Only Exceptional Proff

The Household: Consumption and Social Reproduction

Neoclassical economists tend to ignore the household or family and focus instead on the

individual. One of the reasons for this is that the theory evolved out of classical liberal political

theory, in the tradition of John Locke; and this tradition argues that the individual has rights that

stand prior to the formation of political society and government. As a political theory this is quite

adequate, since it’s primary purpose is to argue against government intrusion into individual

liberty. But as an economic theory, intent on understanding humans as social creatures, it is

inadequate. The major problem is that it ignores or is unaware of the enormous literature in all of

the other social sciences, not to mention the heterodox traditions within the discipline of

economics, which underscores the social nature of human behavior. The crux of the problem is

that Neoclassicals argue that the individual has preferences that exist prior to society, or

independent of the possible influence of culture, history socialization, and social identity; and

this, of course, is simply not true.

There are important ideological reasons for why the Neoclassicals tenaciously hold onto

this assumption, despite – one must assume – their knowledge of anthropology, sociology and

psychology. The primary ideological reason for holding onto this belief is that central to

neoclassical theory is the claim that markets, and the firms that feed those markets, give vent to

the sovereign preferences of individuals. Market societies, from this point of view, are seen as

elaborate systems that ultimately reflect the choices of individuals. Accepting the idea that

individual preferences might instead be heavily influenced by culture invalidates this proposition

and opens up the possibility that, instead, individual preferences reflect the preferences of

business and more broadly the bourgeois culture that emerges from the business class. If this is

true, and there’s ample evidence to claim it is true, then one can no longer say that markets

reflect the preferences of individuals, they instead reflect the preferences of a broader bourgeois

culture and, specifically, the marketing preferences of business.

There is a deeper, theoretical, issue as well. If business choices affect not only the supply

of goods, but the preferences of consumers as well, then market demand cannot be said to be

truly independent of market supply, leaving market prices indeterminate. This would seriously

undermine a central proposition of neoclassical theory. Yet, it’s important to note that even the

dean of Neoclassical economics, Alfred Marshall, was aware of this problem. He nevertheless

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thought that it could be ignored, not because he was unaware of the role of culture and

socialization in the formation of preferences, but because he didn’t think it seriously affected the

commonsensical use of the theory of consumer behavior. From this, more pragmatic perspective,

the question of where the preferences come from is somewhat secondary to the fact that the

individual nevertheless does make choices and does try to do the best he/she can, given the

circumstances. This is not an unreasonable position to take and can be grafted onto a much richer

theory of the individual that acknowledges the role of culture and, in particular, bourgeois

culture.

For these reasons, Neoclassicals generally ignore the household or the family. And when

they do cast their gaze in that direction, they inevitably try to explain behavior within the

household as a series of exchanges that are entered into by the members of the household. We do

not have the time here to explore these theories, especially since much of it can be surmised after

having been exposed to the neoclassical theory of utility maximization. Nor do we have the time

to fully explore the way in which the household or the family organizes its resources to maintain

and enhance the social unit. It’s enough to note that this activity is a collective or social endeavor

that isn’t driven by self-interest but rather by sentiments of collegiality, sympathy, cooperation,

reciprocity, caring, and love. In short, the allocation of resources within the family are driven by

motives other than those of market self-interest.

We’ll leave aside the question of how exactly this is done and simply assume that,

somehow, the family allocates its resources among it’s members in ways that are intended to

enhance the quality of household life. We’ll also assume that the choices made by the family are

carried out by one individual, or a collective of individuals, acting as the “government”, the

“head”, of the family. If we work with these assumptions then we can think of the household as

an individual, in the sense that the head of the household is making the choices on behalf of the

group. The preferences of the head of the household will be the preference of the family, rather

than the preferences of the person acting on behalf of the family. Of course, as we know, this too

is problematic, since it’s not uncommon to find the head of the household sometimes making

choices that reflect his/her own preferences and not those of the collective, i.e. the family. This

too, is something we must leave aside, for the sake of time and space, and stick with the fiction

of the family as an individual represented by the head of the household.

