The Wealth Effect and the Law of Demand: A Comment on Karl-Friedrich Israel
Abstract: Karl-Friedrich Israel (2018) sees “obvious tension” in a book chapter (Salerno 2018) in which I argue that the Hicksian income effect plays no role in the causal-realist approach to the demand curve. Israel’s reconstructed “wealth effect” is an effort to solve this perceived problem. This comment addresses the expositional gap in my analysis, and resolves the perceived tension. I then outline the problems with Israel’s proposed solution, which involves a wholesale reconstruction of demand theory that, in the end, implies a denial of the law of demand.
income effect — demand curve — austrian economics
JEF Classification: B53, D11
Joseph T. Salerno ([email protected]) is Academic Vice President of the Mises Institute and John V. Denson II Endowed Professor in the Department of Economics at Auburn University.
In his article, “The Income Effect Reconsidered,” Karl-Friedrich Israel (2018) perceives a tension in a book chapter (Salerno 2018) in which I argue that the Hicksian income effect plays no role in the causal-realist approach to the demand curve. In section 2, I address the ambiguity in my exposition which leads to this perceived tension and show how it can be readily resolved. Section 3 presents a critical analysis of Israel’s attempt to solve the problem by drastically minimizing the substitution effect in favor of a reconstructed “wealth effect,” which Israel (2018, 384) claims is “more fundamental” to demand analysis. In section 4, I consider Israel’s reformulation of the wealth effect in more detail and argue that it implies a denial of the law of demand. Section 5 offers concluding remarks.
2. THE CAUSAL-REALIST DEMAND CURVE: A CLARIFICATION OF ASSUMPTIONS
When I derived the demand curve in my original article I assumed that the following remained constant: 1. the buyer’s value scale; 2. the prices of all other goods; 3. the buyer’s stock of money balances; and 4. the purchasing power of money. The third and fourth assumptions together imply that the buyer’s real money balances are constant. I argued that the stock of real money balances must remain unchanged for units of money to attain an ordinal ranking against goods on the value scale. If the purchasing power of money and hence the stock of real money balances were permitted to vary as the money price of the good in question changed, the buyer would not be able to compare the marginal utility of goods against that of money, and a demand curve based strictly on the law of marginal utility could not be traced out. I thus maintained that there is no “income” or, more accurately, “purchasing-power” effect because the value of money does not increase (decrease) as the price of a good falls (rises) along the demand curve. I concluded that there is only a substitution effect when demand curve analysis is based on the law of marginal utility.
Israel argues that, as stated, my conclusion contradicts my second assumption that the prices of all other goods remain constant. As Israel (pp. 380–81) puts it,
[W]henever some money price is allowed to change ceteris paribus, it has a direct effect on the purchasing power of money. When a money price increases along the demand curve, then the exchange value of money and hence its purchasing power decreases, and vice versa. If, however, the demand curve for a specific good is itself contingent on the purchasing power of money, a price change along a given demand curve is contradictory as it destroys the underlying assumption on which the demand curve is based.
It was to avoid just such a contradiction that I explicitly stated that it is the ex ante or anticipated purchasing power of money today—based on the individual’s experience of yesterday’s structure of money prices—that is assumed constant. The expected purchasing power of money is used to establish the individual’s marginal utility ranking of money relative to goods that is relevant to today’s market activities. From this value ranking of goods and money is derived the individual demand curve for a particular good.
Israel (2018, 381) recognizes my inclusion of the temporal element in the analysis but rejects it as “unconvincing.” I see now that there is an expositional gap in my analysis that requires repair, but I reject Israel’s proposed solution, which involves a wholesale reconstruction of demand theory that has not been thought out to its logical conclusion. Before proceeding to evaluate Israel’s attempt to resolve the “obvious tension” in my argument, let me present the simple and obvious solution that is ready to hand.
