The Income Effect Reconsidered

Abstract

There is an avoidable tension in a recently presented argument against the income effect from the perspective of Austrian or causal-realist price theory. The argument holds that a constant purchasing power of money is a necessary assumption for constructing an individual demand curve for a specific good, and hence that price changes along the demand curve are by definition incapable of exerting a “purchasing power effect,” that is, an income effect in standard neoclassical terminology. Price changes are, however, never neutral to the purchasing power of money. We show that the necessary assumption for the construction of a demand curve for a specific good is not the constant purchasing power of money as such, but rather constant opportunity costs of expending money on the good in question. On this basis we show that it is possible to derive a type of income effect in causal-realist price theory. Yet, it might be more appropriate to call it a “wealth effect.” Regardless of important and undeniable differences, the gulf between neoclassical and Austrian microeconomics on this point is thus smaller than it has been made to be.

The Wealth Effect and the Law of Demand: A Comment on Karl-Friedrich Israel

“…I n 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.…”

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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.

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