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As an economic institution, the family is doing two things at the same time: on the one

hand, figuring out ways of generating income either through the selling of labor, managing of a

business, or managing real and financial assets; and, on the other hand, allocating the income

that’s captured from this activity toward the purchase of consumer goods, real assets and saving

(the purchase of financial assets and/or the hording of money). The way in which this is done

generally varies with the economic class of which the family is a part: working class, middle

class, or capitalist.

Working class families do not own businesses and have modest savings and consumer

assets. As a result, these families have no other way of generating income than to have the

members of the household offer their labor power on the open market. That is, they sell their

ability to work. They must do this because they do not own means of production, they do not

own a business or productive property that can generate enough income without the need to

work. What’s more they do not control their own labor, it is instead controlled by the businesses

for which they work. This is, by far, the largest percentage of families in an advanced capitalist

economy such as the U.S. While data on the percentage of families that are working class is not

readily available, data on the percentage of individuals that are working class does exist. Michael

Zweig, for example, has estimated that approximately 62% of the labor force can be thought of

as being working class (2000).

Middle class families are those who own a small business, are mid-level management of

corporations, and/or professionals, such as doctors and lawyers. What’s common to this class of

families is that they own some means of production, a small business or enough productive

property to generate a flow of property income, but they must also work the business or property.

That is, they’re not full blown capitalists, since they’re not able to live off property income

without having to work; but, they’re not working class either, forced to work because they don’t

have property income. They’re right in the middle, earning both property income as well as labor

income. They have control over their labor but also control the labor of others, while also owning

productive property. Approximately 36% of the labor force can be thought of as middle class

(Zweig, 2000).

Capitalist families are those who own enough means of production to eliminate the need

for work. But, perhaps more importantly, they control the labor of others. These are the families

that own controlling shares of corporations and whose heads of households are CEOs, CFOs, and

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directors on corporate boards. They might also be independent land barons or own a very

lucrative single proprietorship or partnership. While the necessity of work isn’t there, this

doesn’t mean that they don’t work. This is largely a cultural phenomenon since it’s known that

the capitalist class of the U.S. tends to be more actively involved in the running of their

businesses than is true of the European capitalist class (who are more comfortable delegating

such authority to others). It’s been estimated that, in the US, the capitalist class represents

approximately 2% of the labor force (Zweig, 2000).

In what follows we’ll be focusing most of our attention on the behavior of working class

families.

As with their theory of the firm, the Neoclassicals assume that the consumer always has a

wide range of substitutability. That is, in the search for things needed to survive and hopefully

prosper, the neoclassical consumer is assumed to have a wide range of choices. Unlike the

Classicals who assumed that there was a minimal set of goods that had to be consumed in order

to survive, the Neoclassicals tend to ignore the notion of necessities and argue instead that, for

any one good, there is usually a wide range of substitutes. For example, while it is clearly true

that food is needed for survival, what is not true is that a specific type of food, say beans, is

required. The consumer can always pick other types of food and is not forced to stay with beans.

What’s more, even in the case of beans, it’s not as if there is only one type that must be

consumed, there are generally a wide range of beans (pinto, black, navy, garbanzo, etc), from

which to choose. But, while it’s reasonable to claim that for any one category of consumer

goods, say food, there is generally a wide range from which to choose, it is not reasonable – and

indeed flies in the face of empirical evidence – to argue that food can be substituted for housing

or clothing or transportation. That is, while there may very well be substitutability within each of

these broader consumption categories (food, housing, clothing, transportation, etc.), there is often

very little substitutability between these categories. That is, there’s a minimal amount of food

that must be consumed (a necessity) and a minimal amount of housing (another necessity) that

must be purchased and so on; and while some consumers may very well give up on a little bit

less food so as too purchase a little bit more housing, there is usually a limit that’s reached fairly

quickly preventing the consumer from giving up entirely on the consumption of food for the sake

of housing.

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We’ll explain all of this by first explaining the standard neoclassical argument. To keep

things simple we’ll assume that the consumer has a fixed budget and that he/she must allocate

that budget in the consumption of two goods. The argument can be easily extended to a much

larger number of goods, but the basics of the theory can be more easily understood (and graphed)

if we assume two goods (i.e., two dimensions).

