data: Totals that are reported for a specific time period but that are not cumulative
because the counter that tallies the data during the period is reset to zero at the beginning
of each period. When working with count data, accumulated change in a quantity is
calculated by summing the output data.
Control Variables: A control variable is a variable in a model controlled by an agent in order
to optimize a specific objective.
Costs and Efficiency: A cost is a foregone opportunity. Comparative advantage is the ability
to perform a given task at a lower cost. An individual/country is said to be more efficient if
it has a comparative advantage in the production of some good. In other words it is said to
be more efficient.
Covariance: A parameter, related to correlation, that indicates the tendency for two
random variables to "move together" or "co-vary."
Covariance matrix: A symmetric matrix indicating all the covariances and variances of a
random vector.
Covariance stationarity: A property of some stochastic processes. A stochastic process is
covariance stationary if neither its mean nor its autocovariances depend on the index t.
Critical point: A saddle point or a point corresponding to a relative maximum or relative
minimum on a multivariable surface.
Cross section: For a two-variable function, the curve resulting when the function is
intersected with a plane. A cross section of a function will always have one less dimension
(variable) than the function itself.
Cross-sectional function/model: An equation describing a cross section of a multivariable
function.
Cubic function/model: A function of the form f (x) = ax3+ bx2 + cx + d where a, b, c, and d
are constants and not equal to zero. Cubic functions have one change in concavity (i.e., one
inflection point) and no end behavior limiting values.
Cumulative density function: An accumulation function of a probability density function.
The cumulative density function shows how probabilities accumulate as the value of the
random variable increases.
Cyclic function: A periodic, continuous function that varies between two extremes. The
part of the graph of the function that keeps repeating itself is called a cycle of the graph.

Data: Real-world information recorded as numerical values.

Decision Rules: A decision rule is either a function that maps from the current state to the
agent's decision or choice, or a mapping from the expressed preferences of each of a group
of agents to a group decision. The first is more relevant to decision theory and dynamic
optimization; the second is relevant to game theory. The phrase allocation rule is sometimes
used to mean the same thing as decision rule. The term strategy-proof has been defined in
both contexts.
Decreasing without bound: A term applied to the output of a function that infinitely
decreases in height. Decreasing without bound may describe either the end behavior of a
function or the limiting value of a function as the input approaches a certain value.
Degree: One of 360 equal parts into which a complete revolution is divided. Degree measure
is one of the ways angles can be measured and is denoted by a small circle as a superscript.
Delta: The Greek letter for the factor sensitivities measuring a portfolio's first order (linear)
sensitivity to the value of an underlier.
Delta approximation: A linear approximation for how a portfolio's value will change in
response to a small change in an underlier's value.
Delta-gamma approximation: A quadratic approximation for how a portfolio's value will
change in response to a small change in an underlier's value.
Delta-gamma remapping: A quadratic remapping constructed from a portfolio's deltas and
gammas.
Demand: The amount of a good or service that an individual is willing and able to buy at
each possible price.
Demand curve/function: A graph or equation relating the quantity of goods or services that
consumers demand and the price per unit of those goods or services. Mathematicians use
price as input and quantity demanded as output; economists use quantity demanded as input
and price per unit as output.
Demand curve: A graph illustrating demand, with prices on the vertical axis and quantity
demanded on the horizontal axis. Demand curve slopes downward because of the negative
relationship between price and quantity demanded.
Demand vs. Quantity demanded: Demand is a set of number that lists the quantity
demanded corresponding to each possible price whereas quantity demanded is the amount of
a good or service that an individual is willing and able to buy at a given price. For instance,
the information on price and quantity demanded presented in a table/demand schedule is
collectively referred to as the demand.
Derivative: The mathematical term for an instantaneous rate of change. The terms
derivative, rate of change, instantaneous rate of change, slope of a curve, and slope of the
line tangent to a curve are synonymous.
Derivative instrument: An instrument which derives its value from the value of other
financial instruments.
Depression: A depression is a severe downturn in economic activity. These are considerably
worse than recessions.
Determinants of demand: Demand is affected by a number of factors. Price is the most
important factor but there are other factors also that can influence demand such as:

 income
 prices of related goods
 taste
 expectation of the future, price and other factors

Deterministic Functions and Variables: Deterministic means not random. A deterministic

function or variable often means one that is not random, in the context of other variables
available. That is, those other variables determine the variable in question unerringly, by a
function that would give the same value every time those other variables were given to it
as arguments, unlike a random one which with some probability would give different
answers.
Differential equation: An equation involving one or more derivatives. A general solution for
a differential equation is a function that has derivatives that satisfy the differential
equation, and a particular solution is a function obtained from the general solution and the
initial conditions stated in a specific problem.
Diminishing marginal utility: Each additional unit of X yields less utility than the previous
ones. This is known as the law of diminishing marginal utility. For instance, a thirsty person
would derive more utility from the first glass of water than the successive ones.
Direct proportionality: For variables x and y, y is proportional to x if there exists some
constant k such that y = kx. The terms proportional and directly proportional are used
interchangeably. The constant k is referred to as the constant of proportionality.
Discrete: Discrete information is represented by a scatter plot or a table of data. Discrete
graphs are scatter plots of data. In some situations, continuous functions are interpreted
discretely; that is, outputs of the function have meaning in the context of a real-life
situation only at some, not all, input values in an interval.
Diverge: A term applied to an improper integral for which the limit does not exist.
Dynamic Optimization: Dynamic optimizations are maximization problems to which the
solution is a function; equivalently, optimization problems in infinite-dimensional spaces.

Econometric Model: An econometric model is an economic model formulated so that its

parameters can be estimated if one makes the assumption that the model is correct.
Economics: Economics is the study of how scarce resources are allocated to satisfy
unlimited and competing ends.
Efficiency: Efficiency activity or turnover ratios provide information about management's
ability to control expenses and to earn a return on the resources committed to the business,
for example:

 Cash Turnover = Net Sales / Cash

 Inventory Turnover = Cost of Goods Sold / Average Inventory

Efficient frontier: A theoretical set of portfolios offering optimal risk-reward tradeoffs.

