Topic 2: Decision Making in the Household

Introduction
Now that you are aware of the tools that are required during the course, let us start with the first
topic, decision making in the household. As already mentioned, decision making in the
household essentially has three major aspects. They are:

1. How do households decide how much to work, and how much to earn.

2. Of the money earned, how do households decide how much to save and how much to
spend.

3. Of the money to be spent, how much to buy of each good and service.

We start with the third aspect of decision making in a household - that we have already decided
how much money to spend on goods and services, and now we have to decide how much to buy
of each good and service. The first thing to check is the choice of commodities available and
prices of those commodities for the amount of money we have decided to spend For a consumer,
the term ‘money income’, implies that portion of income from their salary, - which they decide
to spend on goods and services. Therefore for the consumer, the amount they wish to spend the
money income has already been decided upon. They also cannot dictate the prices that will be
charged for products. Since they have no control over these two variables, they are called
exogenous variables. On the other hand, the consumer can choose the quantities of goods that
they can buy with the prevailing prices; therefore, the money income can be decided by them.
These are known as endogenous variables.

The Budget Constraint and the Budget Set

Let the household’s budget be M, which is to be spent only on food, let F denote the quantity of
food, and let pf be the price of food per unit. Therefore, the quantity of food that can be bought is
F <= M/pf. However, if there also exists a second commodity to buy, say clothing, and C denotes
the quantity of clothing bought, the various combinations of food and clothing he can buy is
given by the budget inequality PfF + PcC <= M. The combination of food and clothing that can
possibly be bought is given in Figure 2.1.

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 Figure 2.1: The Budget Line

Clothing

M
PF

Budget Line

Food

M
PC

In Figure 2.1, the x axis gives the amount of food that can be bought with money income M, and
the price of food, is pf, and the maximum food that can be bought is M/p f, while the y axis gives
the amount of clothing that can be bought, the maximum being M/p c. The line depicted as the
budget line, gives the various combinations of food and clothing that can be purchased when all
of the money income M is spent. The triangle that is with the two axes and the budget line is
called the budget set; it denotes all the feasible commodity bundles that are available to the
consumer with money income M, and prices of food and clothing p f and pc respectively. The
slope of the budget line is pf/pc, and it gives the opportunity cost of consuming food, that is, the
consumer has to sacrifice pf/pc units of clothing in order to buy a unit of food. The idea of
opportunity cost of food will come in handy when the consumer has to decide how much food or
clothing to buy if either of the prices were to change. How does the household decide which
commodity bundle to actually choose? For this we need to know to make some assumptions
about the household’s choice and its impact on household welfare. Please also note that the
budget set may not always be a simple triangle the exercises at the end of the lecture note will
reveal different possible budget sets one can possibly have and it will be fun commenting on
what a household’s choice will be with these budget sets as compared to a simple one.

Exercise 1: Let a consumer’s salary consist of 50 units of food and 100 rupees of cash. The price
of food is one rupee for a unit of food, and that for clothing is one rupee for a unit of clothing.
Draw the consumer’s budget line. Is he better off than in a situation when he was to be given an
extra Rs. 50 of cash rather than 50 units of food?
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Solution: Note that in this case, it will not be a standard budget set, but one where the top
triangle A is not available. If he is given Rs. 50 in cash rather than 50 units of food, he has more
choices; he may or may not change with the availability of new choices. If he does not change,
he is no worse off, if he does change, he is surely better off, since he could have stuck to his
earlier choice, but the very fact that he has changed must imply that the latter one is better.

Clothing

150

100

Food

50 150

This situation is such where one needs to debate whether being paid in kind is better than being
paid in cash. For example, think of a situation where you are offered two jobs, one which offers a
higher cash component but little or no perks to one where the cash component is low, but the
perks are high in terms of free housing or available office transport. One way to analyze which is
better would be to check the current prices of the perks offered and see what each job offer is
worth in monetary terms, and choose the one which is higher. Even if the job with perks is worth
less in monetary terms, many might still opt for it, if they feel the prices of the goods offered as
perks will rise in the future. The reverse is also true:- for example, a job may offer a lavish
accommodation, but a person may not be keen on it, or may not need such lavish housing, so
they would prefer to take a small house rent allowance that allows them to live in a small
apartment and spend the rest of the money on goods and services of their choosing that they like.

There is a huge debate now in the Indian policy circles whether the current public distribution
system is the best way to offer food and other items at a cheaper price. The public distribution
system has been said to be very inefficient and with huge possibilities of the system getting
corrupt. The Ministry of Finance is currently toying with the idea of dismantling the public
distribution system. This system offers some goods of fixed amounts at subsidized prices to
people below the poverty line. It is thus possible to work out the exact amount of subsidy that a
person below the poverty line receives, and it has been suggested that the same amount be
transferred to the bank accounts of the poor, which will be easy especially once all citizens have

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a UID card that has information of the bank account. This will enable a person to buy his goods
from any shop rather than queue up in a ration shop, and they need not buy the exact quantities
that are specified by the government. However, there is a lot of ongoing debate whether such a
policy will be beneficial to all. One of the common fears expressed is in the absence of fair price
shops, prices may increase, which may eventually hurt the poor. Another aspect cited is that the
money may be controlled by men in the family who may actually use it for their own liquor or
drug consumption and may not actually benefit the family. That is why some policy analysts
have even gone to suggest that the money be credited to the women in the household.