With reference to any two goods the consumer is assumed to have a strictly convex

indifference set; that is, the consumer has a clear idea of the rate at which he/she is willing to

trade off one good for another while still holding onto the same level of satisfaction or utility.

This idea is represented in the following graph showing the consumer’s budget constraint and

indifference map.

Utility Maximization (convex indifference curves, substitutability):

The early Neoclassical theorists, such as William Stanley Jevons, Karl Menger, and Leon

Walras, argued that individuals experience diminishing marginal utility in the ownership of

anything. That is, the more of any one thing that an individual owns the smaller the increment of

utility that’s derived from owning one more unit of the same item. This idea is represented in the

following figure, showing utility growing, but at a diminishing rate, as the amount of X owned is

increased.

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While this behavior was assumed to be universal, the degree to which utility would

increase from the ownership of one more unit of anything would differ from one person to the

next. What’s more, it was acknowledged that there might be things and activities that do not

generate utility, indeed owning or doing more of such things would generate disutility. Work, the

Neoclassicals claim, is one such example. It’s assumed to generate disutility and, as a result,

individuals avoid it unless the utility derived from the wages earned by work exceed, at the

margin, the disutility associated with that work. We’ll explore this case later in the chapter. For

the moment, it’s enough to understand that in general, and particularly when it comes consumer

goods, individuals experience greater utility from owning or consuming greater amounts of such

goods. What’s more the increment in utility derived from the ownership of one more unit of any

one thing is assumed to diminish.

The following figure depicts this behavior. It shows how the increment in utility, called

marginal utility, diminishes as the ownership of one more unit of X increases. Assuming that

utility was measureable, then marginal utility could be derived by calculating the slope of the

utility function. And since the slope of the utility function keeps diminishing as X is increased,

the marginal utility (MU) of X will get smaller, as shown in the following figure, as X is

increased.

An important implication of this idea is that the “cost” involved in giving up an amount

of any one good X will depend on the amount of X already owned. For example, if the amount of

X owned is fairly small (close to the origin, in the above graph), then giving up one unit of that

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good will involve foregoing a fairly large marginal utility. On the other hand, when the amount

of X owned is fairly large, then giving up one unit of that good will involve foregoing a small

marginal utility. In other words, it’s easier to offer units of something one already owns in

abundance than to offer units of something one owns in modest amounts. The “psychic cost”

involved in the former is much smaller than it is in the latter.

Since the Neoclassicals conceived of this behavior as applicable to all consumer goods

and services, one could imagine a total utility function, shown below, measuring the utility

derived from the ownership of any two pairs of goods X and Y. Note that the shape of this utility

function is identical to the shape of the three dimensional production function introduced in the

previous chapter. But, while they look the same, their interpretation is different. In the case of the

production function, the shape is a result a assuming diminishing marginal returns, while in the

case of the utility function the shape is a result of diminishing marginal utility.

Notice also that, as in the case of the production function, one can imagine a flat plane,

depicted by the dotted lines, showing all the possible combinations of X and Y that generate the

same level of utility. The combinations of X and Y that are located on the rim of that plane

would be the most efficient in the sense that owning those minimal combinations of X and Y

provide the same level of utility as those located on the inner surface of that plane. Rotating this

figure so that the axis measuring utility is coming off the page and the X axis is now horizontal

while the Y axis is now vertical, provides us with the following “topographical” map of the

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various rims depicting combinations of X and Y that provide the same level of utility. These rims

are referred to as indifference curves and measure the rate at which the consumer is willing to

give up units of any one good Y for one more unit of good X.

As with the isoquants introduced in the previous chapter, the location of the indifference

curves measures the amount of utility derived from the ownership of X and Y. Indifference

curves that are further from the origin represent higher levels of utility, while those that are

closer to the origin represent lower levels of utility. And for any one indifference curve, the rate

at which the consumer is willing to give up units of Y to obtain one more unit of X, is called the

Marginal Rate of Substitution of X for Y, i.e. MRSX,Y, and can be measured by the slope of a

straight line tangent to the indifference curve at any one point. The marginal rate of substitution

of X for Y is also equal to the ratio of the marginal utility of X to the marginal utility of Y. That

is,

𝑀𝑅𝑆(𝑋,𝑌) = ∆𝑌 ∆𝑋⁄ = 𝑀𝑈𝑋 𝑀𝑈𝑌⁄ .