Elasticity: A measure of responsiveness. The responsiveness of behavior measured by
variable Z to a change in environment variable Y is the change in Z observed in response to
a change in Y. Specifically, elasticity = (percentage change in Z) / (percentage change in Y).
(Price) Elasticity of Demand: It is a measure of how much the quantity demanded of a good
responds to a change in the price of that good, computed as the percentage change in
quantity demanded divided by the percentage change in price:
Ed = Price Elasticity of demand = (Percentage change in quantity demanded) / (Percentage
change in Price)
Inelastic: If percentage change in quantity demanded is less than the percentage change in
price.
Unit Elastic: If percentage change in quantity demanded is exactly equal to the percentage
change in price.
Elastic: If percentage change in quantity demanded is greater than the percentage change
in price.
Elasticity and the Shape of the Demand curves: A steep demand curve represents inelastic
demand whereas a flat demand curve represents elastic demand. A vertical demand curve
represents perfectly inelastic demand. A horizontal demand curve represents perfectly
elastic demand curve.
(Price) Elasticity of Supply: It is a measure of how much the quantity supplied of a good
responds to a change in the price of that good, computed as the percentage change in
quantity supplied divided by the percentage change in price.
Es = Price Elasticity of supply = (Percentage change in quantity supplied) / (Percentage
change in Price)
Inelastic: If percentage change in quantity supplied is less than the percentage change in
price.
Unit Elastic: If percentage change in quantity supplied is exactly equal to the percentage
change in price.
Elastic: If percentage change in quantity supplied is greater than the percentage change in
price
Elasticity and the Shape of the Supply curves: A steep supply curve represents inelastic
supply whereas a flat supply curve represents elastic supply. A vertical supply curve
represents perfectly inelastic supply. A horizontal supply curve represents perfectly elastic
supply curve. Since the economic incidence of a sales or an excise tax is independent of its
legal incidence. In other words, the burden of the tax is shared by both buyers and sellers
regardless of whether it is a sales tax or an excise tax. The magnitude of the burden
however depends upon the elasticity of demand and supply curves. For instance, buyers
will share a greater burden of the tax if demand is less elastic and sellers will share a
greater burden if supply is less elastic.
End behavior: The behavior of the output of a graph as the input becomes infinitely large
or infinitely small.
Endogenous: A variable is endogenous in a model if it is at least partly a function of other
parameters and variables in a model, in contrast to exogenous.
Equilibrium: Equilibrium is some balance that can occur in a model, which can represent a
prediction if the model has a real-world analogue. The standard case is the price-quantity
balance found in a supply and demand model. If the term is not otherwise qualified, it often
refers to the supply and demand balance.
Equilibrium point: The point at which the demand curve and the supply curve intersect. At
this point, there is market equilibrium; that is, the supply of a product is equal to the
demand for that product.
Event: An outcome of some happening whose results are subject to chance.
Exogeneous: A variable is exogenous to a model if it is not determined by other parameters
and variables in the model, but it is set externally and any changes to it come from external
forces, in contrast to endogenous.
Expected value : The expected value is a parameter indicating the "center of gravity" of a
probability/density distribution. It is also the average of the data. The expected value is a
parameter indicating the "center of gravity" of a probability distribution.
Exponential function/model: A function with an equation of the form f(x) = abx or f (x) =
aekx . Exponential models are characterized by constant percentage change (percentage
differences) in output values when input values are evenly spaced.
Extrapolation: The process of predicting an output value using an input value that is
outside a given interval of input data. Extrapolation should always be viewed with caution.
Extreme point: A point at which a maximum or minimum output occurs. At an extreme
point on a graph, the slope of the line tangent to the curve at that point is zero or the slope
does not exist at that point (but the function output exists at that point). Extreme points
occur at an input value, but the extreme value is an output value. For multivariable
functions, relative extreme points cannot be visually identified on the edges of tables or
contour graphs.

First differences: The changes in successive output values. It is helpful to calculate first
differences for a data set only if all input data values are evenly spaced.
Fixed costs: Also called start-up costs, these costs do not vary with the number of items
produced or the amount of service performed.
Four-Step Method: An algebraic method of finding the derivative of a function using the
definition of the derivative.
Function: A function is a rule that assigns exactly one output to each input. Functions are
represented verbally by word descriptions, numerically in tables, visually with graphs, or
algebraically with equations. If x is the input symbol and f is the rule, then f(x) symbolizes
the output. Input/output diagrams display the input, how the input is measured (input units),
the rule that relates the input and output; and the output, including how the output is
measured (output units).
Future value: The value of an investment at some time in the future. Future value for
discrete situations is calculated using the appropriate compound interest formula. The future
value of a continuous income stream is the total accumulated value of the income stream and
its earned interest.

Gamma: The Greek letter for the factor sensitivities measuring a portfolio's second order
(quadratic) sensitivity to the value of an underlie.
Generalized Linear Model: A generalized linear model is a model where y is a vector of
dependent variable, and x is a column vector of independent variables. The model is often
called a link function.
Graph: One of the ways to represent a function or a real-life situation by plotting output and
input points on coordinate axes. Discrete graphs are scatter plots. Continuous graphs can be
drawn without lifting the writing instrument from the page.

Hedging: The taking of offsetting risks.

Hessian Matrix: The Hessian matrix is the matrix of second derivatives of a multivariate
function. That is, the gradient of the gradient of a function. Properties of the Hessian matrix
at an optimum of differentiable function are relevant in many places in economics and
finance.
Histogram: A graph that is composed of rectangles and constructed so that the area of each
rectangle is the percentage of outputs in the corresponding input interval. These histograms
are also called probability histograms because the area of each rectangle is the probability
that the value of the random variable under discussion is in the interval that forms the base of
the rectangle.

Identification: A parameter in a model is identified, if and only if, complete knowledge of

the joint distribution of the observed variables gives enough information to calculate the
parameter exactly.
If the model has been written in such a way that its parameters can be consistently estimated
from the observables, then the parameters are identified. A model is identified if there is no
observationally equivalent model. That is, potentially observable random variables in the
model have different distributions for different values of the parameter.
Indifference curve (IC): IC is a locus of points representing different baskets of
commodities X and Y that may give consumers the same level of utility or satisfaction so
that he is indifferent among them.
Income stream : A flow of money into an interest-bearing account over a period of time.
When the money flows continuously into the account, the flow is called a continuous income
stream. A discrete income stream is a one into which money flows at specific intervals of
time (quarterly, monthly, daily, and so on.)
Increasing without bound: A term applied to the output of a function that infinitely
increases in height. Increasing without bound may describe either the end behavior of a
function or the limiting value of a function as the input approaches a certain value.
Inflation: An ongoing rise in the average level of absolute prices.
Inflection point : A point where the concavity of a graph changes. Cubic and logistic
functions have one point. Sine and cosine functions have two inflection points in each cycle
and an infinite number of inflection points over all real number inputs. In real-life
applications, the inflection point is interpreted as the point of most rapid change or least
rapid change in an area near the inflection point.
Initial condition : A known point on the graph of a particular solution for a differential
equation.
Instantaneous rate of change: The instantaneous rate of change at a point on a curve is the
slope of the curve at that point and the slope of the line tangent to the curve at that point.
Instantaneous rates of change have labels of output units per input unit.
Integration: The process of evaluating a definite integral to determine the accumulation of
change or the process of recovering a quantity function from a rate-of-change function.
Interpretation of a result: A simple non-technical sentence explaining the real-life meaning
of a result.
Intercept: The input value where the graph crosses or touches the horizontal axis or the
output value where the graph touches or crosses the vertical axis.
Interpolation: The process of predicting an output value using an input value that is within
a given interval of input data.
Inverse function: If a rule obtained by reversing the input and output of a function is also a
function, then it is called an inverse function.
Ito Process: An Ito process is a stochastic process: a generalized Wiener process with
normally distributed jumps. A generalized Wiener process is a continuous-time random walk
with a drift and random jumps at every point in time.

Jackknife Estimator: A jackknife estimator creates a series of estimates, from a single data
set by generating that statistic repeatedly on the data set, leaving one data value out each
time. This produces a mean estimate of the parameter and a standard deviation of the
estimates of the parameter.
Joint proportionality: For variables x, y, and z, y is jointly proportional to x and z if there
exists some constant k such that y = kxz. The constant k is the constant of proportionality.

Kurtosis: A parameter describing the peakedness and tails of a probability distribution.