In short what the above problem implies, is that with more choices one can be always better off
or always as well of as before, never worse off. This is the Economists view. However,
Psychologist Barry Schwartz has written a very interesting book titled, “The Paradox of Choice:
Why more is less, how the culture of abundance robs us of satisfaction”, where he/she gives
examples of cases that if an individual is faced with too many choices over which he/she cannot
decide, he/she will be in fact worse off than in a situation where he just has one choice, a lot of
time and effort may be spent in deciding which one to choose, in case he/she has too many
choices.

This situation is one where one needs to debate whether being paid in kind is better than being
paid in cash. In many situations we face the dilemma, of two jobs, one which offers a higher cash
component but little or no perks to one where cash component is low, but the perks are high in
terms of free housing or available office transport. One way to analyze which is better would be
to check current prices and see what each job offer is worth in monetary terms, and choose the
one which is higher. Even if in monetary terms the job with perks is worth less, many people
might still go for it, if they feel prices of the goods offered as perks will rise in future. The
reverse is also true, a job may offer a lavish accommodation, a person may not be keen or need

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such housing he may choose to take a small house rent allowance which allows him to live in a
small apartment and spend the rest of the money on goods and services he likes.

There is a huge debate now in the Indian policy circles whether the current public distribution
system is the best way to offer food and a variety of necessary items cheap. The public
distribution system has been said to be very inefficient and with huge possibilities of the system
getting corrupt. The Ministry of Finance is currently toying with the idea of dismantling the
public distribution system. This system offers some goods of fixed amounts at subsidized prices
to people below the poverty line. It is thus possible to work out the exact amount of subsidy that
a person below the poverty line receives, and it has been suggested that the same amount be
transferred to the bank accounts of the poor, which will be easy especially once all citizens have
a UID card one that has information of the bank account. This will enable a person to buy his
goods from any shop rather than queue up in a ration shop; he need not buy the exact quantities
that are specified by the government. He has more choice of what to buy so must surely be better
off.

However, there is a lot of ongoing debate whether such a policy will be beneficial to all. One of
the common fears expressed is in the absence of fair price shops, prices may increase which may
eventually hurt the poor. Another aspect cited is that the money may be controlled by men in the
family who may actually use it for their own liquor or drug consumption and may not actually
benefit the family. That is why some policy analysts have even gone to suggest that the money
be credited to the women in the household.

Reetika Khera, a famous academician, has written various articles on this issue. In one of her
article titled ‘Cash versus In-kind transfer: Indian Data meets theory’ she argues that across all
states, on an average, 67 percent of the population would prefer food over cash, whereas 18
percent of the population would prefer cash over food. Some of the major concerns related to the
public distributed system were corruption, irregular supplies, and poor quality grains.
Conversely, the sample who preferred food grains mentioned food security, protection from the
misuse of money, and lower transaction costs as some of the advantages. The study mentioned
that providing cash could have ill effects such as theft, inflation, large distances to banks and
post offices to collect the money. Conversely, some of the respondents in the study mentioned
that cash would give them the choice to choose their type of grain in whatever quantity they
liked.

In most cases however, whenever a new policy comes up, some earlier options are lost and some
new ones are gained. This is best depicted in the example below

Question: Let a consumer with an income of 100 units consume food and telephone calls. Food
costs one rupee a unit, and telephone costs one rupee a call. Draw the budget line for the

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consumer. If the telephone company is thinking of replacing it with a tariff of 50 rupees for 75
free calls, and 2 rupees for every extra call made, draw the new budget line. Is he better or worse
off?

Answer:

Food 100

50 B

100 Telephone Calls

If the individual is in the bottom triangle (B), then the policy change makes him worse off.
However, if the individual is placed in the upper triangle (A), he is better off. Just by this
diagram, it is therefore difficult to predict whether the consumer is worse off or better off. To
answer this question, we need the concept of indifference curves. Based on the position of the
indifference curves, one can infer the overall welfare of the consumer.

The concept of Indifference Curves

Now the question is how one compares the different commodity bundles. If there exists only a
single commodity, then a bundle having more of the good will be preferred to that having less.
The problem arises when we encounter two, or more than two commodities In a two- commodity
scenario of say food and clothing, a commodity bundle having more of both food and clothing
will be preferred to one having less, that is, a bundle with 10 units of food and 8 units of clothing
will be preferred to 6 units of food and 4 units of clothing.

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 Figure 2.3 Possible Commodity Bundles for a two-commodity world

Clothing

C B

D E

Food

Figure 2.3 represents all possible commodity bundles of food and clothing. Bundle B will be
preferred to bundle A. Bundle A will be preferred to bundle D. However how can one compare
bundle C and bundle E? In order to compare such bundles that have less food and more clothing
and vice versa, we need to come up with a set of assumptions. The first assumption we make is
that of completeness which implies that a consumer has experienced all such bundles and can
make a comparison between any two bundles. That is, a household is in a position to say if
bundle C is at least as good as bundle E, or bundle E is at least as good as bundle C or both. In
order for the household to prefer bundle C to bundle E, it must be that bundle C is at least as
good as bundle E and it is not the case that bundle E is at least as good as bundle C. In order for a
household C to be indifferent to bundle E, it must be the case that bundle C is at least as good as
bundle E and bundle E is at least as good bundle C. For household choices to be consistent, we
add in two more assumptions: that is household preferences reflexive and transitive. Reflexivity
means that any bundle is at least as good as itself and transitivity means that if there are three
bundles, A, B and C, if A is at least as good as B and B is at least as good as C, then A must be at
least as good as C. The assumption of transitivity might seem obvious, but there are instances
when transitivity is violated. For example, as per Marie Jean Antoine Nicholas Caritat Marquis
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de Condorcet (1743-1794), a society’s choice of candidates during elections need not be
transitive. Table 2.1 gives us the first, second and third preferences of three voters, 1, 2, and 3
over three candidates D, E and F. Given these preferences, if there is a contest between D and E,
D wins, between E and F, E wins, and between D and F, F wins. Given that this society prefers D
to E and E to F, transitivity should imply that the same society should prefer D to F, however, in
the actual voting, F wins.

