Wednesday, September 19, 2007

The Income Effect

Russell Roberts at Cafe Hayek (HT) has a very thought-provoking post that links to a site sponsored by Wal-Mart. Roberts berates the state of economic education in the U.S. when a company like Wal-Mart has to spend big bucks to get people to understand what should be a fundamental aspect of economics.

When studying economics (and I hope personal finance), time is or should be spent getting students to understand that their lifestyle is not a function of money, but rather what money can buy. One only has to think about countries like current Zimbabwe, or 1920s Germany to understand that it doesn't take much to be a millionaire, but being one doesn'tamount to much if coffee is selling for hundreds or thousands of currency units per cup, if it's even available.

The lesson of the income effect is that there is nominal income (what you're paid), and real income (the basket of goods and services that you can buy with what you're paid). And a corollary is that when prices of different items in your real income change, this constitutes a change in income. This is because you must now choose (opportunity cost here) how to adjust your basket of goods and services. If the price of one item in the basket goes up, you have some basic options:
1) Buy less of the item in question - this is because you can now get fewer units for the same amount of nominal income.
2) Buy the same amount, but because you must spend more nominal income to get the same quantity of the good in question, you will have to buy less of something else.
3) Buy the same amount of everything, but borrow against future spending/consumption to pay for current consumption (go into debt).
4) Some combination of above.


Conversely, and here's where the link to the Wal-Mart site figures in, if the price of something goes down, you have similar options:
1) Buy more of the item in question - this is because you can now get more units for the same amount of nominal income.
2) Buy the same amount, but because you spend less nominal income to get the same quantity of the good in question, you can buy more of something else.
3) Buy the same amount of everything, and put aside the unspent nominal income to augment future spending/consumption (save).
4) Some combination of above.


Many folks will argue that when a Wal-Mart moves into town, this creates "unfair" competition with local businesses. I must admit, I am unclear by what they mean by "unfair." If another business opens in town and manages to offer products at lower prices, is that business "unfair?" Or is it a matter of size? If so, at what point does size become unfair? Many firms (not just Wal-Mart) are able to offer reduced price because they are able to take advantageof economies of scale. If those costs get passed on to the consumer, how are they hurt? If pressure is put on producers to meet quality and price, that makes for a more efficient economy and more "real income" for consumers.

I know there's more to this, but I think the opportunity to discuss an important aspect of economic thinking is too good to pass up.

Let's hear more. (Oh, and don't overlook the "comments" on the Cafe Hayek post.)

2 comments:

julie said...

Tim, excellent post on income effect and tying it in with Wal-Mart. Often Wal-Mart becomes a topic of discussion in my AP classes because in the Catholic social teaching class the same students are discussing " a living wage" and also fair labor practices. A year or so ago Global Insight did a study on the "Wal-Mart" effect on inflation and savings to all consumers, whether they shopped Wal-Mart or not. You point out many useful discussion points and a way to always always reinforce the concept of "opportunity cost" even when studying price indices. Your blog is a valuable resource to teachers.

Mike Fladlien said...

When Wal-Mart comes to town, they drive the high-cost producers out of business...If you want to pay more for your stuff, then shop at the mom and pop places...David Anderson in his book, Economics by Example, shows how economies of scale allows Wal-Mart to operate at a minimum efficiency scale and be the low-cost producer...It's funny how Wal-Mart rivals suddenly find a way to deliver goods cheaper when faced with competition...