Many societies strive to improve the well-being of their members by increasing their incomes. But an increase in one’s income (wage, pension, and so forth) does not necessarily mean that he or she is better off unless inflation is appropriately factored in. This is because inflation reduces purchasing power, the amount of goods or services that one can afford with a given amount of income, thus eroding some or all of one’s nominal income gains. In order to make an accurate assessment of the effect of an income change on well-being, it is important to consider real income (income in constant dollars), which takes inflation into account, instead of nominal income (income in current dollars), which does not.
Real income of a particular individual or household is the income that is adjusted for the effects of inflation on purchasing power. To see the rationale for inflation adjustments, suppose that your nominal income increases by 50 percent (from $200 to $300) this year over last year, but the price per bottle of your favorite drink increases by 25 percent (from $2.00 to $2.50) over the same period. With last year’s lower income ($200) you could afford $200/$2.00 = 100 bottles of the drink at that year’s price ($2.00). With this year’s higher income ($300), you can afford $300/$2.50 = 120 bottles of the drink, which is more than the 100 bottles you could afford with last year’s income, indicating that you are better off (i.e., your real income has increased). However, if the price of a bottle of the drink increases by 100 percent (from $2.00 to $4.00), you can afford $300/$4.00 = 75 bottles of the drink with this year’s higher income ($300) at this year’s higher price ($4.00), which is less than the 100 bottles you could afford with last year’s lower income ($200) at last year’s lower price ($2.00). Hence you are worse off this year relative to last year, even though your income has increased, because your real income has decreased. You are better (worse) off if the percentage increase in your nominal income is greater (less) than the percentage inflation rate because the percentage growth in your real income (i.e., the percentage growth in your nominal income minus the percentage inflation rate) is positive (negative). A fall in your nominal income does not necessarily imply that you are worse off as long as the percentage decrease in the price level is higher than the percentage decrease in your nominal income, because the percentage change in your real income is positive. In summary, you are better off as a result of an increase or decrease in your nominal income provided that the percentage change in your real income is positive. If the inflation rate is positive, doubling nominal income this year over last year will less than double the corresponding real income. If the inflation rate is zero, however, doubling nominal income also doubles the corresponding real income.
Real income could be viewed in two equivalent ways. Again suppose that your nominal income rises by 50 percent (from $200 to $300) this year over last year but the price per bottle of your favorite drink rises by 25 percent (from $2.00 to $2.50) over the same period. First, with the $200 you could afford $200/$2.00 = 100 bottles of the drink at last year’s price ($2.00). However, to buy the same 100 bottles of the drink at this year’s price ($2.50), you require $250. Because your income has increased from $200 to $300, your real income has increased by only $300 – $250 = $50, a 25 percent increase from your original income of $200 last year (i.e., less than the 50 percent increase in your nominal income). Second, because your nominal income increases by 50 percent (from $200 to $300) and the price of the drink increases by 25 percent (from $2.00 to $2.50), your real income increases by 50 – 25 = 25 percent, which also amounts to $50.
Real income is relevant in wage contract negotiations. An important goal of unions is to protect the real wages of their members. Achieving this goal involves determining the appropriate amount of nominal income adjustment that would protect union members’ real incomes in inflationary situations. To demonstrate the adjustment process, suppose that your nominal wage increases from $50,000 to $52,000 this year over last year, but the price of a given basket of goods and services that you buy increases by 10 percent. With the 10 percent price increase, you would require $50,000 × 1.10 = $55,000 this year to afford the same basket as last year. Because your new nominal income is only $52,000, your real income will have decreased by $55,000 – $52,000 = $3,000, which is 6 percent lower than your nominal wage of $50,000 last year. This can also be confirmed by noting that the percentage increase in your nominal wage from $50,000 to $52,000 is 4; the percentage increase in the price level is 10; hence the percentage increase in your real wage is 4 – 10 = –6, indicating a 6 percent decrease in your real wage. To maintain the same real income, your nominal income has to be increased (or indexed) by 10 percent, the same as the inflation rate (i.e., from $50,000 to $50,000 × 1.1 = $55,000). The same principle is used to index pensions, welfare allowances, and other incomes in order to maintain desired real income levels. In general, if real income decreases by, say, 5 percent, nominal incomes must be increased by 5 percent in order to maintain the same real income as before.