Law of demand: All else equal, if the price of a good goes up, quantity demanded goes
down and vice versa.
Least squares method: A procedure to determine the line that best fits a set of data using
the criterion that the sum of the squares of the deviations of all the data points from the fitted
line, i.e., SSE is at a minimum.
Least squares line: The linear function that best fits a set of data, where best fit is defined
according to the least squares method.
Legal Incidence vs. Economic Incidence of a Tax Legal incidence refers to the division of
a tax burden according to who is required by law to pay the tax, while economic incidence
refers to the division of a tax burden according to who actually pays the tax after all price
adjustments are taken into account. A change in the legal incidence of a tax will have no
effect on the economic incidence. If the legal incidence of a per-unit tax is entirely on
suppliers, the supply curve will shift up by the amount of the tax. On the other hand, if the
legal incidence is entirely on demanders, the demand curve will shift down by the amount of
the tax. In both situations, the equilibrium quantity will fall, suppliers will receive a lower
post-tax price, and demanders will pay a higher post-tax price.
Leverage Ratios: Leverage ratios measure the degree of protection of suppliers of long-term
funds and can also aid in judging a firm's ability to raise additional debt and its capacity to
pay its liabilities on time, for example:

 Total Debts to Assets = Total Liabilities / Total Assets

 Capitalization Ratio= Long-Term Debt /(Long-Term Debt + Owners' Equity)

Limit: A number to which the output of a function becomes closer and closer as the input
becomes closer and closer to a stated value.
Linear function/model: A function that repeatedly and at even intervals adds the same
value to the output. A linear model is a function of the form f(x) = ax + b representing a
situation in which incremental change is constant. In the linear function, a is the constant
rate of change of the output, i.e., the slope of the graph of the linear function and b is the
output corresponding to an input of zero, i.e., the vertical axis intercept. When input values
in a set of data are evenly spaced and the first differences of the output values are
constant, the data should be modeled by a linear function.
Linear system of equations: Two or more equations in which all the variables occur to the
first power and there are no terms in which two different variables are multiplied or
divided.
Liquidity Ratios: Liquidity ratios measure a firm's ability to meet its current obligations, for
example:

 Acid Test or Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) /

Current Liabilities
 Cash Ratio = (Cash Equivalents + Marketable Securities) / Current Liabilities

Local linearity: The principle that if we graph a smooth, continuous function over a small
enough interval around a point, then the graph looks like the line tangent to the curve at
that point. That is, the tangent line and the curve are basically indistinguishable over the
interval.
Logarithmic (log) function/model: A function with an equation of the form f(x) = a + blnx.
This function is the inverse of the exponential function y = AB , where A = ex/b and B = e-a/b.
Logistic function/model: A function of the form f(x) = L + Ae-bx. The graph of a logistic
function is bounded by the horizontal axis and the line f(x) = L. We refer to L as the limiting
value (or carrying capacity or saturation level) of the function.

Marginal analysis: A type of approximation of change used in economics. The rates of

change of cost, revenue, and profit with respect to the number of units produced or sold are
called marginal cost, marginal revenue, and marginal profit. These rates are often used to
approximate the actual change in cost, revenue, or profit when the number of units produced
or sold is increased by one.
Marginal utility: The marginal utility of a good say X is defined to be the amount of
additional utility derived from the consumption of an additional unit of X while keeping the
quantity of the other good say Y as constant.
Market price: The actual price that a consumer pays for one unit of goods or services.
Mathematical modeling: The process of translating a real-world problem into a useable
mathematical equation.
Matrix: A rectangular arrangement of numbers in rows and columns. Matrices are useful in
solving systems of linear equations.
Mean: One of the measures of the center of a probability distribution, the mean (also called
the expected value or average) is the input value of the "balance point" of the region between
the density function and the horizontal axis.
Microeconomics: Microeconomics is the study of the economic choices made by individual
economic units such as consumers, households and firms etc.
Model: A mathematical model is an equation, along with descriptions and units of the
variables, that describes a real-life situation. There are four important elements to every
model: an equation, a label denoting the units on the output, a description (including units)
of what the input variable represents, and an indication of the interval of input values over
which the model is valid.
Monopoly: If a certain firm is the only one that can produce a certain goodsor service, it has
a monopoly in the market for that goods or service.
Mortgage Terms:

 "Good faith" estimate: It is an estimate of the fees that you will pay to close your
loan.
 A cash-out option? If your equity in your property qualifies, you can refinance with a
loan amount greater than your current mortgage - and keep the difference! Use it for
home improvement, debt consolidation, or whatever you desire.
 Housing-to-income ratio: Your income, debt, and mortgage payments are the
primary factors that affect whether you qualify for a loan. If you do qualify for a loan,
you can apply, and ditech.com will move to the next step of checking to see if you
can be approved.

To determine your qualification, the first thing ditech.com will do is divide the
monthly payment of your proposed loan by your gross monthly income. This provides
your housing-to-income ratio. If the resulting percentage falls within a certain range,
the next step is to divide your total monthly debt by your gross monthly income. This
provides your debt-to-income ratio. Again, if the ratio falls within prescribed limits,
you are qualified for the loan.

The limits within which your housing and debt ratios must fall are determined
primarily by the size of the loan, the value of the property, and the ratio between the
two (known as the loan-to-value ratio, or LTV). This loan-to-value ratio is one of the
most important factors in determining a home loan.

 Appraisal: The appraisal determines the value of the property in question, which
becomes a prime factor in determining the loan-to-value - or LTV - ratio (the amount
of your loan divided by the value of your property). Your LTV is important because it
 determines your equity in the property. With the exception of leveraged equity and
some second mortgages, ditech.com will arrange an appraisal of your property to
verify its value. An appraiser is an authorized professional who estimates the value of
the property and sends the information to ditech.com and to you.
 An impound/escrow account: An impound account or an escrow account (the terms
are interchangeable; each is used in different states) is the name of the account in
which a lender collects payments you make toward your property taxes and
hazard/fire insurance. If you have an impound/escrow account, each of your monthly
payments will contain a fraction of your annual property tax and insurance costs.
Your lender keeps these funds in the impound/escrow account and then pays your
taxes and insurance directly when they become due.

An impound/escrow account can be a convenient and trouble-free manner of ensuring

that your insurance and tax payments are made on time. Additionally, choosing the
convenience of an impound/escrow account allows ditech.com to offer you a better
rate or lower fee. Please note that impound/escrow accounts are mandatory for
purchase or refinance Loans where the loan amount is 80.01 percent or more of the
property value (loan-to-value ratios of 80.01 percent or more), unless otherwise
restricted by laws in your property's state (in California, impound accounts are
required for refinance loans, purchase loans with LTV of 90 percent or greater, and
for second mortgages with LTVs of 80.01 percent or greater).

 Income-to-debt ratio: Your income, debt, and mortgage payments make up your
income-to-debt ratio. These are the primary factors that affect whether or not you
qualify for a loan. If you do qualify for a loan, you can apply, and ditech.com will
move to the next step of checking to see if you can be approved. To determine your
qualification, the first thing ditech.com will do is divide the monthly payment of your
proposed loan by your gross monthly income. This provides your housing-to-income
ratio.

If the resulting percentage falls within a certain range, the next step is to divide your
total monthly debt by your gross monthly income. This provides your debt-to-income
ratio. Again, if the ratio falls within prescribed limits, you are qualified for the loan.

The limits within which your housing and debt ratios must fall are determined
primarily by the size of the loan, the value of the property, and the ratio between the
two (known as the loan-to-value ratio, or LTV). This loan-to-value ratio is one of the
most important factors in determining a home loan.

 Owner's estimate of value: For the 125% Freedom loan product, ditech.com relies on
your estimate of the value of your property. You can estimate the value by reviewing
neighborhood comparable properties (comps). A good way to do this is to simply call
a local real estate agent. You can also visit open house events in your neighborhood.
This may give you an indication of what prices are being asked for various properties.
 PITI: PITI is the acronym for Principal, Interest, Taxes and Insurance. That is, each
month your payment to your lender will consist of:
o Funds to be applied to the principal - to repay the actual money you borrowed
 o Funds to be applied to the interest - to repay the interest you're being
charged on the loan, over the life of the loan
o Funds being collected in an impound/escrow account to pay your
property taxes when they come due
o Funds being collected in an impound/escrow account to pay your
hazard/fire Insurance when it comes due
 PMI: Private Mortgage Insurance (PMI) is usually mandatory for loans when the ratio
of the loan amount to the value of the subject property is greater than 80 percent;
that is, 80.01 percent or more of the property is being paid for by the loan. This is
known as the loan-to-value ratio, or LTV. Basically, the lower your loan-to-value
ratio, the higher your equity in the property will be. You can think of equity as the
part of your property you actually own. If you sold your property (for its appraised
value), equity is the amount of cash you'd have left after you repay your loan balance
in full.