Note that, if the indifference curves are strictly convex as shown in the figure, then the

MRS(X,Y) diminishes as the individual consumes more X at the expense of Y while maintaining

the same level of utility. That is, the amount of Y the individual is willing to give up so to obtain

one more unit of X, and maintain the same utility, diminishes as the amount of Y owned

decreases.

The amount of X and Y the individual will purchase (own) will depend on the amount of

income (the budget) available per time period. We can explain this choice by first writing the

individual’s budget constraint in the following terms

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𝑀 = 𝑝𝑋 ⋅ 𝑋 + 𝑝𝑌 ⋅ 𝑌,

where M represents the amount of money available per time period, pX represents the price of X

and pY represents the price of Y. Note that we’re assuming that the total amount of spending on

both X and Y is constrained by the amount of money, M, available per time period. This could

be modified by allowing for the possibility of debt; that is, modifying the above equation to

include the amount of X and Y purchased with debt. We’ll ignore this possibility for the

moment, and come back to after we’ve studied the choice of X and Y with a fixed budget (a

fixed amount of money available per time period).

Rewriting the above equation to make Y a function of everything else provide us with

𝑌 = 𝑀

𝑝𝑌 +

𝑝𝑋

𝑝𝑦 ⋅ 𝑋,

which can be superimposed on the individual’s indifference map to analyze the choice of X and

Y. The following figure provides a visual image of how the choice is arrived at.

While the format looks identical to the firm’s cost-minimizing choice of K and L, there is

an important difference. Unlike the firm where the level of output is given and the objective is to

find that combination of K and L that will minimize the production of that level of output, the

individual is seeking to maximize the level of utility that can be derived from the consumption of

X and Y, given the fixed budget constraint. That is, the budget constraint is fixed and the

individual finds that combination of X and Y that will maximizing utility, and this occurs at the

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point where the budget constraint is just tangent to an indifference curve that is furthest from the

origin but tangent to the budget constraint.

The budget constraint is given by the objective conditions in the market, i.e. the amount

of money available to the consumer per time period and the prices of the two goods, in this case

goods X and Y. In the above graph, the budget constraint is represented by the downward

sloping line M/PY, M/PX. The consumer could purchase any combination of X and Y on that

constraint or within it, such as, for example X1,Y3. The slope of the budget constraint is equal to

the ratio of the price of X to the price of Y, that is PX/PY, and is also known as the relative price

of X in terms of Y. The relative price X in terms of Y represents the rate at which the consumer

must give up units of Y to purchase one more unit of X. It’s the rate of trade off established in

the market.

The consumer’s preferences are represented by two indifference curves, out of the

infinite number that could exist in that space. Any one indifference curve contains information

on the rate at which the consumer is willing to trade off one good for another and still maintain

the same level of satisfaction. Thus as we move down any one indifference curve we get

information on the rate at which the consumer is willing to give up units of Y for a little bit more

X. The rate at which the consumer is willing to substitute X for Y and still maintain the same

level of utility is called the Marginal Rate of Substitution of X for Y (MRSX,Y). It can also be

thought of as providing information on the intensity of desire the consumer has to exchange Y

for X. That is, the MRSX,Y provides information on the marginal utility that is lost by giving up

Y for the marginal utility that is gained by getting X.

Note that the convexity of these indifference curves has built into them the idea that the

consumer becomes increasingly reluctant to give up any one good in return for extra units of

another good (while remaining on the same level of utility). Another way of saying this is that

the consumer’s MRS of X for Y gets smaller and smaller with each extra unit of X the consumer

is thinking of getting. The amount of Y the consumer is willing to give up, so as to obtain one

more unit of X, keeps getting smaller as the amount of Y owned diminishes. We could interpret

this as a concession, on the part of Neoclassicals, to the notion of a necessity. If, for example, the

indifference curve had a flat horizontal portion at the bottom of the curve, then this would imply

that the consumer is not willing to give up any more Y for a little bit more of X. At that point, Y

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would represent the minimal amount the consumer feels he/she must have, and can be thought of

as the minimally necessary amount.

