Income Determination: Ex-Ante and

Ex-Post

When you have to make that tough choice between catching the most
popular movie in the theatre just the first weekend of its release versus
waiting for ticket ​prices​ to come down a little, income decisions come
into play. How much had you planned to spend this weekend and how
much do you actually end up spending if you choose to catch the
movie at the theatre? Income decisions such as this but of larger
magnitude plague countries as well. Read this lesson to know more
about how a country determines its income and the concepts of
ex-ante and ex-post.

Income Determination
One of the crucial objectives of ​Macroeconomics​ is to determine the
values of different variables, one of the most important of which is
income. Income has the ability to affect both, the demand-side of the
economy, as well as the total national output. Through theoretical
models in Macroeconomics, we are able to understand the effect of
one variable on another and also determine the values of each of these
variables, including income. These models explain why there is say,
unemployment​ in a country or what caused the 2009 U.S. recession
using some crucial variables called explanatory and dependent
variables and keeping other factors constant. This is famous ‘​ceteris
paribus’ ​concept in economics.

Browse more Topics under Income Determination

● Movement Along a Curve versus Shift of a Curve
● The Short Run Fixed Price Analysis of the Product Market

Concepts of Ex-Ante and Ex-Post

To understand ex-ante and ex-post, let us take the example the act of
going to a grocery store. You usually ​plan​ in advance, the list of items
that you wish to buy from the store. When at the store, however,
certain items that might not be on your list might interest you and you
‘actually’ end up purchasing more than what you had ‘planned’. What
you had planned or what ‘could be’ is called ex-ante, while what
actually is, is called ex-post.

Economic variables like consumption, investment, savings, etc. are all

defined in terms of ex-ante and ex-post. The above example was that
of planned and actual spending. There normally arises a difference or
deviation between what is intended or planned and what actually takes
place, and the concepts of ex-ante and ex-post account for that. The
concepts now sound much familiar, right?

Economists constantly strive to determine the strength of countries in

terms of their GDP. For this again, they must know what was the
planned ​demand​ and supply and what turned out to be the actual
values of these variables. To explore why exactly such a deviation
may arise, let us assume the economy of a country to be agrarian. Let
us assume it’s GDP was expected to be, say, $100 million in a year.
That year, however, the country gets hit by a terrible famine due to
crop failure which causes the supply of output of food to fall. Thus,
the actual GDP turns out to be, say, $60 million only. In this case,
ex-ante ​GDP​ or national output is $100 million and ex-post GDP is
$60 million and the deviation is caused by ‘external factors’ (here,
famine).

Marginal propensities

Assume that you receive an income of $100 a month as salary. Let’s

say you were to receive a hike one month and the salary increases to
$150. The additional $50 may be spent by you to ​purchase​ goods or
you may choose to save it. Usually, a mix of savings and
consumptions is chosen.

If you chose to spend $20 and save the rest, i.e. $30, your marginal
propensity to consume (MPC) is 0.4 ($20 / $50). It is the additional
amount you choose to consume out of additional income
earned/received.

The complement of MPC is marginal propensity to save (MPS). It is

the additional amount you choose to save out of additional income
earned/received. Thus, the mathematic relation that may be derived is:

MPC = 1-MPS

or, MPC + MPS = 1

While normally, the mix is between saving and consumption, an
individual might choose to purchase his entire income and not save at
all. Naturally, here, MPC = 1 and MPS = 0. This also explains another
crucial national income identity where for an economy, whatever it
chooses not to consume out o its total national output, it saves.

Example: Ex-ante Consumption

Irrespective of what the income may be, a country will always

consume some basic minimum amount. If income (denoted by ‘Y’) is
zero, a country might consume out of previous year’s stocked income.
Thus, this basic level is always there and is called subsistence
consumption, denoted by ‘C​o​’. Also note, the ​product​, c.Y denotes the
additional consumption resulting from additional income, where ‘c’ is
the MPC or ​proportion​ of additional income devoted to additional
consumption. Does it sound complicated? It will be simpler with just
one equation:

We define the consumption function of an ​economy​ as follows:

C = C​o​ + c.Y
Here, C is the total planned consumption or ex-ante consumption.
Ex-post consumption shall be the actual consumption and the
deviation, again, is explained by ex-ante and ex-post concepts.