Common wisdom holds that the more equity a borrower has in a property, the lower
the risk of defaulting on the loan. Thus, Private Mortgage Insurance (PMI) must be
paid for lower equity (high LTV) loans to safeguard the lender from possible loan
defaults.

 What is prequalification vs. preapproval: Ditech.com simultaneously gives

prequalification and preapproval based upon the information you provide in the
online application. Because this preapproval is based on information provided to
ditech.com verbally and as set forth on the application, it is considered conditional
loan approval.

The conditional approval is subject to the verification and/or receipt of additional

information. Once all closing conditions and lender requirements are satisfied, the
loan will receive final approval.

 Refinancing: Rolling in your loan costs is especially attractive when refinancing. By

rolling in your costs, you incur no expenses, thus you have no "payback period." The
payback period is the time required to recoup the cost of your new loan through the
monthly savings you get from the difference between your new lower payments and
your old ones. For example, if your new loan's payments are $100 a month less than
your old one, but you had to pay $1,200 to refinance, you'd have a payback period of
12 months before you'd actually start saving. By rolling in the cost of your refinance,
your actual savings begin immediately. Rolling in your costs is particularly
appropriate if you are planning to sell or refinance again in a few years because, in
this case, it doesn't really matter that your loan amount is higher as long as you
enjoy savings right now.
 Equity Line of Credit and another type of second mortgage: An Equity Line of Credit
is money in an account that can be used as you need it. You can use any portion of it
at any time and pay it back at any time. The interest rate is usually variable and is
tied to the prime rate. Other types of second mortgages, such as the Home Equity
Loan and 125 percent Freedom Loans are simple interest products. You borrow a
 lump sum and pay it back over a period of years with interest. The interest rate for
these products is fixed.
 Closing costs: Closing costs are sometimes also called settlement costs. These are the
costs a lender charges for funding and completing your loan and are generally
charged at the time of closing (or settlement). They often include discount points,
which are fees paid to lower your interest rate. Settlement costs/closing costs vary
greatly depending on your state, county, and/or metropolitan area. They also vary
from one lender to another, so it pays to shop around.
 Income, debt, and mortgage payments: These are the primary factors that effect
whether you qualify for a loan. In order to determine if you qualify for a loan, your
lender will calculate two defining ratios: the housing-to-income ratio and the debt-
to-income ratio. The first of the two ratios, the housing-to-income ratio, is calculated
by dividing the monthly payment of your proposed loan by your gross monthly
income. If the resulting percentage falls within a predetermined range, the lender
will then go on to calculate your debt-to-income ratio. The debt-to-income ratio is
calculated by dividing your total monthly debt by your gross monthly income. Once
again, if this ratio falls within prescribed limits, the lender will qualify you for the
loan. The limits within which your housing and debt ratios must fall are determined
primarily by the size of the loan, the value of the property, and the ratio between the
two (known as the loan-to-value ratio, or LTV). This loan-to-value ratio is one of the
most important factors in determining a home loan.
 Prepaid interest and impound/escrow funds: Prepaid interest and impound/escrow
funds are costs generally associated with a mortgage. At the time of closing your
loan, a lender will often require you to provide the funds to establish your
impound/escrow accounts (so your taxes and insurance can be paid on time) and to
pay the interest for the time period between the loan closing date and the end of the
closing month.
 Rates, terms, and APR: All mortgages have an interest rate, a term, and an annual
percentage rate (APR). For example, a mortgage might be defined as a 30-year fixed-
rate loan at 7.625 percent, with an APR of 7.800 percent. In this example, the
mortgage term is 30 years. As the borrower, you will pay back the loan in
installments over the course of 30 years.

The interest rate in this example is 7.625 percent. This means you must pay interest on
the money you've borrowed at a rate of 7.625 percent per year. That is, in addition to
paying back the loan, you will pay your lender an additional 7.625 percent of the
current loan balance every year. This interest is basically the fee your lender charges
you in return for lending you the money.

The annual percentage rate (APR) is a measure of the cost of credit, expressed as a
yearly rate. Because APR includes points and other costs such as origination fees, it's
usually higher than the advertised rate. The APR allows you to compare different
mortgages based on actual annual costs.

 "Locking in a rate": You can secure your rate by completing a written agreement in
which ditech.com guarantees a specified interest rate for a specified period of time.
 Locking in a mortgage rate protects you against interest rate changes from the date
of the rate lock until the date of the closing as long as your rate lock has not expired.
Should interest rates rise during that period, ditech.com is obligated to honor the
committed rate. Should interest rates fall during that period, you must honor the
lock.
 Mortgage: A mortgage is a loan you acquire in order to purchase property, but you
can also get cash for other purposes using the property as equity. In return for the
loan, you pledge real property (land and/or a building) as security in case you fail to
live up to your obligation.

When you borrow money against property, you commit to two financial documents:

o The NOTE that is a personal obligation to repay the loan on a timely basis
o The MORTGAGE DEED OF TRUST that is the pledge of the property as security;
the mortgage deed of trust defines your obligations to your lender, as well as
your rights and those of the lender.

You are pledged to repay the mortgage loan, along with an additional charge for the
lender's service of lending you the money.

The cost of borrowing the money is the interest rate specified in your note. The
amount of time you have to pay back the loan is the note's term.

 Amortization:Amortization means paying down your principal. You repay your loan in
monthly installments. If you have a fixed mortgage (that is, an interest rate that
remains fixed for the entire term of the loan), your payments will always be the same
amount. Part of the payment goes toward the payment of the interest, and part
toward the repayment of the money you've borrowed (the principal).

The balance of the principal (what you still owe at any given time) is reduced with
each payment. As a result, your monthly payment will pay the principal in increasing
amounts over time. With a fixed-interest rate, the amount of interest you owe will
decrease as your principal balance decreases.

You can create an amortization schedule for fixed loans when they are originated.
This schedule will show how much of each payment will go toward interest and how
much will go toward principal over the life of the loan.

As your principal decreases, your equity in the mortgaged property increases. Equity
is a very important factor in mortgage financing.

 Equity: Equity is a crucial aspect of home loans. Equity is simply the value of a
homeowner's unencumbered interest on real estate. Equity is computed by
subtracting the total of the unpaid mortgage balance and any outstanding liens or
other debts against the property from the property's fair market value. A
homeowner's equity increases as he or she pays off his or her mortgage or as the
property appreciates in value. When a mortgage and all other debts against the
 property are paid in full, the homeowner has 100 percent equity in his or her
property.

Equity exists in conjunction with your loan-to-value ratio (or LTV). Your LTV is a
ratio expressing the value of your property to the amount of your loan. You determine
your LTV by dividing your loan amount by your property's value or selling/purchase
price, whichever is lower.

For example, you buy a $100,000 home with a $20,000 down payment of your own
money, and cover the remaining $80,000 with a mortgage - 80,000 divided by
100,000 gives you a loan-to-value ratio of 80 percent and equity of 20 percent.

Equity and LTVs are important because lenders prefer a borrower to have as much
equity as possible. Traditional wisdom holds that the higher the LTV on a loan, the
higher the risk of default; alternatively, the higher the equity, the lower the risk - and
therefore the lower the interest rate, cost, and fees associated with doing the loan.
Equity also determines how much a lender will allow you to refinance your property
for and how much they will lend you for a second mortgage.

Another way to think of equity is as the amount that you'll receive when you sell the
property and pay back the remaining loan balance. Again, for a $100,000 house
bought with an $80,000 loan and sold for $100,000, you would get $20,000 in cash
back - or 20 percent of the home's value.