It should also be noted that there is no empirical reason for claiming that indifference

curves are convex, as shown in the above diagram. They could just as easily be straight lines,

parallel to the budget constraint, or they might instead be concave, or horizontal or vertical lines.

In short, the form that indifference curves take, and consequently the consumers MRS for any

two goods, will depend totally on the consumer’s idiosyncratic preferences. Nevertheless, it’s

common for Neoclassicals to portray the indifference curves as convex not so much because they

capture the behavior of real consumers but because convex indifference curves makes it easier to

claim that there is a unique combination of goods that the consumer will pick while trying to

maximize utility. But, it’s also the case that convex indifference curves make it easier to explain

the idea of substitutability, giving up amounts of Y in exchange for X.

Lastly, indifference curves further from the origin generate greater utility than

indifference curves closer to the origin. Since it’s assumed that the consumer always wants more,

this means that the consumer will be motivated to keep picking combinations of X and Y that are

further and further away from the origin. But the only thing that prevents the individual from

moving further and further away from the origin is the budget constraint, namely the total

amount of money he/she has available and the prices of the goods. The consumer will thus be

motivated to spend the entire budget.

The consumer will spend all of his/her money in the purchase of the two goods and will

seek that indifference curve which is as far away from the origin as possible but still laying

within the consumer’s monetary constraint (the budget). Another way of viewing this is that the

consumer will pick a combination of X and Y that lies on the budget constraint and maximizes

utility. In the above diagram that occurs when the indifference curve that is furthest from the

origin is just tangent to the budget constraint. At that point, the consumer will be exhausting

his/her budget while choosing that combination of X and Y such that the MRSX,Y is just equal to

the relative price of X in terms of Y. Another way of saying the same thing is that the consumer

will be maximizing utility when the budget is exhausted and marginal utility per dollar spent on

any one good X just matches the marginal utility per dollar spent on any other good Y.

It’s important to not get too carried away with what utility maximization means. It

doesn’t mean that the consumer will be as happy as possible, given the purchase of those two

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goods. All it really means is that the consumer has done as well as he/she can, given the budget

and his/her preferences. This also means that if the budget constraint is quite meager, say at

poverty or below, the consumer will still be able attain a maximum of utility, but still be at, or

below, poverty. It’s also important to realize that the consumer will generally go through a

learning period during which the combination of X and Y chosen will not necessarily be utility

maximizing amounts. That is, the consumer may at first purchase too much of X and not enough

of Y, or vice versa. But, the argument that Neoclassicals make is that eventually, the desire to do

the best he/she can, will move the consumer to that combination of X and Y that feels best for

him/her. Once the consumer arrives at that choice then the same amount will be purchased per

time period so long as money and prices per time period remain unchanged.

The idea that mistakes might be made is depicted in the above diagram by the two points

at which the first indifference curve crosses the budget constraint. Notice that if either one of

those choices had been made the consumer will indeed have exhausted his/her budget, but will

not have attained a maximum of utility. In the first case, where the consumer has chosen X1,Y1,

the marginal utility per dollar spent on X is greater than the marginal utility per dollar spent on

Y. This means that the consumer is deriving a bit more pleasure from consuming one extra

dollar’s worth of X over the pleasure being derived from consuming one extra dollar’s worth of

Y. As a result, this consumer will be motivated to move down the budget constraint, purchasing

a bit more X and a bit less Y. The opposite would be occurring on the other edge of the budget

constraint, where the first indifference curve crosses the budget constraint at a point where X3,Y3

is chosen by the consumer. In this case the marginal utility per dollar spent on the purchase of X

is less than the marginal utility per dollar spent on the purchase of Y. This would induce the

consumer to move up the budget constraint by purchasing a bit less X and a bit more Y.

Eventually, the consumer would arrive at the unique combination of X and Y that maximizes

utility (the point at which the marginal utility per dollar in the purchase of X just matches the

marginal utility per dollar in the purchase of Y). In the above diagram this occurs with the

purchase of X2,Y2 units of X and Y.

It should be noted that it’s common for Neoclassicals to assume that preferences are

fairly stable, indeed static. What they mean by this is that once preferences have been

established, say X is preferred to Y, then that pattern remains stable and the consumer would not

switch back to preferring Y over X. In short, Neoclassicals assume that preferences are rational

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constructs uninfluenced by the emotive context from which values emerge. Of course, and as

already noted earlier, this also means that the Neoclassicals do not see individual choice being

influenced by socialization, marketing, or the broader culture.

