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The expenditure approach to income and substitution effects

Author

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  • Karl-Friedrich Israel

    (Western Catholic University)

Abstract

Visible substitutions between goods as a result of a price change have to occur insofar as the price elasticity of demand deviates from unity. A price-elastic demand leads to a larger expenditure share after a price decrease. This implies that the aggregate expenditure share for all other goods, including money in one's cash balance, has to decrease. A visible substitution takes place as the demand for other goods is reduced. Similarly, a price-inelastic demand for a specific good leads to a larger expenditure share after a price increase. The aggregate expenditure share of all other goods has to decrease and the consumer reduces demand for at least one other good. By following the expenditure approach to income and substitution effects it is shown that the conventional analysis of deadweight loss from taxation is misleading. The deadweight loss is underestimated when demand is inelastic and overestimated when it is elastic. Visible substitutions between goods as a result of a price change have to occur insofar as the price elasticity of demand deviates from unity. A price-elastic demand leads to a larger expenditure share after a price decrease. This implies that the aggregate expenditure share for all other goods, including money in one's cash balance, has to decrease. A visible substitution takes place as the demand for other goods is reduced. Similarly, a price-inelastic demand for a specific good leads to a larger expenditure share after a price increase. The aggregate expenditure share of all other goods has to decrease and the consumer reduces demand for at least one other good. By following the expenditure approach to income and substitution effects it is shown that the conventional analysis of deadweight loss from taxation is misleading. The deadweight loss is underestimated when demand is inelastic and overestimated when it is elastic. Visible substitutions between goods as a result of a price change have to occur insofar as the price elasticity of demand deviates from unity. A price-elastic demand leads to a larger expenditure share after a price decrease. This implies that the aggregate expenditure share for all other goods, including money in one's cash balance, has to decrease. A visible substitution takes place as the demand for other goods is reduced. Similarly, a price-inelastic demand for a specific good leads to a larger expenditure share after a price increase. The aggregate expenditure share of all other goods has to decrease and the consumer reduces demand for at least one other good. By following the expenditure approach to income and substitution effects it is shown that the conventional analysis of deadweight loss from taxation is misleading. The deadweight loss is underestimated when demand is inelastic and overestimated when it is elastic.

Suggested Citation

  • Karl-Friedrich Israel, 2022. "The expenditure approach to income and substitution effects," Economics Bulletin, AccessEcon, vol. 42(2), pages 431-446.
    • Handle: RePEc:ebl:ecbull:eb-21-00257
    as

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    References listed on IDEAS

    as
    1. Zabalza, Antoni, 1982. "Compensating and Equivalent Variations, and the Deadweight Loss of Taxation," Economica, London School of Economics and Political Science, vol. 49(195), pages 355-359, August.
    2. James R. Hines, 1999. "Three Sides of Harberger Triangles," Journal of Economic Perspectives, American Economic Association, vol. 13(2), pages 167-188, Spring.
    3. Kay, J. A., 1980. "The deadweight loss from a tax system," Journal of Public Economics, Elsevier, vol. 13(1), pages 111-119, February.
    4. Diamond, P. A. & McFadden, D. L., 1974. "Some uses of the expenditure function in public finance," Journal of Public Economics, Elsevier, vol. 3(1), pages 3-21, February.
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    More about this item

    Keywords

    substitution effect; income effect; expenditure share; deadweight loss; taxation; JEL-Codes: D60; H21;
    All these keywords.

    JEL classification:

    • D6 - Microeconomics - - Welfare Economics
    • H2 - Public Economics - - Taxation, Subsidies, and Revenue

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