Multivariable function: A function that has two or more input variables and one output
variable. Multivariable functions with two input variables can be illustrated with graphs of
three-dimensional surfaces, tables of data, and/or contour graphs.

Normal distribution: A continuous probability distribution whose probability density

function has a "bell" shape.

Oligopoly: A market for a good where a few major suppliers account for a large majority of
sales.
Operational risk: Risk to financial or other institutions from inadequate or failed internal
processes, people and systems or from external events.
Optimization: The process of finding relative or absolute extreme points.
Option: A type of derivative instrument. A contract which gives the holder of the contract
the right to buy or sell a commodity or financial asset for a given price before a specified
date.

Partial derivative: A derivative of a multivariable function found by taking the derivative

of the function with respect to one of the input variables while all the other input variables
are held constant.
Partial rate of change: The rate of change of a cross-sectional function that is computed as
a partial derivative.
Percentage change: A quantity calculated from data with increasing input values by
dividing each first difference by the output value of the lesser input value and multiplying by
100%. That is, if a quantity changes from a value of m to a value of n over a certain interval,
then the percentage change equals n-mm×100%.
Percentage rate of change : A quantity that is useful in describing the relative magnitude of
a rate of change. A percentage rate of change at a point is found by dividing the rate of
change at the point by the function value at that same point and multiplying the result by
100%. Percentage rates of change have labels of percent per input unit.
Piecewise continuous function: A function formed by combining two or more pieces of
continuous functions. A piecewise continuous function is not necessarily a continuous
function.
Point of diminishing returns: An inflection point on the graph of a function beyond which
the function output increases at a decreasing rate.
Point of tangency: The point at which the line tangent to a curve touches the curve and at
which the slope of the line tangent to the curve is the instantaneous rate of change of the
curve.
Polynomial function: A function that has the form f(x) = anxn+ an-1xn-1+ … + a1x + a0 , where
a0, a1, … , an are constants and n is a positive integer called the degree of the polynomial. If n
= 1, then the polynomial function is a linear function; if n = 2, it is a quadratic function; and
if n = 3, it is a cubic function.
Portfolio: The entire collection of financial assets held by an investor.
Premium: The purchase price of an option.
Present value: The amount of money that would have to be invested now in an interest-
bearing account in order for the amount to grow to a given future value.
Probability: A measure of how likely an event is to happen. The probability of an event is
always a number between 0 (for an impossible event) and 1 (for a sure event). One of the
methods for computing probabilities is to find areas under probability density functions.
Probability density function: A continuous or piecewise continuous function with input
consisting of some interval of real numbers and output satisfying the conditions that each
output value is greater than or equal to 0 and the area of the region between the density
function and the horizontal axis is 1.
Probability distribution: When all outcomes of a particular situation are considered, the
pattern indicated by the variability in the data is called the distribution of the quantity being
studied.
Producers' revenue: The actual amount of money that producers receive for supplying a
certain quantity of goods or services. The producers' revenue equals the market price times
the quantity supplied.
Producers' surplus: The amount of money that producers receive above the minimum
amount they are willing and able to accept for a certain quantity of goods or services.
Producers' willingness and ability to receive: The minimum amount of money that
producers are willing and able to receive for supplying a certain quantity of goods or
services.
Profit: Revenue minus total cost.
Profitability Ratios: Profitability ratios profitability ratios measure management's ability to
control expenses and to earn a return on the resources committed to the business, for
example:
  Operating Income Margin = Operating Income / Net Sales
 Gross Profit Margin = Gross Profit / Net Sales

Properties of indifference curves (IC):

1. All points on the same indifference curve carry same level of satisfaction or utility. A
point with higher level of utility will be on a higher indifference curve while a point
with lower level of satisfaction will be on a lower indifference curve.
2. Indifference curves slope downward. This is because when a person moves along an
indifference curve, he/she faces a tradeoff. In order to get more of one good, one
has to give up some amount of the other.
3. Indifference curves do not intersect each other. The IC's are convex to the origin. The
indifference curves slope downward.
4. The Marginal Rate of Substitution / The marginal value and the Slope of IC. The
marginal rate of substitution is the rate at which the consumer is just willing to
substitute one good for another. For instance the marginal rate of substitution of Y
for X is the amount of Y that a consumer is willing to give up in order to get one
additional unit of X. The marginal rate of substitution is in fact the slope of the
indifference curve. The steeper the indifference curve is, higher would be the slope
and so higher would be the marginal rate of substitution.
5. Shape of the Indifference Curves and the Law of Diminishing Marginal Utility.
Indifference curves are convex to the origin. In other words, they are steeper in the
beginning and then flatten out towards the end. Since the slope of the IC is simply
the marginal rate of substitution of X for Y , therefore we can say that the marginal
rate of substitution of X for Y declines as we move along the curve. This is due to the
law of diminishing marginal utility. As we move along the indifference curve, we are
having more and more units of Y (measured on horizontal axis) and according to the
law of diminishing marginal utility, each additional unit gives less and less marginal
utility compared to the previous ones. So as we get more of Y, it becomes less
valuable for us and we are willing to give up less of the other good in order to get
more Y.

Quadratic function/model : A function of the form f(x) = ax2+ bx + c where a, b, and c are
constants and a is nonzero. In this function, a is called the leading coefficient. The graph of a
quadratic model is called a parabola. If a is less than zero, the parabola is cocave and if a If a
is more than zero, the parabola is concvex. When input values of a set of data are evenly
spaced and the second differences of the output values are constant, the data should be
modeled by a quadratic function.
Quadratic portfolio: In the context of value-at-risk (VaR), a portfolio whose portfolio
mapping function is a quadratic polynomial.

Random variable: A variable whose numerical values are determined by the results of a
situation involving chance.
Ratings transition matrix: A matrix indicating probabilities of upgrades or downgrades in
bonds' credit ratings.
Reduced form model: Intensity model.
Relative maximum: An output value that is larger than all other output values in some
interval around the maximum. A graph increases to the relative maximum and decreases
after it. For a multivariable function, a relative maximum is an output value that is greater
than all values around it.
Relative minimum: An output value that is that is smaller than all other output values in
some interval around the minimum. A graph decreases to the relative minimum and
increases after it. For a multivariable function, a relative minimum is an output value that is
smaller than all values around it.
Replacement cost : The cost of replacing an obligation of a counterparty.
Revenue: Quantity sold times price per unit.
Risk: Comprises two components: uncertainty and exposure.
Risk averse: Preferring less risk to more.

Saddle point: For a multivariable function, a saddle point appears to be a maximum point
when approached from one direction and a minimum point when approached from another
direction. Saddle points cannot be visually identified on the edges of tables or contour
graphs.
Scatter plot: A discrete graph showing points in isolation from one another on a rectangular
grid. A graph of data is a scatter plot.
Secant line: A line through two points on a scatter plot or a function graph. The slope of the
secant line through two points is the average rate of change of the quantity between the input
values of those two points.
Second derivative: The derivative of the derivative (provided it exists). At a point of
inflection on a graph, the second derivative is zero or does not exist. Where the second
derivative of a function is positive, the function graph is convex up, and where the second
derivative of a function is negative, the function graph is concave.
Second differences : The differences between the first differences. Separation of variables :
A technique for solving certain differential equations in which all terms containing one
variable are put on one side of the equation, all terms involving the other variable are put on
to the other side of the equation, and then antiderivatives of both sides are taken.
Shutdown price: The price below which producers are not willing or able to supply any
quantity of particular goods or services to consumers. The point on the supply curve that
corresponds to the shutdown price is called the shutdown point.
Signed area : The negative of the area of a region.
Semi-variance: An alternative to variance that focuses on negative values of a distribution.
Slope: A measure of how steeply tilted a line or curve is. The rate of change of a linear
function is its slope. The slope of the line tangent to a curve at a point is the limiting value of
the slopes of nearby secant lines. The slope of a curve (graph) at a point is the slope of the
line tangent to the curve at that point (provided the slope exists). The instantaneous rate of
change (also called the derivative or rate of change) at a point on a curve is the slope of the
curve at that point (provided that slope exists).
Slope graph: Also called the rate-of-change graph or derivative graph, a slope graph depicts
the changing nature of the slopes of lines tangent to a graph of a function. Where a function
is increasing, its slope graph is positive; where a function is decreasing, its slope graph is
negative. Where a function has a maximum, has a minimum, or levels off, the slope graph is
zero. Where a function has an inflection point, the slope graph has a maximum or minimum
point.
Smooth: A continuous function is smooth if it has no sharp points; that is, no points where
two pieces of a function have different slopes at the point where they meet.
Solvency Ratios: These ratios measure the financial soundness of a business and how well
the company can satisfy its short- and long-term obligations:

