Income Determination

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.

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Income Determination

economy

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.

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 ‘Co’. 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 = Co + 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.

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