Table 2.1 Voter Preference for candidates in elections

Voter 1 2 3
First Preference D E F
Second Preference E F D
Third Preference F D E

Given that the household needs to compare infinite bundles, it must give a mark or a score to
each bundle. Please note that unlike marks we get in an examination, there is no maximum score
that the household can assign any bundle, since there will always exist another bundle with more
food or clothing or both, which should get a higher score. Also note that two different
households can give different scores to the same bundle, these marks or scores serve the purpose
of ranking different consumption bundles; the one that the household likes more gets a higher
score than the one the household likes less. These marks or scores are also defined as utility.

Table 2.2: Utility assigned to each household

C\F 1 2 3

1 400 800 1000

2 850 1000 1100

3 950 1150 1175

4 1000 1175 1200

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Table 2.2 gives scores or utility assigned by a particular household to bundles with different
combinations of food and clothing. The first column indicates the amount of food in the bundle
while the first row gives the amount of clothing in the bundle. The value in any cell indicates the
score or utility assigned by a household, given amount of food and clothing the bundle contains.
For example, the value in the third row and third column is 1150 and indicates that the household
assigns a score of 1150 to a bundle containing 2 units of food and 3 units of clothing. Again,
notice that scores or utility increase at a decreasing rate for any commodity, when the
consumption of the other commodity is kept constant. Notice that scores along any row or along
any column increase at a decreasing rate. This is due to decreasing marginal utility from the
consumption of a commodity that we discussed in the introduction, that is, satisfaction from the
consumption of a commodity increases at a decreasing rate. Notice also that 1 unit of food and 4
units of clothing or 2 units of food and 2 units of clothing or 3 units of food and 1 unit of
clothing are given the same score of 1000, so that all these bundles provide the same satisfaction.
If these bundles are mapped to a food/clothing graph, the curve formed by joining these points
forms an indifference curve. Therefore, the locus of commodity bundles with the same score
when plotted on a graph gives an indifference curve as in Figure 2.4. Also, notice when you join
the points (1, 4), (2, 2) and (3, 1), the indifference curve that we get is convex, and that occurs
for our assumption of diminishing marginal utility in consumption.

Figure 2.4 Indifference curve under diminishing marginal utility

Indifference Curves

6
C lothing

4
2
0
0 1 2 3 4
Food

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Please notice that instead, if we had assumed increasing marginal utility (IMU) in consumption
as is done in Table 2.3, the corresponding indifference curves generated for a score of 1000
would be concave as shown in Figure 2.5. Likewise, if we had assumed constant marginal utility
(CMU) in consumption as is in Table 2.4, the corresponding indifference curves generated for a
score of 1000 would be concave as shown in Figure 2.6.

Table 2.3: Increasing Marginal Utility in Consumption

C/F 1 2 3

1 100 200 1000

2 200 500 1500

3 500 1000 2500

Figure 2.5: Indifference Curve under Increasing Marginal Utility

Indifference Curve

6
4
Clothing

2
0
0 1 2 3 4
Food

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 Table 2.4& Figure 2.6: Table depicting Constant Marginal Utility with corresponding
indifference curves:

Indifference curve for bundles a

score of 500.

Indifference Curve

Clothing
3
2
1
0
0 1 2 3 4
Food

We can now draw many indifference curves on a graph as seen in Figure 2.7, where we assume
diminishing marginal utility. Note that indifference curves further away from the origin have
higher scores or utility. For commodity bundles on each of the three indifference curves having
20 units of clothing, those with higher utility have a larger quantity of food and thus will be
preferred to ones having a smaller quantity of food. Any two indifference curves will never
intersect, if the same were true, the commodity bundle at which the two curves intersect, will be
endowed with two scores, which is inconsistent.

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 Figure 2.7: IC’s representing different bundles with respective utilities

Clothing

20

U=1500

U=1000

U=500

Food

5 10 20

Now that we have got our indifference curves, the next question to address is: a household is
currently consuming some bundle, say 10 units of food and 20 units of clothing, from this point,
how much clothing will this household be willing to sacrifice in order to consume an extra unit
of food. That is, we are talking of the slope of the indifference curve at the point (10, 20). The
slope of the indifference curve at any point gives us what is called the marginal rate of
substitution. It is also important to know that the value of the marginal rate of substitution
depends on the incremental satisfaction that we receive from consuming an extra unit of food as
well as from clothing. This incremental satisfaction is captured by the concept of marginal
utility from the consumption of any commodity, be it food or clothing. As is obvious, if one
consumes an incremental unit of food and, clothing consumption remaining unchanged, one
arrives at a commodity bundle at which one is better off, which is assigned a higher score or
utility. The increase in score or utility will be the marginal utility from the consumption of food,
which we denote as MUF. In order for the household to be brought back to the same indifference
curve, its clothing consumption must be reduced. Its last unit of clothing consumption must have
increased its score or utility by the marginal utility from the consumption of clothing, which we
denote as MUC. Therefore, in order for the household to be brought back to the original

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indifference curve, the household’s clothing consumption must be reduced by MU F/MUC.
Therefore, the slope of the indifference curve at any point must be dC/dF = MUF/MUC.