 Quick Ratio – This ratio, also called "acid test" or "liquid" ratio, considers only cash,
marketable securities (cash equivalents) and accounts receivable because they are
considered to be the most liquid forms of current assets. A Quick Ratio less than 1.0
implies dependency on inventory and other current assets to liquidate short-term
debt. This ratio is calculated using the following formula:

Cash + Accounts Receivable / Current Liabilities

 Current Ratio – This ratio is a comparison of current assets to current liabilities,

commonly used as a measure of short-run solvency, i.e., the immediate ability of a
business to pay its current debts as they come due. Potential creditors use this ratio
to measure a company's liquidity or ability to pay off short-term debts. This ratio is
calculated using the following formula:

Current Assets / Current Liabilities

 Current Liabilities to Net Worth Ratio – This ratio indicates the amount due creditors
within a year as a percentage of the owners or stockholders investment. The smaller
the net worth and the larger the liabilities, imply the less security for creditors.
Normally a business starts to have trouble when this relationship exceeds 80%. This
ratio is calculated using the following formula:

Current Liabilities / Net Worth

 Current Liabilities to Inventory Ratio – This ratio shows, as a percentage, the reliance
on available inventory for payment of debt (how much a company relies on funds
from disposal of unsold inventories to meet its current debt). This ratio is calculated
using the following formula:

Current Liabilities / Inventory

 Total Liabilities to Net Worth Ratio – This ratio shows well how all of a company's
debt relates to the equity of the owners or stockholders. The higher this ratio, the
less protection there is for the creditors of the business. This ratio is calculated using
the following formula:

Total Liabilities / Net Worth

 Fixed Assets to Net Worth Ratio – This ratio shows the percentage of assets centered
in fixed assets compared to total equity. Generally the higher this percentage is over
75%, the more vulnerable a concern becomes to unexpected hazards and business
 climate changes. Capital is frozen in the form of machinery and the margin for
operating funds becomes too narrow for day-to-day operations. This ratio is
calculated using the following formula:

Fixed Assets / Net Worth

Standard deviation: A measure of how closely the values of a probability distribution

cluster about its mean.
Standard position: An angle drawn so that one side, called the initial side, is along the
positive x-axis and the other side, called the terminal side, is in one of the four quadrants.
Stochastic process: A model for a time series.
Sum of squared errors (SSE): A measure of best fit for linear functions. SSE is calculated as
the sum of the squares of the deviations where the deviation for each data point is the data
output minus the output of the fitted linear function y = ax + b.
Supply: Supply is the amount of a good or service that a producer is willing and able to offer
for sale at each possible price. Supply is affected by a number of factors. Price is the most
important factor but there are other factors also that can influence supply such as
technology, future expectations and
prices of inputs: A change in price leads to a change in quantity supplied. A change in price
does not lead to a change in supply. All else equal, if the price of a good goes up, quantity
supplied goes up and vice versa.
Supply vs. Quantity supplied: Supply is a set of number that lists the quantity supplied
corresponding to each possible price whereas quantity supplied is the amount of a good or
service that a producer is willing to offer for sale at a given price. For instance, the
information on price and quantity supplied presented in a table/demand schedule is
collectively referred to as the supply.
Supply curve: A graph illustrating supply, with prices on the vertical axis and quantity
supplied on the horizontal axis. Supply curve slopes upward because of the positive
relationship between price and quantity. A change in supply leads to a shift in the supply
curve. A fall in supply shifts the supply curve to the left and a rise in supply shifts the curve
to the right supplied.
Supply and the Excise Tax: An excise tax is a tax that is paid directly by suppliers to the
government. An excise tax affects the supply curve. It causes the curve to shift to the left
parallel to itself by the amount of the tax.
Supply Market: Market supply is the sum of the individual supplies by all the sellers.
Market supply curve is the horizontal summation of individual supply curves.
Demand and Supply Equilibrium: The points where the demand and supply curves
intersect each other. Shifts in demand, supply or both the curves changes the equilibrium.
In order to find the effect of a certain event on equilibrium, we have to know first whether
the event shifts the demand or supply curve and then trace the effect on equilibrium
systematically. Both the sales tax and excise tax reduce the equilibrium quantity. In both
cases, the price paid by demanders increase and the price received by suppliers decrease.
In other words, both the suppliers and demanders are worse off regardless of whether it is
a sales tax or an excise tax. In other words, both the demanders and the suppliers bear the
burden of the tax. The magnitude of burden however, depends upon the shapes of the
demand and supply curves.
Supply curve/function: A graph or equation that expresses the quantity supplied relative to
the price per unit.
Symmetric difference quotient: A method of approximating instantaneous rates of change
from data or an equation by using a close point on either side of the point of interest and
the same horizontal distance away. The symmetric difference quotient is the difference
between the outputs of the two close points divided by the corresponding difference in
inputs of the two close points.
Systematic risk: That component of an instrument or portfolio's market risk that is
correlated with the overall market.

Tangent line: A line that touches a graph at a point and is tilted exactly the way the graph is
tilted at that point. The tangent line at a point on a smooth continuous graph is the limiting
position of the secant lines between nearby points and that point (if the limiting position
exists). Provided the slope exists, the slope of the tangent line at a point is a measure of the
slope of the graph at that point and gives the instantaneous rate of change of the graph at that
point.
Time series: A series of observations made over a period of time.
Total cost: The sum of the fixed costs and the variable costs.
Total social gain: The benefit to society whenever consumers and/or producers have surplus
funds. When the market price of a product is the equilibrium price for that product, the total
social gain is the consumers' surplus plus the producers' surplus.
Trend : As associated with limits, a trend is a value to which a quantity becomes closer and
closer as the input becomes infinitely large or infinitely small.

Unexpected loss: A risk metric related to the second moment of a portfolio's losses due to
default over a specified horizon.
Uniform distribution: A continuous probability distribution that has constant probability on
a finite interval.
Unit of measure: A word or short phrase telling how a quantity is measured, not an entire
description telling what the variable represents.
Utility: Utility is a measure of pleasure or satisfaction. Suppose we have two goods: X and
Y and there is a basket containing 5 units of X and 7 units of Y, and the consumption of this
basket gives 6 units of utility, then we can write: U(5,7) = 6.
Utilization: Given a risk limit, the amount of risk being taken as a fraction of the limit.
Value-at-risk (VaR): A category of market risk measures.
Variable costs: Costs that change according to the number of items produced or the amount
of service performed.
Variation: the spread of a set of observations or of a random variable, usually measured by
the variance, the standard deviation, the range or the inter-quartile range.
Vertical Line Test: A method of visually determining whether a graph with inputs located
along the horizontal axis and outputs located along the vertical axis is a function. If there is
no input at which a vertical line crosses or touches the graph in two or more places, then the
graph represents a function.
Why People Trade? Everyone benefits when each person specializes in his area of
comparative advantage and then engages in trade. Trade can help people specialize in
different activities and helps them enjoy a variety of goods and services. Trade can take
place because of two major reasons: difference in tastes and difference in abilities.
Volatility: A metric of variability in a stochastic process.
Work Simplification: Analysis of any aspects of work with the objective of removing any
unnecessary obstacles to its effective achievement, such as motion and time study.

