Engel curve

Last updated May 13, 2024

In microeconomics, an Engel curve describes how household expenditure on a particular good or service varies with household income.^[1]^[2] There are two varieties of Engel curves. Budget share Engel curves describe how the proportion of household income spent on a good varies with income. Alternatively, Engel curves can also describe how real expenditure varies with household income. They are named after the German statistician Ernst Engel (1821–1896), who was the first to investigate this relationship between goods expenditure and income systematically in 1857. The best-known single result from the article is Engel's law which states that as income grows, spending on food becomes a smaller share of income; therefore, the share of a household's or country's income spent on food is an indication of their affluence.

Shape

Graphically, the Engel curve is represented in the first quadrant of the Cartesian coordinate system. Income is shown on the horizontal axis and the quantity demanded for the selected good or service is shown on the vertical.

The attached figure shows the derivation process of the Engel curve in case of necessities. Panel (a) is an undifferentiated graph representing consumers' preferences for goods X and Y. The three parallel lines of Rs.300, Rs 400. And Rs.500 are called budget lines. And the slope of these three lines is the same, which implies that the prices of the two goods are constant, while the budget line farther from the origin indicates a larger budget amount. The three points R, S, and T in the graph hint different preference combinations. The line connecting these three points is called the income consumption curve (ICC). By extending Panel (a) to Panel (b), the Engel curve for good X is obtained by connecting the points R’, S’, and T’.^[3]

The shapes of Engel curves depend on many demographic variables and other consumer characteristics. A good's Engel curve reflects its income elasticity and indicates whether the good is an inferior, normal, or luxury good. Empirical Engel curves are close to linear for some goods, and highly nonlinear for others.

For normal goods, the Engel curve has a positive gradient. That is, as income increases, the quantity demanded increases. Amongst normal goods, there are two possibilities. Although the Engel curve remains upward sloping in both cases, it bends toward the X-axis for necessities and towards the Y-axis for luxury goods.

For inferior goods, the Engel curve has a negative gradient. That means that as the consumer has more income, they will buy less of the inferior good because they are able to purchase better goods.

For goods with a Marshallian demand function generated from a utility function of Gorman polar form, the Engel curve is linear.

Many Engel curves feature saturation properties in that their slope tends toward infinity at high income levels, which suggests that there exists an absolute limit on how much expenditure on a good will rise as household income increases.^[4] This saturation property has been linked to slowdowns in the growth of demand for some sectors in the economy, causing major changes in an economy's sectoral composition to take place.^[5]

Other properties

When considering a system of Engel curves, the adding-up theorem dictates that the sum of all total expenditure elasticities, when weighted by the corresponding budget share, must add up to unity. This rules out the possibility of saturation being a general property of Engel curves across all goods as this would imply that the income elasticity of all goods approaches zero starting from a certain level of income. The adding-up restriction stems from the assumption that consumption always takes place at the upper boundary of the household's opportunity set, which is only fulfilled if the household cannot completely satisfy all its wants within the boundaries of the opportunity set.^[6]

Other scholars argue that an upper saturation level exists for all types of goods and services.^[5]^[7]

Applications

In microeconomics Engel curves are used for equivalence scale calculations and related welfare comparisons, and determine properties of demand systems such as aggregability and rank.

Engel curves have also been used to study how the changing industrial composition of growing economies are linked to the changes in the composition of household demand.^[8]

In trade theory, one explanation of inter-industry trade has been the hypothesis that countries with similar income levels possess similar preferences for goods and services (the Lindner hypothesis), which suggests that understanding how the composition of household demand changes with income may play an important role in determining global trade patterns.^[9]

Engel curves are also of great relevance in the measurement of inflation,^[10] and tax policy.^[11]

The Engel curve allows estimating the consumer price index deviation for old age.^[12]

The Engel curve method is used to study the improvement of farmers' welfare by comparing food consumption and income growth.^[13] What is more, it infers the cost of living of households.^[14] Additionally, it also studies the impact of the sources of household consumption diversity on welfare.^[15]

The Engel curve estimates the collective household model.^[16]

Engel curves assess whether outdoor leisure is a luxury or a necessity.^[17]

The deflator of the Engel curve is not sufficiently representative of the deflator obtained from the multilateral price index. It is not appropriate to use only the Engel method in some regions, the changes in poverty and inequality, the estimated locations and levels will be greatly distorted, which will result in wrong conclusions.^[18]

Engel curves have found a wide range of applications, including assessing policies related to agriculture, taxation, trade, industrial organization, housing, and the measurement of poverty and inequality.