Note that we are ignoring the negative sign, for convenience sake, we would refer only to the
absolute slope. Also note in Figure 2.8, that as we consume more and more food as seen by a
shift from point A to point B, the marginal rate of substitution declines for a convex indifference
curves. This is because the more right we go in an indifference curve, we are left with less and
less clothing, and the little that is left is precious to us, therefore we will like to give up very little
of clothing for every incremental unit of food.

Figure 2.8: Marginal Rate of Substitution under different choices of goods

Clothing

Food

It will be interesting to check the marginal rate of substitution between different commodities.
Think of two commodities being a left shoe and a right shoe, the marginal rate of substitution
between them would obviously be zero as in Figure 2.9, although you would not mind many
more shoes provided it comes as a pair. Such goods are termed as perfect complements. Think
again of red, black and blue pens, if you are not too fussy about the color of the pen, you may not
mind exchanging a black pen for a blue pen, in which case the marginal rate of substitution
would be constant and one as shown in the right panel of Figure 2.9. Such goods are termed as
perfect substitutes.

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 Figure 2.9: IC for perfect complements and substitutes

Left Shoe Black Pen

Right Shoe Blue Pen

Now that we have adequately defined a household’s choices over consumption bundles and have
also defined the budget set available to the household, let’s investigate which consumption
bundle the household finally chooses. The household will choose the bundle that gives it the
maximum satisfaction from the bundles available to it, that is, the bundle that is on the
indifference curve with a maximum score or one that yields the maximum utility. The final
choice of the household is depicted in Figure 2.10 and the bundle chosen is marked as A, the
bundle where the household satisfaction is maximized subject to the budget constraint.

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Figure 2.10: Equilibrium choice of the household

Clothing

M
PC

M
Food
PF

At the optimum, the slope of the budget line is equal to the slope of the indifference curve. That
is, the marginal rate of substitution is equal to the opportunity cost of purchasing food. Notice
that with a convex indifference curve, only one of the bundles in the budget set will yield the
maximum satisfaction, and therefore we say that a household’s choice is unique. Check out what
the household’s choice would be with a concave or a straight line indifference curve.

Deriving the Market Demand from Individual Demand Curves

The household’s choice as depicted in figure 2.11 will not remain the same over time. This may
be due to the fact that prices of food, clothing as well as money income might change. Let the
initial money income be M0, the initial price of food and clothing be p f0 and pc0 respectively. Let
the price of food increase from pf0 to pf1. The household’s choice of the optimum bundle will
change from bundle A to bundle B as shown in figure 2.11. Notice that in this situation, the
money income of the household, the price of clothing has been left unchanged, only the price of
food has been changed, to identify the effect of a change in price of food on the demand for food
from a household. In this analysis we assume price of clothing as well as money income remains
unchanged which is said as the ceteris paribus assumption, that is all other thing remaining
unchanged. If we now plot the amount of food consumed, and the price of food, we can map the
two points (f0, pf0) and (f1, pf1) as in figure 2.11, on to a quantity of food bought and price of food
graph, given a money income of M0 and price of clothing at pc0. The right panel of Figure 2.11,
thus gives us the demand curve for food for an individual household.

Figure 2.11: Effect of the change in the price of food with constant money income

Clothing Price
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MO
PC

D f ( p f , p c , M o)

A pf 0

B pf 1

Food Food

M MO
FO F1 Fo F1
P FO PF1

Now that we have obtained the demand curve for an individual household, let us understand how
we get the market demand curve. For the sake of simplicity, let us assume there exist two
households, A and B, with incomes MA and MB, there demand curves given in figures 2.12. At
any prevailing price of food say pf, the demand for food from household A is x Af and that from B
is xBf, and therefore the market demand for food at price pf is xAf + xBf which forms a point on the
market demand curve illustrated in figure 2.12. If we repeat this exercise for each price level we
finally get the market demand for food.

Figure 2.12 Market demand curve for a two-household economy

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These concepts can now help us in answering the question that was posed before the beginning
of this section. The question as well as the solution (using indifference curves) is presented
below

Question: Let a consumer with an income of 100 units consume food and telephone calls. Food
costs one rupee a unit, and telephone costs one rupee a call. Draw the budget line for the
consumer. If the telephone company is thinking of replacing it with a tariff of 50 rupees for 75
free calls, and 2 rupees for every extra call made, draw the new budget line. Is he better or worse
off?

Answer:

Food 100

50 B

100 Telephone Calls

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 Food

100

50

75 100 Telephone Calls

Food 100

50 B

75 100 Telephone Calls

If we look at the first figure, it is seen that the individual is at a higher indifference curve, post
the policy change. However, in the second diagram, it is seen that post the policy change for
telephone calls, the individual is now at a lower indifference curve which makes him worse off
that the initial scenario. Finally, in the last diagram, based on the position of the indifference
curves, the individual moves from an equilibrium that was positioned in the upper triangle A to
the lower triangle B moving up to a higher indifference curve. Thus, this example shows us that
the mapping of the indifference curve on the budget line provides a clearer explanation of the
overall welfare position of the individual after the change with respect

Getting the Ranking of Commodity Bundles through the Revealed Preference

Route
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In real life preferences of a household will be known only when we ask the household to rank
commodity bundles. Psychologist Dan Ariely illustrates how difficult it is for people to come up
with ranking with an experiment narrated in his book titled, “Predictably Irrational”. People
collected for the experiment had three choices; first, buy the electronic version of the magazine
Economist at some cost, second buy print only at a higher cost and third buy print plus electronic
version at the same price as the print version. It is obvious that the second choice is irrelevant, no
one will pick it up, and the outcome was a large number of people chose the third option. When
the experiment was repeated with the third option removed, a much smaller number chose the
third option. Ariely explained since people are confused about making comparisons, people get
inclined to choose an option which looks distinctly better than another option. When this dummy
option is removed, we might get a different result altogether.