X-bar chart: A quality control chart for the mean of a process.

Yates' correction for continuity: An old correction to adjust chi-square for a 2 by 2 table
for the fact that cell frequencies are integer, rather than continuous; however, rarely
recommended any longer.

Zero Defects: A type of quality control in which the objective is to make no mistake or
produce no reject material whatsoever.
Z score: Number of standard deviations above or below the mean.

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Educational Multimedia, of materials presented on this Web site is permitted for non-
commercial and classroom purposes only.
This site may be mirrored intact (including these notices), on any server with public access.
All files are available at http://home.ubalt.edu/ntsbarsh/Business-stat for mirroring.

Kindly e-mail me your comments, suggestions, and concerns. Thank you.

Professor Hossein Arsham

This site was launched on 2/18/1994, and its intellectual materials have been thoroughly revised on a
yearly basis. The current version is the 9th Edition. All external links are checked once a month.

Back to:
Time-Critical Decision Making for Economics and Finance

EOF: © 1994-2012.
What is the difference between relative and absolute change?

Absolute change refers to the simple difference in the indicator over two periods in time, i.e.
Relative change expresses the absolute change as a percentage of the value of the indicator in
the earlier period, i.e.

What is relative change in statistics?

Relative change shows the change of a value of an indicator in the first period and in
percentage terms, i.e. Relative change is calculated by subtracting the value of the indicator in
the first period from the value of the indicator in the second period which is then divided by the
value of the indicator in the first …

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How do you find absolute and relative increase?

The absolute increase from an old value O to a new value N is N–O. To find the increase
relative to the old value, divide the absolute increase by the old value O to get the relative
increase, (N–O)/O. This value is the fraction of the old value that was added to get the new
value.

Is Relative change always positive?

Relative change is the absolute change divided by the original value. Note that the “quantity”
values are always positive (at least in almost all contexts). But the absolute change can turn out
to be a negative number or a positive number.

What is the difference between relative time and absolute time?

Relative time is the physical subdivision of the rocks found in the Earth’s geology and the time
and order of events they represent. Absolute time is the measurement taken from the same
rocks to determine the amount of time that has expired.

What is the difference between absolute and relative change?

Absolute change refers to the simple difference in the indicator over two periods in time, i.e.
Relative change expresses the absolute change as a percentage of the value of the indicator in
the earlier period, i.e. The concepts of absolute and relative change also apply to indicators
measured in percentage terms, for example unemployment rate.

Is the percent change measure valid for Statistics?

Percent change is an asymmetric measure that is not valid to compute statistics on. You would
need to analyze the log ratio if you think relative changes are more appropriate than absolute
changes. But the central question is what are the properties of the measurement and what is
the correct model to use.
Which is an example of a relative change?

Relative change also refers to the change in the indicator in percentage terms, i.e. absolute
change as a percentage of the value of the indicator in period 1. Example 1. 9,800 workers were
made redundant (i.e. retrenched or prematurely released from their contracts) in 2010,
compared with 23,430 in 2009.

How to analyze change from baseline, absolute or percentage?

From his point of view, one of the advantages of percentage change is that per- centage change
is independent of the unit of measurement. For instance, a man who weighs 100 Kg lost 10% of
weight after a treatment, i.e. 10 Kg. Equivalently, he lost 22.05 pounds (1Kg = 2:2046 Pounds).

The problem with Relative vs Absolute changes

When numbers change people can report how big that change was in relative or absolute terms.

 Relative change - By what percentage (larger or smaller) did the number change from the original
number?
 Absolute change - What is the difference between the original number and the new one?

While these two statements do not sound that different, let’s explore how they can each be misleading.

Relative changes
Relative changes on small numbers can appear to be more significant than they are. This is because a
small absolute change in the number can result in a large percentage change.

So if I got a $50 return on my $10 investment, my relative change was a 400% increase.
There is also some variation in how relative changes are reported. Here we have a 400% increase which
is also the same as saying five times as much. This becomes more confusing when a relative change is
negative. Something that is five times as small is an 80% decrease from the original amount.

Relative changes on big numbers can appear less significant. This is because any absolute change in the
number needs to be large to show a large relative change. Even when the absolute change is large, if it is
a change on a larger number the relative change can be small. Let’s say that the national deficit
increased by 5%. This may seem small, but the actual increase or absolute change to the
$20,000,000,000,000 budget is $1 trillion.

Absolute changes
Absolute changes work the other way:

 Absolute changes on small numbers can look small even if their relative changes are large. To allude to
the example used earlier, I earned $40 on my investment.
 Absolute changes on big numbers can look big even if their relative changes are small. The deficit has
increased by $1 trillion.

When to use Relative vs Absolute change

Use Both
When choosing between reporting a relative change or absolute change, take a second to think about
whether you are choosing the type of change that best represents what is actually happening. Or, are you
simply selecting the more sensational number? The best practice is to provide both numbers. Personally,
I recommend putting the less sensational number first so people have context and are not distrusting
when you reveal the less significant number.
Context Matters
When numbers change, we want to know the reason. Sometimes the context completely changes the
story. If home prices increased by 20% over the past ten years we might be concerned about this trend.
However, if you factor in inflation which also increased by 20% over the past ten years, then the relative
value of homes has stayed constant. Even if the change in home prices was put in absolute terms, there
was no actual change in the value of the homes. For any chart focused on tracking a monetary value over
a time period, you will always need to adjust for inflation.

Compare
To get a clearer idea of whether an absolute or relative change is significant, compare it to other changes
that are related to it. For example, if sharks kill 16 people per year, and this year they killed 20, that is a
25% increase of sharks killing people. If you compare this to heart disease killing approximately
600,000 people per year, the total number and the relative change of shark-related deaths don’t sound so
significant. Even if heart disease declined 25% in the same year, it should still help us better understand
the lack of significance to shark-related deaths.

Interpreting Relative vs Absolute change

Let’s look at an example of changes in share price to demonstrate how the change in price could be
represented in different ways.
Here we can see the absolute change in price everyday. There is a lot of variance which can distract
from the relative and absolute returns of the investment. If we bought the stock on May 1st we could
look at the return per share in absolute terms.

Now this may not look like that much money but when we look at the relative change from our starting
positions we can see we got a high relative return on our money.

Next time we would want to put more money in so that the absolute return would be bigger.

Summary:
 Relative changes on small numbers often look big.
 Relative changes on big numbers often look small.
 Absolute changes on small numbers often look small.
 Absolute changes on big numbers often look big.
 Explore both types of changes when looking at data

When studying labour market indicators, we are often interested in how they compare with past
periods, say relative to a year ago or ten years ago.

Absolute change refers to the simple difference in the indicator over two periods in time, i.e.
Relative change expresses the absolute change as a percentage of the value of the indicator in
the earlier period, i.e.

The concepts of absolute and relative change also apply to indicators measured in percentage
terms, for example unemployment rate. For such indicators,

Absolute change also refers to the change in the indicator in percentage points,
i.e. value of the indicator in period 2 minus that in period 1.

Relative change also refers to the change in the indicator in percentage terms,
i.e. absolute change as a percentage of the value of the indicator in period 1.