One could, of course, use the mechanics of utility maximization to imagine that

preferences do change and are influenced by culture, marketing and socialization. The consumer

could still be thought of as maximizing utility, except that now utility would be assumed to be

malleable, influenced by social fads or broader cultural issues. There’s nothing inherently wrong

in taking this approach but it does have the effect of destroying a key neoclassical proposition,

namely that individual choice is sovereign and uninfluenced by society at large. It also

diminishes a corollary principle, that’s always accompanied utilitarian theories, namely that the

consumer makes choices based on a dispassionate assessment of what’s truly needed. Built into

the utility maximizing interpretation of human behavior is the belief that the individual will not

be prone to flights of fancy or an incapacity to organize life in a way that ensures that things be

obtained in their proper order. There is, in short, the underlying belief that, even though the

individual wants it all, he will be wise in the way he goes about obtaining it.

Necessity (no substitutability, income changes):

While Neoclassicals generally avoid the notion of a necessity, the concept can

nevertheless be incorporated into the indifference curve framework. The following two diagrams

provide one way of thinking about this. Instead of thinking of a specific commodity we can

instead think in terms of a consumption category that is required for survival, say food. While

there may very well be substitutability within that category (say beans as a substitute for steak or

either of these as a substitute for tofu), the category itself must be consumed for purposes of

survival. One way to think of this is to calculate the calories and nutritional value that must be

consumed to sustain a healthy life. While there will be substitutability among the various types

of food that can fit that requirement, the requirement itself is nevertheless a necessity of life.

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In the diagram, food is measured on the horizontal axis and all other goods (Y) are

measured on the vertical axis. The choice, in this simple example is between food and all other

goods. The straight vertical line represents the minimal amount of food the consumer must have

so as to sustain life. Note that this straight vertical line represents one indifference curve out of

the infinite amount that must exist in this two-dimensional space. It’s reasonable to imagine that

the indifference curves to the left of that line would also be straight vertical lines parallel to the

one shown in the diagram. The indifference curves to the right of that line would probably

exhibit some substitutability. At this point we don’t need to explore the form such substitutability

might take place, since our focus here is on the notion of a minimally necessary flow of food per

time period.

Note that any budget constraint that’s equal to or less than the one with M1 amount of

money per time period will generate a corner solution where the consumer will end up

consuming all of his/her income in the purchase of the necessity. But, as income begins to grow

beyond that amount, say M2, as shown in the above diagram, then the individual will now be able

to purchase not only the minimal amount of food needed for survival but the other goods (Y)

he/she might want, desire or need.

Obviously this idea can be extended to include what’s normally thought of as the cost of

living. We can now think of the straight vertical line as representing the minimal bundle of

consumer goods that must be obtained to sustain life in society (food, clothing, housing,

transportation, education, insurance, health care, etc.). Any income that falls short of the amount

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needed to cover the cost of living will be exhausted in purchasing those necessities. But once

income begins to exceed the minimal amount needed to cover the cost of living, the individual

will begin to use that extra income to purchase other things, including luxury goods and various

types of consumptive and financial assets.

Necessity (no substitutability, price change):

What if, instead, the price of food (or the cost of living) was to increase? The above

diagram underscores what you already know. If the price of a necessity increases, then the

consumer continues to purchase the necessity (in this case food or the cost of living) by cutting

down on the purchase of all the other goods (Y). An increase in the price of food, so long as

income is above the amount needed to purchase food, would induce the consumer to cut back on

the consumption of other goods (Y) while still holding onto the amount of food that must be

consumed per time period. Of course, if the price of food were to continue rising, then even the

consumption of food would begin to diminish.

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Utility Maximization (normal goods, income changes):

Let’s now go back to the case of convex indifference curves, implying substitutability, so

as to explain the concept of normal and inferior goods. The following two diagrams provide a

visual interpretation of these ideas. Goods that are consumed in greater amounts as income

increases are referred to as normal goods, while goods that are consumed in smaller amounts as

income grows are defined as inferior goods. The first diagram provides a visual interpretation of

a normal good. Actually, in this case both X and Y are normal goods since greater amounts of

both X and Y are purchased as the budget constraint moves out due to rising flows of income per

time period.

