Diminishing marginal utility, transfers, and prices

When justifying progressive taxes or any type of transfer people often use the idea of diminishing marginal utility. Now I am not against transfers, I think there are many good reasons justifying transfers, however DMU is not one of them.

We’ve discussed issues with this approach before here and here. Fundamentally these were:

  1. The utility from income differs between people and we can’t observe it. Furthermore, people with higher utility from income will work more – so if there is any “choice” in the work decision then DMU is not sufficient to ensure the optimality of progressivity.
  2. Liquidity constraints and the discrete nature of purchases ensures that even if we have diminishing marginal utility for individual products we cannot assume that marginal utility is falling in income.

Another possible critique of the DMU justification for transfers comes from prices. Assume for now that there are two types of people, poor and rich. Assume that poor people buy goods with perfectly price inelastic supply, and rich people buy goods with elastic supply.

In this case, any transfer from rich to poor would lead to no increase in the welfare of the poor – as the price of the goods they buy would simply increase by the amount their income has increased! However, there would be a welfare loss for the rich – as both the price and the quantity sold would fall. As a result, the transfer is pareto inferior.

Now this was an extremely simplistic, stylized cases. However, it does show us that if the supply of goods that the poor buy are sufficiently price inelastic relative to the goods that the “rich” buy then even in the case of diminishing marginal utility transfers may not be effective – because of price changes.

What we are using here is the fact that, the more elastic a (normal) good is, the greater the proportion of any income change will actually lead to an increase in “consumer surplus”. In the case where the supply is perfectly price inelastic, any increase in income simply increases firms profit.

4 replies
  1. Azran
    Azran says:

    Stimulus Package “Deja vu”, Not really!

    As the brains of our economy continue to brainstorm how to get us out of the mess the real estate market first got us in and now high gas prices and a declining economy over all the easy way out seems to be again, an economic stimulus package.

    Not so fast, not again.

    First president bush opposes it.
    Second, according to the experts only 20 percent of the people who got stimulus package number one said the rebate led them to spend more and the rest, well it seems that the rest just took the money and put it into their savings account.

    Economic stimulus package number one was suppose to get our slow economy going, by then president bush had not heard of a 4 dollar a gallon of gasoline.
    By now that’s old news and as he put it on he’s own words “he’s heard of it now”.

    Well now mr president one gallon of gas almost hits the 5 dollar mark, have you heard of it?

    Anyhow, the 100 billion dollars in checks that circulated among many Americans (600.00 for singles, 1,200.00 for couples) apparently didn’t help.
    The money went out on time and gas prices went up just on time as well.
    With gas prices, food prices also went up.
    Isn’t that how it usually works?
    Gas prices go up everything goes up, after all business have to make up for the extra expenses and they just pass the check onto us.

    Here’s an idea!

    How about lowering the tax on gasoline?
    Do we really know how much money we pay on gas taxes in the u.s?
    Aren’t this taxes imposed by our government, well maybe our government can really give a stimulus to our morale and lower the taxes we pay on gas prices.
    A lower tax in gasoline prices will stimulate business and consumers, it’s not rocket science!

    Source for this quote: Wikipedia
    “Fuel taxes in the United States vary by state. For the first quarter of 2008, the average state gasoline tax is 28.6 cents per US gallon, plus 18.4 cents per US gallon federal tax making the total 47 cents per US gallon”

  2. yanni raz
    yanni raz says:

    Wake up call number 6? IndyMac is not the first one to go.

    American’s woke up to another slap in the face, IndyMac.
    The bank giant where many people deposited their life savings is going out of business.
    There you had them!

    People waiting in line to take their money out, only to be rejected later by other bank institutions when trying to deposit their money or what they could get of it because the letterhead of the cashier’s check had the infamous word: Indymac.

    It was reported in the media that a california woman tried to deposit a cashier’s check from Indymac at a washington mutual branch in pasadena and she was told that it could take up to eight weeks for her funds to be available
    Other bank institutions said that they are following the federal guidelines in regards to availability of funds on the new deposits, and that those same guidelines apply to checks from indymac.

    The truth of the matter is that failures like indymac’s have name: greed from the Real Estate boom.
    Now banks are paying the consequences, first it was Countrywide that have bailed out by a purchase from Bank of America, not without having the ceo (angelo mozillo) walk away with a multimillion severance package.
    Now indymac is under investigation by the fbi for possible fraud in the subprime market.

    According to the media reports, the investigation is focusing in the company and not in the individuals who run it.
    Apparently, indymac officials approved loans to people who otherwise wouldn’t be able to qualify for one, leaving now thousands on the verge of foreclosure.

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