In order to maintain the expected purchasing power of money constant along the demand curve it is necessary only to restrict my second ceteris paribus assumption to the prices of closely related goods and to interpret the fourth assumption as implying that the general prices of all other goods move inversely to the price of the good in question so as to offset the change in the value of money entailed by the initial price change. This is simply another way of saying that the relation between the supply of money and the demand for money remains constant. Thus interpreted, the assumption of a constant purchasing power of money is no more unrealistic than assuming that all prices but the price of the good under consideration remain constant while the value of money varies. In fact, Milton Friedman ( 1953, 51), following Marshall, considers this assumption as one—although not his preferred—way of generating the “income-compensated demand curve.” Accordingly, he assumes that the price of “the commodity in question” changes while holding the prices of “closely related commodities” constant but allowing the “average” price of “all other commodities to rise or fall with a fall or rise of the price of [the commodity in question], so as to keep the ‘purchasing power of money’ constant.”1
Revising the set of assumptions underlying my approach in this way has the virtue of enabling analysis of the substitution effect in isolation from the purchasing-power effect. From an economy-wide perspective, this demand curve construct allows the economist to analyze the effect on a good’s price of a change in its supply (a movement along the demand curve) in abstraction from the effect on its price of a change in money demand or money supply (a shift in its demand curve). For if we allow the purchasing-power effect to manifest itself when, for example, the price of a good falls along an individual’s demand curve, then it implies that either the overall demand for money in the economy has risen or supply of money has fallen.
Now this solution does not deny that a change in the price of a good may cause both a substitution effect and a wealth or purchasing-power effect. It merely permits the two effects to be analyzed separately in order to isolate the operation of the law of marginal utility. Holding the purchasing power of money constant permits the substitution effect to be portrayed as a movement along the demand curve. With respect to the purchasing-power effect, under my revised set of assumptions, we would treat this effect as we would any change that exogenously alters an individual’s real money balances, that is, as a “real balance effect.” For example, in the case of a fall in price, real balances would rise, causing a rightward shift of the agent’s demand curves for various (normal) goods including the good in question. Using this analysis, we could also show, for example, that in the case of a big enough drop in the price of an inferior good that absorbs a large part of a household’s budget, the purchasing-power effect (shift to the left of the demand curve for the inferior good) outweighs the substitution effect (a movement down along the demand curve), which would result in less of the good being purchased by the household at the lower price. This allows us to explain Giffen’s Paradox without invoking an upward-sloping demand curve.
Alchian and Allen (1977, 69) give a very similar analysis of the “income effect.” As the price of a good falls, there occurs what they call an “expenditure-releasing effect”—that is, an increase in the purchasing power of money—because less money now is spent on the good at the initial quantity demanded. This “released purchasing power” causes a rightward shift of the individual’s demand curves for (normal) goods, including the good whose price has fallen. The substitution effect is then represented as a sliding down along a higher demand curve.2
3. A CRITIQUE OF ISRAEL’S SOLUTION
Israel offers a very different resolution of the tension he perceives in my article. He suggests that what must remain constant is “the opportunity costs of expending a given sum of money in exchange for the good in question” or, more precisely, “the purchasing power of money with respect to other goods that the person values and might want to acquire.” He argues that the fulfillment of this condition will lead to the “important assumption” for deriving the demand curve, namely, a fixed ordinal ranking of money and the good in question. There are several problems with Israel’s approach.
First, a fixed ordinal ranking is exactly what results from my revised set of assumptions above. With the purchasing power of money constant, the relative ranking of units of money and units of the good demanded will remain unchanged. Second, Israel (2018, 282) is curiously reluctant to explicitly state the assumptions about the external, objective conditions that underlie the internal or subjective prerequisite for deriving the demand curve, namely, that “the subjective value of money does not vary relative to the subjective value of the good in question.” He explains his disinclination to do so by asserting that because a fixed ordinal ranking is subjective “we cannot boil this assumption further down.” But this is a non sequitur.
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