Movement Along a Curve versus Shift of

a Curve

Income comprises consumption, savings, and investment components.

But what happens to these variables when income changes? And, what
happens to them when at a given level of income, other variables
change? The answer lies in the difference between a movement along
a ​curve​ and shift of a curve. Read this simple lesson with a
diagrammatic explanation to understand the distinction.

National Income and Movement of Curves

In the lesson on Income determination, we have learned how income

is determined in an ​economy​. We have also understood the concept of
ex-ante and ex-post. But what happens when a country’s income
changes? Does the ​national income​ of India remain constant? No,
certainly.
The implication of this change in ​Macroeconomics​ is reflected
through two kinds of movements of curves: movement along a curve
and shift of a curve. It is best to understand the difference between
them so as not to confuse them. This lesson will make it simple to
understand the difference.

Browse more Topics under Income Determination

● Ex Ante and Ex Post
● The Short Run Fixed Price Analysis of the Product Market

Movement along a Curve

We know that as income increases, consumption increases due to a

positive marginal propensity to consume (MPC). This explains the
relation​ between consumption and income, i.e.

C = f(Y)

The consumption function slopes upward because of this positive

income-consumption relation. The more income you have in hand, the
more you can spend to consume goods and ​services​, right? Now, if
income increases, from Y​0 ​to Y​1​, consumption increases as we can
see, from C​0​ to C​1​.

Let us now look at savings. As income increases, you have more

income in hand that you can choose to save for future use. Thus, more
the income more will be the savings. This explains a positive relation
between income and savings as well, due to a positive marginal
propensity to save (MPS). This is the savings function, as under:

S = f(Y)

Thus, the savings function slopes upward as well. Now, as income

increases from Y​0 ​to Y​1, ​from the positively sloped savings function,
we can see that savings must increases from S​0​ to S​1​.

The above two cases are shown in the first two panels of the figure
below. Here, since the consumption and savings increases as functions
of income on which they are dependent, we call it movement along a
curve.

No discussion of income, consumption, and savings can be complete

without considering investment, right? In our discussion, we consider
investment as autonomous or determined from outside and to be a
given value. Hence, as income increases, investment remains the same
and does not change. The horizontal investment curve shows that it is
given and constant.

Fig. 1: Movement along a curve versus shift of a curve

Shift of a Curve

Think about this. Your consumption depends not only on your income
but also other factors, like your tastes and preferences, your ​wealth​,
etc. For instance, you might experience a shift in taste in favour of jute
bags from polythene bags. Or, when your wealth increases due to
accumulated savings, you may ​feel​ richer to spend more on
consumption. Such cases represent factors other than income that
cause consumption to increase. This leads to a shift of the
consumption curve from C to C’. An increase in consumption is
depicted by an ‘upward’ shift of the consumption curve.

We know that consumption and savings functions are analogous to

each other and when consumption must increase, less income is
available to be saved. Hence, the savings function ‘shifts downward’.
Again, here other factors rather than income have affected savings
level and caused the shift.

If you are to look at investment, the investment function may shift due
to other factors like interest rate. When the interest rate falls, the cost
of investing falls and it is more profitable to invest. Thus, the
investment function shifts upward.

To sum up,​ movement along a curve is always associated with a

change in the independent variable​. In case of the consumption and
savings ​functions​, income is the independent variable. On the other
hand,​ a shift of a curve is associated with changes in other variables
affecting the dependent variable other than the independent variable
(say, wealth in case of consumption) and is caused due to changes in
other factors affecting consumption/savings/investment at any given
level of income.

Solved Example for You

Q: What is the ​ratio​ of Marginal Propensity to Consume?

Ans: The ratio between the change in consumption expenditure and

the change in Income is called Marginal Propensity to Consume
(MPC).

MPC = Δ C / Δ Y

The Short Run Fixed Price Analysis of

the Product Market

Do prices remain the same throughout or do they behave differently in

different time periods? And if ​prices​ are ‘fixed’ and unchanging in the
short-run, what possible impact could it have on the equilibrium
output determination? This lesson on short-run fixed price analysis
breaks down the effect of fixed prices in the short run on equilibrium
output using AD-AS equations and diagrams. It also examines what
happens when the AD curve shifts.