The second diagram (below) depicts an inferior good (in this case X). As the consumer’s

income (money) increases per time period, the consumption of X diminishes. Notice, however,

that now good Y is a normal good since it’s consumption increases with increased income.

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One way to think of the difference between normal and inferior goods is that normal

goods represent the things we would like to own or have, while inferior goods represent the

things we would rather not have but end up consuming anyway because it’s all our income

affords. This way of thinking of the difference between normal and inferior goods also helps to

explain the pattern of consumption found across the distribution of income. The consumption

patterns typical of poor households or neighborhoods is one in which a significant number of the

goods making up their consumption is inferior. They have no other option but to purchase the

inferior goods. But the consumption patterns typical of affluent households or neighborhoods is

one in which a significant number of the goods making up their consumption is normal. Second

hand goods, generally thought of as inferior, are more frequently purchased by the poor than by

the rich. In contrast, luxurious automobiles, generally thought of as normal, are more frequently

purchased by the wealthy. So, we can think of the distribution of normal and inferior goods

across society as one way of measuring the distribution of income and wealth and, in particular,

the notion of poverty and opulence.

Utility Maximization (price changes):

The neoclassicals see utility maximization as the foundation of market demand. The

negative relationship that generally exists between the price of a good and the amount purchased

per time period is thought to be a result of the utility maximizing choices on the part of the

consumer. The following diagram shows one way of thinking about this (an earlier version was

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already introduced when we considered the case of an increase in the price of a necessity). In this

case, as the price of good X is decreased from Px1 to Px2 the consumer ends up choosing a greater

utility maximizing amount of X. This is the pattern that is normally expected; as the price of X

decreases, the amount of X consumed per time period increases.

However, this need not always be the case. There may be times when a decrease in the

price of a good does not alter the amount purchased per time period, and other times when a

decrease in the price of a good causes the amount purchased per time period to fall. An

understanding of these possibilities requires that we understand the difference between the

substitution effect and the income effect brought about by a change in the price of a good.

A change in the price of any good, let’s say a price decrease, will have the effect of

reducing the relative price of that good with reference to another substitutable good. Since both

goods are thought of as substitutes by the consumer, then a reduction in the price of one of the

goods, other things equal, will induce the consumer to purchase more of that good while cutting

back on the purchase of the other substitutable good. This is what is meant by the substitution

effect. But, at the same time, a reduction in the price of any one good will also have the effect of

increasing the purchasing power of the consumer, allowing her/him to purchase more of the good

if it’s a normal, or less of it if it’s inferior. This is what is called the income effect.

Utility Maximization (Price changes, normal good, income and substitution effects):

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The following diagram provides one way of visualizing what’s meant by the substitution

and income effects. In the diagram we start by showing the initial utility maximizing choice of

the consumer, X1, given his/her income, the prices of the goods, and his/her preference pattern.

The price is decreased from PX1 to PX2. This causes the relative price of X in terms of Y

to decrease making X relatively less expensive compared to the substitute Y. This would induce

the consumer to purchase more X and less Y, even if we could somehow hold income constant.

One way to think of this is to imagine the slope of the budget constraint rotating (become flatter,

given that this is a decrease in the relative price of X in terms of Y) along the first indifference

curve U1. If we think of the consumer’s real purchasing power as being measured by utility, then

the consumer’s real purchasing power must be constant along the entire length of the

indifference curve. Therefore, forcing the budget constraint to rotate along the edge of the

indifference curve would be one way of imagining a change in the relative price of X in terms of

Y while holding income constant. If this could be done, then the consumer would end up

purchasing more X and less Y, shown in the above diagram as a move from X1 to X1’.

But, of course, real purchasing power cannot be held constant. So, once we account for

this by allowing real income to grow as a result of the price decrease, we must consider whether

the good in question is a normal or inferior good. If the commodity is a normal good, then the

consumer will end up purchasing an amount that’s greater than X1’, but if the commodity is an

inferior good, then the consumer will end up purchasing an amount that’s less than X1’. In the

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above diagram, X is thought of as a normal good and, as a result the consumer ends up

purchasing X2 amounts of X.