Problems

Low explanatory power

Heteroscedasticity is a well known problem in the estimation of Engel curves: as income rises the difference between actual observation and the estimated expenditure level tends to increase dramatically. Engel curve and other demand function models still fail to explain most of the observed variation in individual consumption behavior.^[2]

As a result, many scholars acknowledge that influences other than current prices and current total expenditure must be systematically modeled if even the broad pattern of demand is to be explained in a theoretically coherent and empirically robust way.^[6]

For example, some success has been achieved in understanding how social status concerns have influenced household expenditure on highly visible goods.^[19]^[20]

Accounting for their shape

Ernst Engel argued that households possessed a hierarchy of wants that determined the shape of Engel curves. As household income rises some motivations become more prominent in household expenditure as the more basic wants that dominate consumption patterns at low-income levels, such as hunger, eventually become satiated at higher income levels.^[21] Engel's argument is formalized in neoclassical consumer theory, which conceives of the relationship between income and consumption patterns in terms of utility optimization. In such models, consumers allocate their expenditures to goods and services with the highest marginal utility. After basic needs are satiated, the marginal utility from further consumption of those goods declines, and additional income is allocated to other goods and services. A "necessity" is thus a good whose marginal utility declines more quickly than the average good.

In the standard household engel curve, there are three possible sources of heterogeneity that are statistically ignorable when estimating household engel curves:

1. There can be latent household effects on individual demand behavior. Families gather selectively, and they may influence each other's behavior, such as consumption patterns and preferences.

2. There are differences in individual demand parameters within households. We know that when the income gains are assigned to people with different consumption patterns and different preferences over how the extra money should be spent, Engel's Law may stop to hold.

3. There is heterogeneity in the extent of inequality within households. Intra-household inequality amplifies the effect of the bias on the Engel curve.

There is no apparent reason why these sources of heterogeneity are statistically ignorable when estimating household Engel curves. Latent heterogeneity in demand behavior may well be correlated with household total spending or income. For example, there may well be latent differences in human capital that influence demands, such as when a mother's education influences the priority given to nutrition. In turn, human capital is likely to be positively correlated with household consumption or income. Another example relates to the household's social status in the local community of residence. Perceptions of the obligations that come with higher social status may well influence spending patterns; for example, one may feel the need to show off with a TV or have enough food ready if someone shows up. Such "status-seeking" behavior can be expected at a given level of total spending and correlated with that spending. These factors above are why Engel's coefficient of a family may be affected in the statistical process.^[22]

Related Research Articles

Microeconomics is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, sectors, or industries as opposed to the national economy as a whole, which is studied in macroeconomics.

In economics, elasticity measures the responsiveness of one economic variable to a change in another. If the price elasticity of the demand of something is -2, a 10% increase in price causes the quantity demanded to fall by 20%. Elasticity in economics provides an understanding of changes in the behavior of the buyers and sellers with price changes. There are two types of elasticity for demand and supply, one is inelastic demand and supply and the other one is elastic demand and supply.

A good's price elasticity of demand is a measure of how sensitive the quantity demanded is to its price. When the price rises, quantity demanded falls for almost any good, but it falls more for some than for others. The price elasticity gives the percentage change in quantity demanded when there is a one percent increase in price, holding everything else constant. If the elasticity is −2, that means a one percent price rise leads to a two percent decline in quantity demanded. Other elasticities measure how the quantity demanded changes with other variables.

The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption, by maximizing utility subject to a consumer budget constraint. Factors influencing consumers' evaluation of the utility of goods include: income level, cultural factors, product information and physio-psychological factors.

A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, so that the average tax rate exceeds the marginal tax rate.

<span class="mw-page-title-main">Giffen good</span> Product that people consume more of as the price rises

In microeconomics and consumer theory, a Giffen good is a product that people consume more of as the price rises and vice versa, violating the law of demand.

In economics, a normal good is a type of a good which experiences an increase in demand due to an increase in income, unlike inferior goods, for which the opposite is observed. When there is an increase in a person's income, for example due to a wage rise, a good for which the demand rises due to the wage increase, is referred as a normal good. Conversely, the demand for normal goods declines when the income decreases, for example due to a wage decrease or layoffs.

