Income inequity may not lead to a lower effective demand for a good.

Introduction

Income inequity may lead to failure of the free market to allocate some goods and services to the people who need them more. Effective demand is the desire to buy backed by the ability to pay. Ineffective demand is merely the desire to buy not backed by the ability to pay. The free market only responds to effective demand which means that it only distributes goods and services to the people with the willingness and the ability to pay for them. However, the ability to pay for a good does not reflect the need for the good. Therefore, individuals who need some goods and services but do not have the ability to pay for them have to go without the goods and services. In the free market, the prices of goods and services are determined by the market forces of demand and supply. If the income gap is large, high income individuals with a high willingness and ability to pay may push up the prices of some goods and services to the levels which make the goods and services unaffordable to low income individuals with a low ability to pay. This is a matter of concern particularly if the goods and services are necessities. For example, education is a necessity particularly to low income individuals who have a high need to increase their skills and knowledge and hence their income earning power. Therefore, inaccessibility of education to low income individuals due to a high price which will make it difficult for them to increase their skills and knowledge is likely to cause them to be trapped in poverty.

Many students think that income inequity will lead to a lower demand for a good resulting in under-consumption of the good. This is an economic misconception. This economic misconception will be discussed in economics tuition at Economics Cafe.

Exposition

Many students think that income inequity will lead to a lower effective demand for a good resulting in under-consumption of the good as some low income individuals who have the desire to buy the good will not have the ability to pay for the good. This is erroneous. In order to understand the misconception, one simply needs to examine the reason why low income individuals are unable to afford a good as a result of income inequity. As was explained earlier, with the presence of income inequity, high income individuals with a high willingness and ability to pay may push up the prices of some goods and services to the levels which make the goods and services unaffordable to low income individuals with a low ability to pay. Take housing for example. With the presence of income inequity, the effective demand for housing by high income individuals will be high and this is evidenced by the large number of houses which these individuals are willing and able to buy in reality. In the absence of government intervention, the high effective demand for housing by high income individuals will lead to a high price which will make housing unaffordable to low income individuals with a low ability to pay resulting in a lower effective demand for housing by these individuals. Although the effective demand for housing by low income individuals is low, this occurs due to the high effective demand for housing by high income individuals. Therefore, one cannot reasonably and convincingly argue that income inequity will lead to a lower effective demand for a good resulting in under-consumption of the good.

In order to understand the misconception from a different angle, one can examine how income inequity occurs in reality. Assume an economy with an equal distribution of income which means the absence of income inequity. Further assume that income inequity occurs as the incomes of some individuals start rising rapidly and the incomes of some individuals start rising slowly. As the incomes of some individuals rise rapidly, the demand for housing by these individuals will rise rapidly which will lead to a sharp rise in the price. This will make housing unaffordable to the individuals whose incomes are rising slowly. Therefore, the effective demand for housing after the rise in income is not necessarily lower compared to the case before the rise in income. One can argue that if the incomes of some individuals rise rapidly, they may not increase the demand for a good by a large extent. However, in such a scenario, it would also mean that the price of the good will not rise sharply, other things being equal. Therefore, the good is still likely to be affordable to the individuals whose incomes are rising slowly, assuming the cost of production is not high. Indeed, when the incomes of some individuals rise rapidly, the demand for some goods such as cancer treatment may not rise at all. Therefore, the price of cancer treatment will not rise, other things being equal. Therefore, cancer treatment may still be affordable to the individuals whose incomes are rising slowly. Even if cancer treatment is unaffordable to individuals whose incomes are rising slowly, this is not a result of income inequality with individuals whose incomes are rising rapidly pushing up the price of cancer treatment. Rather, this is due to the fact that the cost of production of cancer treatment is high which leads to a high price. Indeed, even in the hypothetical scenario of income equality, in the absence of financial assistance provided by the government, there is a possibility that no individual is able to afford cancer treatment due to the high price as a result of the high cost of production. For example, no individual is able to afford a Ferrari car due to the high price as a result of the high cost of production, even in the hypothetical scenario of income equality. To put it somewhat differently, this is a supply factor rather than a demand factor and hence is irrelevant to income inequality.

Economics Tuition Singapore @ Economics Cafe
Principal Economics Tutor: Mr. Edmund Quek