From the Firm to Economic Integration
Chapter 17: The income effect does not exist
It is traditional in microeconomics to state that any price change has consequences that can be split into two different effects, the substitution effect and the income effect. As it is assumed that both effects work in divergent directions, the precise reaction of demand or supply to a relative price change can operate either way: The supply curve is not necessarily upward sloping and the demand curve is not necessarily downward sloping. Thus, the income effect has an important role in traditional microeconomics, as well as in applied economics, since it causes one to think, for instance, that there are “kinked curves.” Such curves are particularly assumed to exist as regards the supply of labor. Within a certain range, a decrease in the real wage would not bring about a decrease in the supply of labor, since people want to maintain their income and, therefore, increase their supply of labor. As an important consequence in tax theory, the “Laffer effect” would not exist, at least in a given area (the one in which the supply curve for labor is supposed to be atypical). In such a case, an increase in the tax rate on labor income – that is, a decrease in the real after-tax wage – would create a negative income effect which would be compensated for by working more, whereas the Laffer effect assumes that there is always an inverse relation between the tax rate and productive efforts. Similarly, the income effect would account for a possible increase in the rate of savings when the return on savings is decreasing.
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