Sunday, May 19, 2013

Substitution Effect, meet Income Effect

Assume for a moment that you have the complete ability to adjust your hours at work to any degree you want, with your pay rising or falling proportionately. Then one day, your boss walks in and tells you that you along with everyone else is getting a 20% pay cut.

After the change, do you work more hours or less hours?

The answer is non-obvious. You now have a lot less money, and need to work more to maintain your current lifestyle and have "enough". On the other hand, the lower hourly pay means that alternatives to work (such as leisure or spending time with your family) are now more attractive relative to work, and hence you might work less. These two effects are called the income effect and the substitution effect, respectively. Note that in this case, like almost all others, they are in opposition to each other: one causes people to work more in response to an economic change, the other less.

These two effects also occur due to changes in government policies, such as tax rate changes, welfare benefits, or pensions. Raising peoples' taxes, for example, is similar to the pay cut - hourly take-home pay drops, discouraging work, but having less money causes people to work harder. It is not clear at all which effect wins under which circumstance. Peoples' responses to such policies are extremely complex and cannot simply be summed up as "higher taxes cause people to work less". They might under some circumstances, they might not under others, due to income effects.

A simple way to see the power of the income effect is to imagine a scenario where your pay was absurd, perhaps $10,000 an hour. Would you work less over the course of your lifetime, or more, relative to what you would with your current pay? The answer is almost certainly less, as after a few years you would have more money than you would ever need. At least in this extreme case, the income effect is dominant. It is likely that a lot of high earners, such as medical specialists or corporate executives, actually work LESS over their lifetime than they might with lower pay (or higher taxes!) because by the time they are in their late 50's or early 60's, earning more money is superfluous.

It is also impossible for conservatives to argue that income effects are trivial, as they constantly invoke the income effect when they assert that giving out welfare or unemployment benefits discourage work. However, it is illogical to assert a priori that with respect to benefits and pensions, that income effects are very powerful and cause large changes in behavior, but with respect to tax policy changes, income effects are minimal and dominated by substitution effects. Yet this is ultimately what conservatives are claiming. The reality is much more complex.