In real life preferences of a household will be known only when we ask the household to rank
commodity bundles. Paul Samuelson suggested a method can we discover household preferences
by observing their purchase in the market. The theory of revealed preference helps us rank some
consumption bundles that have already been purchased in the market.

An illustration of this is given in Table 2.5. Situation A is one with a certain set of price for good
1 and good 2 and with a money income which is different in situation 2 for a consumer. In both
cases, is it possible to rank the commodity bundles purchased in situations A and B given that
they are not comparable from immediate observation? The theory of revealed preference gives us
a way of arriving at a conclusion.

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 Table 2.5 Price and quantity of two-commodities under two situations with changing
income

Situation p1 p2 x1 x2 M

A 1 2 3 1 5

B 2 2 1 2 6

Let the list of situations be given by the set I = {A, B} and the set of commodities by the by J =
{1, 2}. Let p I J = {pI1, pI2} the set of prices in situation I. Let the commodity bundle consumed
in situation I.

In situation A, given prices {1,2} and money income 5, bundle is chosen. Bundle is affordable
since pAxB = 5. Therefore bundle A is revealed preferred to bundle B. In situation B given prices
(2, 2) and money income 6,m bundle is chosen. Bundle is not affordable since pB xA = 8.

Bundle A is chosen when bundle B is affordable. Therefore A is revealed preferred to B.

Choices are consistent since when B is chosen A is no longer affordable.

This method of coming to a preference ranking is usually termed as the Weak Axiom of
Revealed Preference in the literature. If in a given price income situation, commodity bundle A
is chosen when commodity bundle B was affordable, then commodity bundle A is revealed
preferred to commodity bundle B. Consistency must imply that in a price income situation when
commodity bundle B is chosen, commodity bundle A must not have been affordable.

Evaluating Overall Price Changes through Index Numbers

The Consumer Price Index (CPI) is the standard measure of inflation that is computed by the
Central Statistical Office. In India, the CPI is a weighted measure of different basket of items.
The major items are: food, housing, fuel, clothing and footwear, and other miscellaneous items
such as household appliances and household services. The weights to these items are assigned
based on a consumer expenditure survey carried out by the National Sample Survey
Organization (NSSO). As per the latest CPI Manual, food and beverages is given 45 percent,
housing is assigned 10 percent, fuel and light is assigned 7 percent, clothing and footwear is
assigned another 7 percent, and other miscellaneous items are assigned around 30-31 percent.
The method of revealed preference gives us a method of judging how individuals rank some of
the commodity bundles that they have purchased in the market. Once we get the ranking, we can

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evaluate whether a person is better off or worse off in different situations. Money incomes may
change over time, some commodities may become more expensive, some cheap over time, we
then need to have some understanding whether overall prices have increased or decreased. Such
an index will help employers to decide on a dearness allowance which is normally given to
public sector employees in India to tide over price increases. Such an index also helps one to
calculate inflation rate which is of huge interest to Macroeconomists.

Two academics Etienne Laaspeyres and Hermann Paasches worked on developing such indices.
Laspeyres took a consumption bundle of a standard family in the previous period as base and
found the ratio of expenditures of consuming this bundle in the current period to consuming this
bundle in the previous period as a measure of the proportionate price increase in the economy.
Paasche instead took the consumption bundle of the family in the current period after the price
change as the base and then worked out the ratio of expenditure on consuming this bundle in this
period to that expenditure of consuming this same bundle in the previous period.

Etienne Laspeyers Hermann Paasche

There are two popular index numbers

1. Laspeyer’s Index

2. Paasche’s Index

Let the price and quantity vectors at the base period be denoted as

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 x of
p0=( p of , poc ) , x0 =
( ) x oc

Similarly, let the price and quantity vectors at time period 1, be denoted as

x1 f
( )
p1 = ( p1 f , p1 c ) , x 0 =
x1 c

Then the Laspeyer’s and Paasche’s Index is defined as

p1 x 0 p1 x1
L= ; P=
p 0 x0 p0 x1

L = Laspeyer’s Index

P = Paasche’s Index

Impact of Laspeyer and Paasche Index on Inflation

While both the Laspeyer and the Paasche index of inflation provides a comprehensive measure
of inflation, it is observed that the Laspeyer Index overstates inflation, and the Paasche Index
understates inflation. This is because the Laspeyer index account for constant quality, and
therefore does not assume that individuals might shift their bundle of goods to other affordable
bundles, if prices of certain goods become very expensive. Thus, if prices increase, but people by
the same quantity as in the base period, then Laspeyer index tends to overstate the true inflation.
Conversely, it is seen that Paasche index tends to understate inflation, because when prices
increase current items will tend to have a lower weight in the consumption basket as consumers
substitute them for cheaper goods, and therefore would provide a lower estimate of inflation. The
concept of understating and overstating inflation is depicted in the numerical example below

To remove this problem of substitution bias, the Fisher Index, developed by Irwing Fisher,
provided an index of inflation which is the geometric mean of the Laspeyer and the Paasche
Index and is denoted as

F=√ L∗P

Question: The Laspeyres Index and the Paasche’s Index gives the proportionate increase in
expenditure if one were to consume the same bundle that one did in the base and the current
period respectively. In an economy let citizens consume only vanilla ice-cream and strawberry
ice-cream, and they consider both of them perfect substitutes and are willing to give up one
strawberry ice-cream for every one vanilla ice-cream. In the base period vanilla ice-cream costs

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Rs. 2 a cup, and strawberry ice-cream Rs. 4 a cup. In the current period vanilla ice-cream costs
Rs. 8 a cup and strawberry ice-cream Rs. 6 a cup. (a) Calculate and comment on the extent the
Laspeyres Index over-estimates the proportionate increase in expenditure and the extent to which
the Paasche’s Index under-estimates the same in its own context.