A Veblen good is a type of luxury good, named after American economist Thorstein Veblen, for which the demand increases as the price increases, in apparent contradiction of the law of demand, resulting in an upward-sloping demand curve. The higher prices of Veblen goods may make them desirable as a status symbol in the practices of conspicuous consumption and conspicuous leisure. A product may be a Veblen good because it is a positional good, something few others can own.

Managerial economics is a branch of economics involving the application of economic methods in the organizational decision-making process. Economics is the study of the production, distribution, and consumption of goods and services. Managerial economics involves the use of economic theories and principles to make decisions regarding the allocation of scarce resources. It guides managers in making decisions relating to the company's customers, competitors, suppliers, and internal operations.

Consumption is the act of using resources to satisfy current needs and wants. It is seen in contrast to investing, which is spending for acquisition of future income. Consumption is a major concept in economics and is also studied in many other social sciences.

In microeconomics, the law of demand is a fundamental principle which states that there is an inverse relationship between price and quantity demanded. In other words, "conditional on all else being equal, as the price of a good increases (↑), quantity demanded will decrease (↓); conversely, as the price of a good decreases (↓), quantity demanded will increase (↑)". Alfred Marshall worded this as: "When we say that a person's demand for anything increases, we mean that he will buy more of it than he would before at the same price, and that he will buy as much of it as before at a higher price". The law of demand, however, only makes a qualitative statement in the sense that it describes the direction of change in the amount of quantity demanded but not the magnitude of change.

In economics, a luxury good is a good for which demand increases more than what is proportional as income rises, so that expenditures on the good become a more significant proportion of overall spending. Luxury goods are in contrast to necessity goods, where demand increases proportionally less than income. Luxury goods is often used synonymously with superior goods.

<span class="mw-page-title-main">Engel's law</span> Empirical observation in economics that as income rises, less is spent on food

Engel's law is an economic relationship proposed by the statistician Ernst Engel in 1857. It suggests that as family income increases, the percentage spent on food decreases, even though the total amount of food expenditure increases. Expenditure on housing and clothing remains proportionally the same, and that spent on education, health and recreation rises.

The wealth elasticity of demand, in microeconomics and macroeconomics, is the proportional change in the consumption of a good relative to a change in consumers' wealth. Measuring and accounting for the variability in this elasticity is a continuing problem in behavioral finance and consumer theory.

Martin James Browning is Professor of Economics at the University of Oxford, Oxford, England, a Fellow of Nuffield College, Oxford, a Fellow of the Econometric Society, and an emeritus Fellow of the European Economic Association.

In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given time. The relationship between price and quantity demand is also called the demand curve. Demand for a specific item is a function of an item's perceived necessity, price, perceived quality, convenience, available alternatives, purchasers' disposable income and tastes, and many other options.

In economics, aggregate behavior refers to economy-wide sums of individual behavior. It involves relationships between economic aggregates such as national income, government expenditure, and aggregate demand. For example, the consumption function is a relationship between aggregate demand for consumption and aggregate disposable income.

Economic theory evaluates how taxes are able to provide the government with required amount of the financial resources and what are the impacts of this tax system on overall economic efficiency. If tax efficiency needs to be assessed, tax cost must be taken into account, including administrative costs and excessive tax burden also known as the dead weight loss of taxation (DWL). Direct administrative costs include state administration costs for the organisation of the tax system, for the evidence of taxpayers, tax collection and control. Indirect administrative costs can include time spent filling out tax returns or money spent on paying tax advisors.

In economics, a necessity good or a necessary good is a type of normal good. Necessity goods are product(s) and services that consumers will buy regardless of the changes in their income levels, therefore making these products less sensitive to income change. As for any other normal good, an income rise will lead to a rise in demand, but the increase for a necessity good is less than proportional to the rise in income, so the proportion of expenditure on these goods falls as income rises. If income elasticity of demand is lower than unity, it is a necessity good. This observation for food, known as Engel's law, states that as income rises, the proportion of income spent on food falls, even if absolute expenditure on food rises. This makes the income elasticity of demand for food between zero and one.

In economics, the income elasticity of demand (YED) is the responsivenesses of the quantity demanded for a good to a change in consumer income. It is measured as the ratio of the percentage change in quantity demanded to the percentage change in income. For example, if in response to a 10% increase in income, quantity demanded for a good or service were to increase by 20%, the income elasticity of demand would be 20%/10% = 2.0.

References

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