## May 28, 2008

### The Income Effect

A little observation about how money isn't really everything.

First, a little lesson in economics. Almost everyone has heard of supply and demand. The quantity supplied of a commodity is essentially the amount of it that is made available for consumption by the producers of that commodity. Both empirical and mathematical (I'd show the math but lots of programmers are allergic to calculus) evidence show that for most commodities, there is a positive correlation between the price of the commodity and the amount that the producers will provide. In English, this means that when there is an increase in the price, the amount of the commodity that the producers will produce increases, all else equal.

This also relates to the labour market. In the labour market however, the positions of producer and consumer are reversed. The producers of labour are the general public, and the consumers of labour are the firms that employ them.
The labour supply comes from the total amount of some unit (ie. man-hours) of labour that is available in a given labour market (say, web programmers). Like the supply in other markets, the amount of labour supplied is affected by the price (the wage rate).

The thing that is interesting about labour supply though, is after a certain point the correlation between wage and labour supplied goes away, then reverses. When the wage rate is low, then an increase in it will mean there is more labour supplied - people will work longer hours, more people will want to work there, etc. However after a certain level of pay, what is called the "income effect" kicks in and the trend reverses. The wage increases and the amount of labour supplied actually decreases. This is primary due to the fact that for most people, work sucks. Suppose you have a monthly budget of \$4000 including rent, food, RRSPs, etc. Suppose you're making \$5000/month and working 40 hours per week. You don't really need any more money. But you get a raise anyway. This means that in order to make that same \$5000/month, you don't need to work 40 hours a week anymore. You can drop down to 35 or 30 hours a week and spend more time doing other stuff like going the beach or playing with your kids, etc. Or getting Ubuntu to work (yeah, right).

It seems like our society is telling us that higher pay is always better. It's like getting a high score in a game, the higher the number, the better. But why? What are you going to do with all that money? Why not instead of searching for higher pay, search for the same pay but less hours per week or even lower pay with a more enjoyable job.
Ultimately, it is your own call. These are just ideas to throw out there.

EDIT: This is a gross oversimplification of the income effect. I do not factor in things like how people spend according to their income, varying utility, sticky wages, market cycles, or various other economic topics that have an effect on labour supply. I'm making an observation of how I feel about higher pay at the moment ;). It's good, but there are also other options worth exploring.

Guillaume Theoret said...

I think you're forgetting to factor in the fact that people spend according to their income.

It's well documented that it's the upper middle class that holds the most in debt. (At least in the United States, but I imagine it's similar in Canada)

When you make more money you buy a more expensive car, a bigger tv, a bigger house, etc. People always find a way to live above their means. While there are a frugal few who say ok I'll live on 5000\$ a month and, when they get a bonus, spend the same, most will actually spend more than the raise they got.

IllegalCharacter said...

5000 was just some random number I threw out there.

I didn't forget to factor that in, just forgot to put the paragraph in that talked about that. It was in there in my head when I was thinking about this article! Also economic phenomena such as the income effect are rather complex, and it will usually be the case that when somebody outlines it in a blog they will forget to factor certain things in.

It is a well-documented fact that individual consumption is a direct function of income, however the marginal utility of income (the usefulness of another dollar on your current income) is decreasing, which is an explaining factor of the income effect. Hold a gun to a beggar and demand \$10 and (s)he'll be much worse off, but hold a gun to a star hockey player and demand \$10 and he'll probably not care at all.

My point is not really in describing how the income effect works, I'm just commenting on how I'm seeing it in practice in my own life.