Fixed Price and the Short-Run

The key terms you must first look at are: ‘short-term’ and ‘fixed
price’. In economics, we always distinguish between short-term and
long-term. A short period of time, extending for usually less than a
year, is called the short -run. A period of time longer than that is
termed as ​long-run​. Our variable of interest to carry out a short-run
fixed price analysis is naturally, ‘price’.

What is the meaning of Fixed Price and why is it fixed in the Short
Run?

By the term fixed price, we mean that price remains constant. They do
not change as per demand and supply conditions in the short run. The
reason behind this is that there are always chances that aggregate
demand and supply do not equalize in an ​economy​. Prices take time to
respond to these conditions.

A single firm may not be in a position to influence prices as it might

be contributing a very small ​share​ to the total ​market​ output.
Therefore, firms might become individual price takers in the short run
(like the case of perfect competition). For these reasons, in the
short-run, prices remain fixed. Prices change in the long-run.

Browse more Topics under Income Determination

● Ex Ante and Ex Post
● Movement Along a Curve versus Shift of a Curve

What is the Economic Impact of Constant prices in the Short Run?

In order for prices to be constant in the short-run, we must assume

aggregate supply to be infinitely elastic.Why? An infinite ​elasticity of
supply​ means that suppliers are willing to supply any amount that the
consumers will demand at the given fixed price. If ​supply​ is not
infinitely elastic, excess supply situations might arise and prices will
have to change to adjust demand and supply for equilibrium.

Therefore, equilibrium is entirely determined by the aggregate

demand​. This is known as the effective demand principle. ‘Effective
demand’ is the total demand which is met by the corresponding supply
level.

Equilibrium Determination under ‘Fixed Price Model’

As stated above, Aggregate Demand (AD) determines the equilibrium
in the fixed price model. Let us understand the scenario using a
two-sector economy with households and firms.

In this economy, AD equals the sum of Consumption (C) and

Investment (I), i.e.

AD = C + I

Now, Consumption can be explained with the help of the consumption

function. The consumption function depicts the positive relationship
between consumption and income (Y). The level of dependence of C
on Y is determined by MPC (here, ‘b’). The consumption function
must also comprise an ‘autonomous’ component, which is the
minimum level of consumption, whatever be the value of income (this
is steady even if income is zero). This component is depicted by ‘C​o​’.

So, C = C​o ​+ b.Y

Here, ‘b’ is the marginal propensity to consume or the increase in

consumption per unit increase in income. It is the slope of the
consumption function and always lies between 0 and 1.
In the two-sector model, we take the investment to be ‘autonomous’
i.e. it is not affected by the income level and therefore, we may write:

I = I​0

We can now write the AD equation from (i) as:

AD = C​o ​+ b.Y + I​o

= C​o ​+ I​o ​+ b.Y

AD = A + b.Y (clubbing the autonomous components)

Diagrammatic Representation

To depict equilibrium diagrammatically, take income or output on the

horizontal axis and aggregate demand on the vertical axis. We take the
Aggregate Supply (AS) curve to be a 45º line to show all the points at
which aggregate output equal aggregate expenditures. This is
necessary to determine equilibrium.

The AD curve is upward sloping and starts from an intercept due to

the combined autonomous component (A). The slope of the AD curve
is ‘b’ (MPC). Note that equilibrium is the point where Aggregate
Supply (AS) equals Aggregate Demand (AD) or where Aggregate
Output equals Aggregate Expenditures.

Fig. 1: Equilibrium Output Determination in Fixed Price Model

We see that the AD curve ‘cuts’ the 45º line at point ‘E’, which is the
equilibrium point. Corresponding output level, OY is the equilibrium
output. This is the equilibrium situation for fixed prices in the
short-run.

What happens when any of the autonomous components change?

Let us examine the situation where autonomous consumption

increases from C​o ​to C​1​. This causes a shift of the curve and AD shifts
upward from AD to AD​1​. At the current output level, there will be
excess demand (EG) but in the short-run, prices cannot change so
quickly. So, the equilibrium must change. The new AD curve (AD​1​)
intersects the 45º ​line​ at a higher point ‘E​1​’. This is the new
equilibrium point and the corresponding output level has increased
from OY to OY​1​.