Saturday, January 01, 2011

Income Effects From Higher Prices

Nick Rowe at the Worthwhile Canadian Initiative argues that income effects from higher prices really don't exist because the loss for buyers is matched by an equal gain for sellers. Therefore he argues that price increases have no aggregate income effects, and that we should therefore only focus on substitution effects.

I agree with him that substitution effects are usually more important than income effects (see here my article on why the income effect is irrelevant when it comes to the issue of whether to have high or low levels of taxes and government spending). And his point about the non-existence of aggregate income effects  is correct in some contexts, specifically when the higher price is the result of higher demand. Here the losses for the buyers are matched by gains for the sellers. However, higher prices can nevertheless be associated with lower real income.

One is a scenario that he acknowledges, namely when a country is a net importer of the higher priced good. Yet he dismisses it by pointing out that when a country is a net exporter of the higher priced good it gains. But setting aside for a moment the caveat for the latter that I discuss below, this only goes to show that income effects can exist for countries for that reason-and that these income effects can be both positive and negative.

The other scenario that he fails to mention is when higher prices are the result of lower supply. Suppose for example that for some reason crops fail. That will push prices higher, but because quantities sold will be lower, the income gains for the farmers will be lower (maybe even non-existent or negative) than the income losses for food buyers.

It is true that in this case it could be argued that the price increase here is a symptom of lower output (and its corollary lower income) rather than the cause of the income decline. But if we reason this way, we could argue that the price increase has a positive effect, as the price adjustment limits the negative effect from lower output. If for example the state had banned the price increase, the income loss would have been even greater.

Here the price increase is thus a symptom of something negative, yet it is also something which limits the negative effects of the negative event it is a symptom of.