Example 1

9,800 workers were made redundant (i.e. retrenched or prematurely released from their
contracts) in 2010, compared with 23,430 in 2009.

Example 2

Total employment rose by 115,900 in 2010 from the level of 2,990,000 in December 2009.

Here, the total employment change of 115,900 is the absolute change in total employment in
2010.
Example 3

The annual average resident unemployment rate was 4.3% in 2009 and 3.1% in 2010.

Lorenz curve
 Max Lorenz developed the Lorenz curve in 1905 as a graphical of income inequality and wealth
inequality.
 This graph shows population percentiles according to income or wealth on a horizontal axis.
 It plots cumulative income or wealth on the vertical axis, so that an x-value of 45 and a y-value of 14.2
indicates that the bottom 45% of the population controls 14.2% of the total income or wealth.
 A Lorenz curve is usually determined from incomplete income or wealth observations. It is generally used
to show the extent of concentration of income and wealth.
 The Lorenz curve represents the distribution of wealth or income within a population. A Lorenz curve
represents percentiles of the population versus their cumulative incomes or wealth.
 It is widely used to measure inequality among a population using Lorenz curves along with their
derivative statistics.
 A Lorenz curve is a mathematical estimate that fits a continuous curve to incomplete and discontinuous
data, so it may be an imperfect measure of underlying inequality.
 Lorenz curves are often accompanied by a straight diagonal line with a slope of 1, indicating perfect
equality in income or wealth distribution; the Lorenz curve lies beneath it, indicating the observed or
estimated distribution.
 As a scalar measure of inequality, the Gini Coefficient involves the difference between the straight line
and the curve.
 The Lorenz curve is most commonly used to illustrate economic inequality, but it can also be used to
illustrate unequal distribution in any system.
 By extending the straight diagonal line farther from the baseline, the level of inequality will increase.
 According to the Lorenz curve, income or wealth distribution is unequal when one has a high income and
a low net worth or a high income with a low net worth.
 Lorenz curves are usually derived from an empirical measurement of the distribution of wealth or income
across a population, for example, using tax returns with income information for a large proportion of the
population.
 Either the graph of the observed data may be used directly as a Lorenz curve, or statisticians and
economists may fit a curve that fills in the gaps in the observed data.
 Compared to summary statistics such as the Gini coefficient or Lorenz asymmetry coefficient, a Lorenz
curve provides more detailed information about the distribution of wealth or income across a population.
 Due to its visual representation of the distribution across each percentile (or other unit), a Lorenz curve

can


 reveal precisely where and by how much the observed distribution varies from equality.
 A Lorenz curve is a graphical representation of the distribution of income or wealth within a population.
 Lorenz curves graph percentiles of the population against cumulative income or wealth of people at or
below that percentile.
 Lorenz curves, along with their derivative statistics, are widely used to measure inequality across a
population.
 Because Lorenz curves are mathematical estimates based on fitting a continuous curve to incomplete and
discontinuous data, they may be imperfect measures of true inequality.
Lorenz Dominance
 It is said that the Lorenz curve of a distribution A dominates the distribution of B when the curve A
overtakes the curve B at all points along the distribution.
 In this case, one can say that A is more equal than B. If both distributions have the same mean, A is
preferable to B.
 There can only be an assumption of stretches of a distribution if two Lorenz curves intersect.
 Whenever such a distribution arises, there are welfare functions that rank it differently.
 Compared to distributions of B and C, distribution of A dominates distribution of B, but distributions of B
do not have dominance.
Generalized Lorenz Curve
 It seems Lorenz curves only imply welfare dominance when the same mean is compared to distributions,
the most restrictive interpretation of the theory.
 The criterion developed by Shorerocks and Kakwani (1984) to compare distributions which differ in their
means is a useful one.
 An alternative to the Lorenz Curve is the Generalized Lorenz Curve, which multiplies by the average
income of the distribution the accumulated fraction of incomes at each fractional level in the population.
 The generalized curve, as a result of this multiplication, provides information about the form and level of
the distribution, or the joint first two moments of the distribution, such as the income distribution curve and
its congeners of basic statistics.
 The Lorenz Generalized Curve is represented by the function L(u,P) = u L(P). In general, any symmetric
welfare function (satisfies anonymity property) and quasi-concave distribution (satisfies Pigu Dalton
property) will lead to higher welfare for A than for B at all points of the graph.
Reasons for income inequality
 The distribution of economic characteristics across the population should be considered.
 Analyzing how the differences give rise to different outcomes in terms of income.
 A country may have a high degree of inequality because of: –
a) A great disparity in these characteristics across the population.
b) These characteristics generate huge effects on the amount of income a person earns.
Uses of the Lorenz Curve
 One can use it to show the effectiveness of a government policy in helping redistribute income.
 The impact of a particular policy introduced can be demonstrated with the help of the Lorenz curve, how
the curve has moved closer to the perfect equality line post-implementation of that policy.
 It is one of the simplest representations of inequality.
 It is most useful in comparing the variability of two or more distributions.
 It shows the distribution of wealth of a country among different percentages of the population with the help
of a graph that helps many businesses establish their target bases.
 It helps in business modeling.
 One can use it majorly while taking specific measures to develop the weaker sections of the economy.
Limitations
 It might not always be rigorously true for a finite population level.
 The equality measure shown may be misleading.
 When two Lorenz curves are being compared and intersected, it is impossible to ascertain which
distribution represented by the curves displays more inequality.
 The Lorenz curve ignores income variation over an individual’s lifecycle while determining inequality.
 Gini Coefficient
 Gini Coefficient is also known as the Gini index is the statistical measure which is used in order to measure
the distribution of the income among the population of the country i.e., it helps in measuring the inequality
of income of the country’s population.
 A higher Gini index indicates greater inequality, with high-income individuals receiving much larger
percentages of the population's total income.
 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.
 The Gini coefficient can be calculated using the formula: Gini Coefficient = A / (A + B), where A is the
area above the Lorenz Curve and B is the area below the Lorenz Curve.

Interpretation of Gini coefficient / index

 If all the elements belong to a single class, then it can be called pure.
 The degree of Gini index varies between 0 and 1,
 0 denotes that all elements belong to a certain class or if there exists only one class, and
 1 denotes that the elements are randomly distributed across various classes.
 A Gini Index of 0.5 denotes equally distributed elements into some classes.
Principles of the Gini Coefficient
The Gini coefficient is one of the most utilized measures of economic inequality because it aligns with the
following principles:
 1. Anonymity: The coefficient does not disclose the identities of high-income and low-income
individuals in a population.
2. Scale of independence: The calculation of the Gini coefficient does not depend on how large the
economy is, how it is measured, or how wealthy a country is. For example, both rich and poor
countries may show the same coefficient due to similar income distribution.
3. Population independence: The coefficient does not depend on the size of the population.
4. Transfer principle: The coefficient reflects situations when income is transferred from a rich to a poor
individual.

Limitations of the Gini Coefficient

Despite its numerous advantages such as universality and scalability, there are still some limitations to the Gini
coefficient:
1. Sample bias: The validity of Gini coefficient calculations can be dependent on the size of a sample. For
example, small countries or countries with less economic diversity frequently tend to show low
coefficients, while large economically diverse countries usually demonstrate high coefficients.
2. Data inaccuracy: The Gini coefficient is prone to systematic and random data errors. Therefore,
inaccurate data can distort the validity of the coefficient.
3. Same Gini coefficient but different income distribution: In some cases, the coefficient can be the same
for countries with different income distributions but equal levels of income.
4. Does not reflect the structural changes in a population: One of the drawbacks of the coefficient is that it
does not take into consideration the structural changes in a population. Such changes can significantly
influence the economic inequality in a population. Generally, the situation arises because young people
tend to earn less relative to older people.