income determination, theory of

Based on the income-determination model developed by English economist John Maynard Keynes (1883-1946), and later modified by American economist Paul Samuelson (1915- ), theory of income determination postulates that the level of national income is determined where aggregate demand equals aggregate supply.

The crucial component of aggregate demand is the consumption function. Keynes asserted that his theory was different from those of the classical economists in that the economy could be in equilibrium at any level of employment.

Also see: equilibrium theory, general equilibrium theory, partial equilibrium theory, disequilibrium theory, classical macroeconomic model, law of markets

Source:
J M Keynes, General Theory of Employment, Interest and Money (New York, 1936)

Economic definitions

In economics, “factor income” is the return accruing for a person, or a nation, derived from the “factors of production”: rental income, wages generated by labor, the interest created by capital, and profits from entrepreneurial ventures.[5]

In consumer theory ‘income’ is another name for the “budget constraint,” an amount {\displaystyle Y} to be spent on different goods x and y in quantities {\displaystyle x} and {\displaystyle y} at prices {\displaystyle P_{x}} and {\displaystyle P_{y}}. The basic equation for this is

{\displaystyle Y=P_{x}\cdot x+P_{y}\cdot y}

This equation implies two things. First buying one more unit of good x implies buying {\displaystyle {\frac {P_{x}}{P_{y}}}} less units of good y. So, {\displaystyle {\frac {P_{x}}{P_{y}}}} is the relative price of a unit of x as to the number of units given up in y. Second, if the price of x falls for a fixed {\displaystyle Y} and fixed {\displaystyle P_{y},} then its relative price falls. The usual hypothesis, the law of demand, is that the quantity demanded of x would increase at the lower price. The analysis can be generalized to more than two goods.

The theoretical generalization to more than one period is a multi-period wealth and income constraint. For example, the same person can gain more productive skills or acquire more productive income-earning assets to earn a higher income. In the multi-period case, something might also happen to the economy beyond the control of the individual to reduce (or increase) the flow of income. Changing measured income and its relation to consumption over time might be modeled accordingly, such as in the permanent income hypothesis.

Full and Haig–Simons income

“Full income” refers to the accumulation of both the monetary and the non-monetary consumption-ability of any given entity, such as a person or a household. According to what the economist Nicholas Barr describes as the “classical definition of income” (the 1938 Haig–Simons definition): “income may be defined as the… sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights…” Since the consumption potential of non-monetary goods, such as leisure, cannot be measured, monetary income may be thought of as a proxy for full income.[3] As such, however, it is criticized[by whom?] for being unreliable, i.e. failing to accurately reflect affluence (and thus the consumption opportunities) of any given agent. It omits the utility a person may derive from non-monetary income and, on a macroeconomic level, fails to accurately chart social welfare. According to Barr, “in practice money income as a proportion of total income varies widely and unsystematically. Non-observability of full-income prevent a complete characterization of the individual opportunity set, forcing us to use the unreliable yardstick of money income.

Income growth

Income per capita has been increasing steadily in most countries.[6] Many factors contribute to people having a higher income, including education,[7] globalisation and favorable political circumstances such as economic freedom and peace. Increases in income also tend to lead to people choosing to work fewer hours. Developed countries (defined as countries with a “developed economy”) have higher incomes as opposed to developing countries tending to have lower incomes.

Income inequality

Income inequality is the extent to which income is distributed in an uneven manner. It can be measured by various methods, including the Lorenz curve and the Gini coefficient. Many economists argue that certain amounts of inequality are necessary and desirable but that excessive inequality leads to efficiency problems and social injustice.[3] Thereby necessitating initiatives like the United Nations Sustainable Development Goal 10 aimed at reducing inequality.[8]

National income, measured by statistics such as net national income (NNI), measures the total income of individuals, corporations, and government in the economy. For more information see Measures of national income and output.

Income in philosophy and ethics

Throughout history, many have written about the impact of income on morality and society. Saint Paul wrote ‘For the love of money is a root of all kinds of evil:’ (1 Timothy 6:10 (ASV)).

Some scholars have come to the conclusion that material progress and prosperity, as manifested in continuous income growth at both the individual and the national level, provide the indispensable foundation for sustaining any kind of morality. This argument was explicitly given by Adam Smith in his Theory of Moral Sentiments,[9] and has more recently been developed by Harvard economist Benjamin Friedman in his book The Moral Consequences of Economic Growth.[10]

Accountancy

The International Accounting Standards Board (IASB) uses the following definition: “Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.” [F.70] (IFRS Framework).

According to John Hicks’ definitions, income “is the maximum amount which can be spent during a period if there is to be an expectation of maintaining intact, the capital value of prospective receipts (in money terms)”.