As noted above, adjusting nominal income to maintain some desired level of real income requires information about the inflation rate. However, practical difficulties arise in the measurement of inflation. In practice, the inflation rate is computed from a price (or cost-of-living) index, a summary measure describing relative price changes between some reference (base) period and another (current) period. For purposes of indexing wages, pensions, and so on, the inflation rates are commonly derived from a Consumer Price Index (CPI). The CPI is based on the prices of a representative “basket of goods and services” purchased by households. The economists M. C. McCracken and E. Ruddick (1980) provide a simple exposition of the nature and practical difficulties associated with CPI as an inflation measure. The economic statistician Roy Allen (1975) describes some applications of price index numbers in the measurement and international comparisons of real incomes. Given the aforementioned connection among real income, prices, and purchasing power, the origin of the real income concept can be linked to that of price index numbers, which the economic statistician Wesley Mitchell (1938) traced as far back as the 1700s.
The concept of real income is used in national income accounting to refer to real gross domestic product (GDP), the real value of all final goods and services produced in a country during a specific time period. In evaluating real GDP, the output for different years is evaluated using a common set of prices, thus eliminating the contamination of the value of actual output by inflation. Real GDP is obtained by deflating nominal GDP by a special price index called the GDP deflator, which measures changes in the average price of a broader “basket of goods and services” than does CPI. The usage of real income to mean real GDP is commonplace in the literature on economic growth and the measurement of human well-being, among others.
Because real income takes into account the actual physical quantity of goods and services that can be consumed with the income, it is a better measure of human well-being than its nominal counterpart. It is therefore not surprising that real income has been incorporated into several measures of human well-being developed by the United Nations Development Program (UNDP) in its annual issues of the Human Development Report. UNDP (2006) describes these measures, including the Human Development Index (HDI), the Gender-Related Development Index (GDI), and two human poverty measures (HPI–1 and HPI–2).
Amartya Sen, winner of the 1998 Nobel Prize in Economics, has raised some philosophical issues surrounding the appropriateness of real (or nominal) income as a measure of well-being. Sen (1985) argues that functional capabilities (i.e., what a person can do or can be) are more important than income improvements. This view, which has come to be known as the “capabilities approach,” emphasizes the removal of obstacles to what a person can be or can do. Such obstacles include illiteracy, poor health, lack of access to resources, and lack of civil or political freedom, among others. The ideas underlying the capabilities approach have been incorporated in UNDP’s human development and poverty measures.
The link between real (or nominal) income and happiness has been the subject of empirical investigations by economists and sociologists. There is evidence that higher incomes may not necessarily translate to greater happiness. The economist Mathias Binswanger (2006) has reviewed several explanations for the failure of (real) income growth to increase happiness.
SEE ALSO Economic Growth; Happiness; Inflation; Mitchell, Wesley Clair; Money Illusion; Nominal Wages; Price Indices; Sen, Amartya Kumar; Welfare Economics
Allen, Roy G. D. 1975. Index Numbers in Theory and Practice. London: Macmillan.
Binswanger, Mathias. 2006. Why Does Income Growth Fail to Make Us Happier? Searching for the Treadmill behind the Paradox of Happiness. Journal of Socio-Economics 35 (2): 366-381.
McCracken, M. C., and E. Ruddick. 1980. Towards a Better Understanding of the Consumer Price Index. Hull, Canada: Minister of Supply and Services Canada.
Mitchell, Wesley C. 1938. The Making and Using of Index Numbers. New York: Sentry.
Sen, Amartya. 1985. Commodities and Capabilities. Amsterdam and New York: North-Holland.
United Nations Development Program. 2006. Human Development Report 2006: Beyond Scarcity: Power, Poverty, and the Global Water Crisis. New York: United Nations Development Program. http://hdr.undp.org/.