Now, of course, the consumer is not aware of all this, it’s a construct that economist use

to explain the impact on relative prices and purchasing power brought about by a change in the

price of any one good. From this perspective all price changes have a substitution and income

effect. But the consumer is only aware of the total effect. In the above diagram all the consumer

knows is that he/she went from consuming X1 to X2 amounts of X, but the economist would

argue that this process involved a substitution effect that moved the consumer from X1 to X1’ and

an income effect that moved the consumer from X1’ to X2.

Demand Curve (normal good, price elastic):

The downward sloping demand curve shown above is consistent with the change in the

utility maximizing choice the consumer made in response to a change in the price of X, as was

just explained. The price of X was decreased and the amount of X consumed per time period was

increased. But it’s important to realize that the neoclassical economist views the demand curve

as saying something quite specific. It’s not just that the quantity purchased per time period will

increase if the price is decreased, it’s rather that the amount chosen, at both prices, are utility

maximizing amounts. That is, every point along the demand curve represents a utility

maximizing choice on the part of the consumer. Another way of saying the same thing is that

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every point on the demand curve represents an equilibrium position for the consumer. If we are

to think of the demand curve as capturing real behavior then what this must also mean is that at

any one moment it’s quite possible for the consumer to be off his/her demand curve, that is, not

maximizing utility or not in equilibrium.

The downward sloping demand curve depicted above is only one possible outcome of the

utility maximizing choices of the consumer. Other possibilities, such as an inelastic demand

curve or even a positively sloped demand curve are also possible. What’s more these other

possibilities are consistent with utility maximizing behavior. It would all depend on the relative

strength of the income and substitution effects.

Utility Maximization (Price change, inferior good, substitution effect > income effect):

The following two graphs depict a situation where the commodity is an inferior good and

the consumer is confronted with a price decrease. What’s more, the substitution effect outweighs

the income effect. In this case the consumer’s utility maximizing choice still ends up growing as

a result of a decrease in the price of X, but as can be seen the response is not quite as elastic as it

was in the case considered above. Indeed, we could have constructed an example in which the

substitution effect was exactly counterbalanced by the income effect leading to no change in the

amount of X consumed per time period. In this case, the demand curve would have been

perfectly inelastic, a straight vertical line.

Notice that the substitution effect always works in the same direction. That is, a decrease

in the price of X will bring about an increase in its purchase as the consumer seeks to substitute

more of X for the alternative Y substitute. Likewise, if the price of X increases then the

substitution effect will bring about a decrease in its purchase. However, the direction of the

income effect will depend on whether the good is a normal good or an inferior good. If it’s a

normal good, then a price decrease will bring about an increase in its purchase; and if it’s an

inferior good, then a price decrease will bring about a reduction in its purchase. The opposite

would occur in the case of a price increase.

The extent to which the income effect outweighs, falls short of, or equals, the substitution

effect depends on the proportion of the budget allocated to the commodity. Commodities that

take up a small share of the consumer’s income, such as bubble gum, will always have a small,

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or insignificant, income effect. Commodities that take up a large share of the consumer’s

income, such as housing, will always have a large income effect.

What this means is that big-ticket items will always have a large income effect whereas

goods that take up a very tiny share of total income will have an insignificant income effect. The

substitution effect is small in the case of commodities that take up a large proportion of the

consumer’s income, while it tends to be large in the case of commodities that take up a small

proportion of the consumer’s income.

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Utility Maximization (Price change, Inferior Good, Substitution Effect < Income Effect):

In this last case the consumer is purchasing an inferior good and a reduction in its price

brings about a reduction in its purchase. This would cause the demand curve to be upward

sloping.

Goods that exhibit this behavior are said to be Giffen goods. The idea behind this is that

the consumer is already far below the poverty level and is forced to consume the one inferior

good that allows him/her to survive. When the price of the good decreases the consumer’s real

purchasing power increases and this will motivate him/her to purchase less of the item so as to

consume other goods. The result is an upward sloping demand curve.

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Demand Curve (Inferior Good, Giffen Good):