The expenditure approach to income and substitution effects

Karl-Friedrich Israel ()
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Karl-Friedrich Israel: Western Catholic University

Economics Bulletin, 2022, vol. 42, issue 2, 431 - 446

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.

Keywords: substitution effect; income effect; expenditure share; deadweight loss; taxation, JEL-Codes: D60; H21 (search for similar items in EconPapers)
JEL-codes: D6 H2 (search for similar items in EconPapers)
Date: 2022-06-30
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