Answer: Let m o and m 1 be the income in period zero and period 1 respectively, and let m o and
m o be the bundles chosen in period zero and period 1 respectively. The optimum consumption
points are shown in the diagram below.

Strawberry

Budget Line

m0
4

Vanilla

m0
2

m0
x
In period zero, the optimum point is given by 0 =
()
2
0

Strawberry

m1
8

Vanilla

m1
6

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 0
x
In period 1, the optimum point is given by 1 = m
8
1
()
Given p1 = (8 , 6) p0=(2 , 4)

p1 x0
=
(8,6)∗ (m0/2) =4
o

Laspeyers Index is p 0 x 0 mo

()
( 2 4 )∗ 2
0

Paasche Indez is p 1 x 1
=
8()
(8 6)∗ m1

=1.5
p0 x1 m
(
( 2 4 )∗ −¿ 0 ¿ 1
8 )
Since one vanilla is equal to one strawberry for the consumer in period 1, instead of m o / 2 vanilla,
he can have m o / 2 strawberry instead, and be equally well off in period 1and the expense would
mo
6
2
be 6m o / 2. The ratio of expenses would be = 3. However, Laspeyer Index calculates it as 4
2 mo
2
which is an overestimation.

Similarly, a consumer is equally well off in period 1 as in period 0, by consuming m 1 / 8

6 m1
8
strawberry ice cream. The ratio of expenses in period 1 over period 0 would be = 3.
2 m1
8
However, the Paasche index calculates is at 3 which is an underestimation

Income and Substitution effect of a Price Change

We now try to address the issue, how much do we decide to earn.To address that we need to
know what we would do with the extra money income. If we have extra income, prices
remaining the same, we might spend it on both goods food and clothing, in which case both food
and clothing are said to be normal goods, therefore x will be said to be a normal good as
depicted in figure 2.13. However if the two goods consumed are high quality basmati rice and

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low quality rice, it is quite possible that with a rise in income, prices remaining unchanged, we
consume less of low quality rice and more of high quality rice. In this case low quality rice will
be said to be an inferior good, and as depicted in figure 2.14, x will be an inferior good.

Figure 2.13: Normal Good Figure 2.14: Inferior Good

M1 M1
PY PY

MO MO
PY PY

A A

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 MO M1 MO
XO X1 X1 XO
PX PX PX
M1
PX

Please note that incomes need not decreased or increase only if our salary changes. It will change
even if prices change. To understand this issue, look at Table 2.7.

Table 2.7: Tabular representation of Income and Substitution Effects

Situation ps pv xs xv M

A 2 1 50 50 150

B 1 1 50 50 100

C 1 1 60 40 100

D 1 1 85 65 150

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In the initial situation A, let the price of vanilla ice cream be 1 and that of strawberry be 2, and a
consumer consumes 50 units of each, with a money income of 150. If the price of strawberry ice
cream were to decrease to 1, would he consume more strawberry ice cream? What about vanilla
ice cream? When the price of strawberry drops from 2 to 1, the household can still consume the
bundle of 50 units each of vanilla and strawberry ice cream with 100 units of money income. So
now the household is richer by 50 units which it can spend on both vanilla and strawberry ice-
cream. This is called the income effect of a price fall. In situation B, prices are the same as that
in situation A, and it is possible to consume the bundle (50, 50) in B, which is the bundle
consumed in situation A. Therefore we say that the real income in situation B is the same as that
in A.So when the price of strawberry and vanilla ice-creams are 1 each, and money income is
100, it is possible to consume the bundles (40, 60) or (60, 40), along with the bundle (50, 50).
Which is the one we are likely to choose? We are not likely to choose the bundle (40, 60). With
prices as in situation A, the cost of the bundle (40, 60) would be 140. Looking at situation A, (50,
50) is revealed preferred to bundles like (40, 60) and looking at situation C, bundles like (60, 40),
which have more of strawberry and less of vanilla are revealed preferred to (50, 50). That is if
real income is held constant, and a prices of goods change, we will consume more of the good
which is relatively cheaper and less of the good which is relatively more expensive. This is
called the substitution effect of a price change. In our example the movement from commodity
bundle A to commodity bundle C would be the substitution effect of a price change. For
substitution effect, there is more consumption of the good which becomes relatively cheaper and
less of that good which becomes relatively more expensive. The final situation after the price fall
will be a situation like D where prices of both strawberry and vanilla ice-creams are 1, and the
money income is still 150. Final consumption in that case might be 85 strawberry ice-creams and
65 vanilla ice-creams. This increase in consumption of both vanilla and strawberry ice-creams
from a situation C to situation D, where prices were same but money income increased from 100
to 150 is the income effect of a price change. A price fall from 2 to 1 of strawberry ice-creams
made the person richer by 50 units, which was used to purchase more of vanilla and strawberry
ice-creams.

Look at figure 2.15, the same issue is explained in more general terms. Initially with a money
income M0, and price of food and clothing p f0 and pc respectively, the optimal choice of the
household is A. If the price of food falls to pf1, the optimal choice is than at point C. M1 is the
money required to consume the same bundle as A at prices p f1 and pc. At money income M1, and
prices pf1 and pc, the optimal choice B must lie to the right of A. This is because choices to the
left of A, were also available at money income M 0 and prices pf0 and pc, but A was chosen in
preference to all of them, so A is revealed preferred to all these choices. Once the optimal choice
of B has been done, it is possible to separate the substitution and the income effects. The increase
in food consumption from f0 to f1 due to a fall in the price of food is the substitution effect and
the increase from f1 to f2 is due to the income effect.

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 Figure2.15: Substitution and Income Effects

Clothing

MO
PC

M1
PC

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 MO M1
fo f1 f2
P FO PF1
MO
PF1

Figure 2.16: The Labor-Leisure Framework

Consumption

w'T

WT

B C

Leisure
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 L2 L1 L0

The above analysis will prove helpful when we address the question on how much we earn. It
should be noted that a household’s utility or satisfaction is an increasing function, of the amount
of goods and services it consumes as well as the free or leisure time that the household enjoy’s
together. Let us suppose the man of the household works and the total available time is T days,
the wage rate is w per day, the amount of leisure enjoyed is l days, therefore the number of days
worked is L = (T-l) days. If there is only one good x, that is consumed whose price is one, then x
= w(T-l). Figure 2.16 shows the optimum consumption and leisure enjoyed at A being l0. Note
that if only leisure is enjoyed, he gets to enjoy T days of leisure, if he works for all the T days, he
earns and consumes Wt. That helps us to draw the budget constraint. Now if the wage rate
increases to w’, l1 is the number of days of leisure enjoyed at the new wage rate. Therefore an
increase in the wage rate leads to a decline in the number of days of leisure that is the person
works for a larger number of days with the higher wage incentive. If we were to find out the
income effect and the substitution effect in this case, we should note that the parallel line through
A, gives us the situation when real income is constant. With an increase in the wage rate, leisure
is relatively more expensive in terms of the amount of money foregone, and therefore there is a
decline in leisure enjoyed from l0 to l2 due to the substitution effect. However, an increase in
wages also means that the person becomes richer, and the extra income is used to consume
leisure as well as goods and therefore the demand for leisure increases froml2 tol1. Please note
with a wage increase as is the case in this situation, in this situation that the income effect and the
substitution effect work in opposite directions, if substitution effect dominates the income effect,
leisure enjoyed decreases that is the number of days worked increases with a rise in the wage
rate. The relationship between wages and the number of days worked can be plotted in a diagram
as in figure 2.17. Do note that at a wage rate w, T- l0 days of labor are supplied, it increases to T-
l1 when wage rate increases to w’. Also note in the diagram we have shown that if wage rate
increases further to w’’, labor supply will decrease; it is a situation where income effect
dominates the substitution effect. If this were to happen, we would have a negatively sloping
supply curve for labor, which economists popularly term as the backward bending supply curve
for labor.

Figure 2.17: Backward bending labor supply curve

Wages C

w ''

w' B

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 w A

T-l o T-l 1 Labor

There has been a huge interest amongst economists, whether we actually witness a situation of
backward bending supply curve for labor. Economists have tried to estimate the number of days
worked in agriculture where one can see large wage variations during busy and non busy
seasons. Much of such work is very technical, but there have been evidence of backward bending
labor supply especially from women laborers in agriculture. This model matches closely the
agricultural situation where workers can decide on the number of days worked. However in
modern day factory or office, one may be required to put in 8 hours of work per day, 20 days a
month, usually there is no flexibility to work less at a lower salary. However, many offices give
an overtime wage if one works over and above the normal work hours, and how many hours of
work the worker decides to put in can be addressed by this model if tweaked in the right manner.

An example of the application of the backward bending labour supply curve is best illustrated in
the book ‘Telecommunication Industry in India: State, Business, and labor in a global economy’
– Dilip Subramanian. The ITI had multiple goals: to produce telecommunication equipment
while supporting the political construction of a labour aristocracy (a male working class with
employment guarantee, regular promotions, social package and trade-union) and the
development of the rural areas of the country. The author describes how the ‘year-end rush
work’, led to workers’ having to work overtime to compensate for previous monetary losses and
a huge waiting list for connections. The overtime had negated the incentive schemes designed
by the company to improve labor productivity. There was a growing source of tension in the
factory. Longer workday, stretching in some cases to 16 hours, was bound to have taken a toll on
worker’s health, in particular the older ones; many of them acknowledged returning home
exhausted. There were reports of people wasting their time during overtime in canteens.
Drinking in the evening and at night also appears to have been an established feature of overtime
working. There are regular references to security personnel foiling worker’s attempts to smuggle
alcohol in the factory. Apart from this issues such as proxy punching of attendance, sleeping
during work hours were not uncommon. This is a clear case of how high wages always do not
relate to higher working hours and increased productivity.

Now that we have decided how much money a household decides to earn, we move on to the
next question on how much it decides to save. Here, we assume that the household is not too far

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sighted it looks at the options today and the next year. It expects an income of y1 this year and
y2 next year. We assume that households can borrow or lend at an interest rate r. Thus, its
consumption in money terms c1 this year and c2 next year need not exactly be y 1 and y2 in this
year and the next. If the household wishes to use up all its income of this year and the next, this
year itself, the maximum it can consume in money terms is y 1 + y2/+(1 + r). If it wants to use all
of the income of this year and the next, this year itself, the maximum that it can consume in
money terms next year is y1(1 + r) + y2. Therefore the budget line of available choices of
spending in this year and the next is given in figure 2.18, the slope of the budget line being (1+r)
which is the opportunity cost of consumption in period one. The endowment point in figure 31 is
at point A, but the household chooses to consume in period zero at point B where it enjoys a
higher utility. Therefore the savings in period 1 is y1 – c10. This is how an individual household
will decide on savings.

Figure 2.18: Inter-temporal consumption and savings

c2

y 1 (1+r )+ y 2

c 20 B

y2

c 10 y1 c1

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The next question is how will savings rise or fall with a rise in interest rate. If interest rate rises,
households can get the same interest income by saving less. This is the income effect which
induces people to save less. However, it is relatively more costly to consume today now since
one has to sacrifice consumption worth (1+r) units by not saving a unit today. With a rise in the
interest rate my forgone consumption tomorrow is much higher. This would induce people to
save more. This is the substitution effect. At low levels of interest, the substitution effect is larger
than the income effect and savings rise with a rise in the rate of interest.

Now we go for a more formal explanation, as illustrated in figure 2.19. If the interest rate rises
from r to r’, it is now relatively more expensive to consume in period 1, therefore due to the
substitution effect, there is a decline in consumption from A to B. If the household is saving in
period 1, it is richer by a rise in interest rate, with the extra income it will like to consume more
in both periods. Therefore consumption in period 1 rises from B to C due to the income effect.
The net effect as shown here is a decline in consumption with a rise in interest rate, implying a
rise in savings with a rise in interest rate.

Figure 2.19: Inter-temporal consumption with a change in interest rates

c2

'
( y 1 +(1+r ) y2

( y 1 +(1+r ) y 2 (c '1 , c'2 ¿

( y1 , y2 ¿

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 B C A c1

Additional Questions
1. There are two individuals A and B in the economy each with income of Rs. 100 in the
base period. Both individuals consume vanilla or strawberry ice-cream. Individual A
consider both of them perfect substitutes and are willing to give up 6 vanilla ice-creams
for every 7 strawberry ice-creams. Individual B wants to consume both vanilla to
strawberry ice-cream in the ratio 1:4 respectively, otherwise it does not give him
satisfaction. In the base period vanilla ice-cream costs Rs. 4 a cup, and strawberry ice-
cream Rs. 4 a cup. In the current period vanilla ice-cream costs Rs. 8 a cup and
strawberry ice-cream Rs. 5 a cup. Dearness allowance in the current period for both
individuals (increased allowance over the base period income of Rs 100 to buy the same
bundle as before) is the same and is based on the expenditure of the consumption bundle
of individual B in the base period. (a) Can we comment on whether individual A is better
off or worse off using the weak axiom of revealed preference and whether the choice is
consistent? (b) Calculate and comment on the extent to which individual B individual is
over-compensated.

2. In the current job that Mr. Kumar has at XLRI, which after taxes and all deductions,
allows him to spend an amount M on goods, the price of which is pg, and campus
housing which is a flat of 1500 square feet. If Mr. Kumar chooses to live outside the
campus, he would get a house rent allowance (HRA) of an amount H 0, but he has to rent
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 an accommodation outside which will cost him an amount p r per square feet per month,
plus an additional amount of transportation cost of T per month, (T < H 0, and HRA is not
taxable).

(a) Describe the initial equilibrium by a diagram, showing his possible consumption
options, showing him living in campus accommodation as his most preferred option.

(b) Describe the income and substitution effect in a diagram, when there is an increase in
HRA from H0 to H1, and he still chooses to live in campus accommodation as before.

(c) Describe the income and substitution effect in a diagram where he chooses to shift
from campus accommodation to accommodation outside campus. Under what
circumstances, will he surely rent a flat which is bigger than his current campus
accommodation?

You may assume that Mr. Kumar has no mistress, and will therefore choose to consume
either campus accommodation or outside accommodation but not both.

3. Citizens of India consume two goods, domestic travel and foreign travel packages, which
cost pd and pf per package. The Government of India (GOI) wants to promote domestic
tourism that is encouraging people to travel by Indian Railways, Indian Airlines and stay
in ITDC hotels. It therefore offers its employees a cash salary X which is taxed at the rate
t per unit of cash earned and a Leave Travel Allowance (LTA) of an amount Y, which
will not be taxed if spent on domestic holiday packages. Citizens have the option to spend
an amount Z which is less than Y on domestic holiday packages, and can avail cash of the
amount Y-Z, but have to pay taxes on the same.

(a) Draw the budget line of a common citizen of India who is a GOI employee.

(b) Indicate on a diagram the income and the substitution effect if GOI reduces the tax
rate to zero, when initial expenditure on domestic holiday packages was more than Y.

(c) Indicate on a diagram the income and the substitution effect if GOI reduces the tax
rate to zero, when initial expenditure on domestic holiday packages was less than Y.

4. Let the going wage rate be w0 per hour for any number of hours worked and a person
chooses to work for L0 hours. Let the salary structure be changed to a wage w1<w0 with a
fixed overtime allowance of B per hour for any number of hours worked above L0 in
addition to the w1 per hour that he already earned. Let the worker choose to work for L1
hours, which may be higher or lower than L0. Is the person always worse off in the new
salary structure?

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