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/pf, while the y axis gives
the amount of clothing that can be bought, the maximum being M/pc. 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 pf 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

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accounts of the poor, which will be easy especially once all citizens have 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 such housing he
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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 consumer.

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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 better off since it
is now possible to consume more of food or telephone calls or both. 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

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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 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.

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 Table 2.2: Utility assigned to each Consumption Bundle

C/F 1 2 3 4
1 400 700 900 1000
2 700 1000 1200 1300
3 900 1200 1400 1500
4 1000 1300 1500 1600

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 second row and third column is 1200 and indicates that the household
assigns a score of 1200 to a bundle containing 3 units of food and 2 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 4 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 (4, 1),
the indifference curve that we get is convex, and that occurs for our assumption of diminishing
marginal utility in consumption.

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 Figure 2.4 Indifference curve under diminishing marginal utility

4.5
4
3.5
3
Clothing

2.5
2
1.5
1
0.5
0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
Food

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 900 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 500
would be concave as shown in Figure 2.6.

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 Table 2.3: Increasing Marginal Utility in Consumption

C/F 1 2 3 4
1 20 50 100 900
2 50 110 300 2000
3 100 300 900 3500
4 900 2000 3500 6000

Figure 2.5: Indifference Curve under Increasing Marginal Utility

4.5
4
3.5
3
Clothing

2.5
2
1.5
1
0.5
0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
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

4
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
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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 indifference curve,
the household’s clothing consumption must be reduced by MUF/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

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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.

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 pf0 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
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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
𝑀𝑂
𝑃𝐶

𝐷𝑓 (𝑝𝑓, 𝑝𝑐 , 𝑀𝑜 )

A 𝑝𝑓0

B 𝑝𝑓1

Food Food
𝑀 𝑀𝑂
𝐹𝑂 𝐹1 𝐹𝑜 𝐹1
𝑃𝐹𝑂 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.

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 Figure 2.12 Market demand curve for a two-household economy

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

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Getting the Ranking of Commodity Bundles through the Revealed Preference
Route
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).

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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 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

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 1. Laspeyer’s Index

2. Paasche’s Index

Let the price and quantity vectors at the base period be denoted as
𝑥𝑜𝑓
𝑝0 = (𝑝𝑜𝑓 , 𝑝𝑜𝑐 ), 𝑥0 = (𝑥 )
𝑜𝑐

Similarly, let the price and quantity vectors at time period 1, be denoted as
𝑥1𝑓
𝑝1 = (𝑝1𝑓 , 𝑝1𝑐 ), 𝑥0 = ( 𝑥 )
1𝑐

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

𝑝1 𝑥0 𝑝1 𝑥1
𝐿= ;𝑃 =
𝑝0 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

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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 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 𝑚𝑜 and 𝑚1 be the income in period zero and period 1 respectively, and let 𝑚𝑜 and
𝑚𝑜 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
In period zero, the optimum point is given by 𝑥0 = ( 2 )
0
Strawberry
𝑚1
8

Vanilla
𝑚1
6

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 0
In period 1, the optimum point is given by 𝑥1 = (𝑚1 )
8

Given 𝑝1 = (8, 6) 𝑝0 = (2, 4)

𝑚 /2
𝑝1 𝑥0 (8,6)∗( 𝑜 )
0
Laspeyers Index is 𝑝 = 𝑚𝑜 =4
0 𝑥0 (2 4)∗( 2 )
0

0
(8 6)∗(𝑚1 )
𝑝 𝑥
Paasche Indez is 𝑝1 𝑥1 = 8
−0 = 1.5
0 1 (2 4)∗(𝑚1 )
8

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

Similarly, a consumer is equally well off in period 1 as in period 0, by consuming 𝑚1 /8 strawberry

6𝑚1
8
ice cream. The ratio of expenses in period 1 over period 0 would be 2𝑚1 = 3. However, the Paasche
8
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 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.

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Figure 2.13: Normal Good Figure 2.14: Inferior Good

𝑀1 𝑀1
𝑃𝑌 𝑃𝑌

𝑀𝑂 𝑀𝑂
𝑃𝑌 𝑃𝑌

A A

𝑀𝑂 𝑀1 𝑀𝑂 𝑀1
𝑋𝑂 𝑋1 𝑋1 𝑋𝑂
𝑃𝑋 𝑃𝑋 𝑃𝑋 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.

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 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

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
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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 pf0 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 pf1 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 M0 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

𝑴𝑶 𝑴𝟏 𝑴𝑶
𝒇𝒐 𝒇𝟏 𝒇𝟐
𝑷𝑭𝑶 𝑷𝑭𝟏 𝑷𝑭𝟏

Deciding how much we earn: The labour leisure Choice

We now extend our analysis to utility or welfare not just arising from consumption of food and
clothing, but also from leisure, or the number of holidays we enjoy of the total T days in a month.
To keep the analysis simple, we reduce the problem to two dimensions again, by taking welfare as
arising from goods and leisure/holidays, the food and clothing being clubbed as goods and the
price of goods being taken as 1. What will be modelled or described is the story of a daily wage
worker. Let the initial wage be w0 per day, and the person chooses to work for L0 days. Therefore

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the number of holidays he enjoys is l0 = T- L0 days. We represent the two choices in the diagram
below, goods and leisure. The maximum leisure, he can enjoy is represented as T on the x axis.

Goods
w0T P

x0 A
U0
Q
T
l0 L0
Leisure/ Holidays

Likewise, the maximum amount of earnings and goods that he can enjoy is w0T. Therefore PQ is
the budget line, giving him the various options of goods and leisure. The slope of the budget line
is w0, giving the opportunity cost of leisure, that is if the person were to enjoy an additional holiday,
he will sacrifice w0 of goods. The highest indifference curve he can achieve is the one which gives
a utility U0, the optimum point is at A, the tangency between the indifference curve and the budget
line. At the optimum point A, the person enjoys holidays for l0 days, and works for L0 days and
earns and consumes x0= w0 L0 of goods.

w1T R

S
W1(T-l’’+l0)
Goods

l’’-l0

w0T P

x0 A
U0
U Q
L0 T
l0

l’’
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Now let the wage rate increase to w1 per day. The new budget line is RT, allowing the person now
to consume still a maximum of T days of holidays or w1T of goods. Since the wage rate has
increased, the person has become richer, the bundle x0 is now inside his budget set. In fact, if he
consumes x0 of goods, he can consumer l’’ units of leisure/holidays which is more than what he
enjoyed before. So the person can be said to be richer by ( l’’-l0 ) days, which can be used as
holidays or converted to goods by working on those days. If ( l’’-l0 ) days are taken away from the
person, he has the same real income as before, and SU will be his new budget line.

w1T R

S
W1(T-l’’+l0)
Goods

l’’-l0
U’ C
U2
w0T P B
x’
x0 A
U0
V Q
L0 T
l0
l’
l1 Leisure/ Holidays

On this budget line B is the new optimum point giving a higher utility U’. Therefore the movement
from A to B is the substitution effect, that is given real income constant, we consume less of the

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good which is relatively more expensive and more of the good which is relatively cheaper. With
the increase in the wage rate, holidays become relatively more expensive, since one has to give up
w1 rather than w0 as foregone wages, so the number of days of holidays enjoyed decreases from l0
to l’. However, and increase in wages is also associated with an income increase by (l’’-l0) days,
so the movement from B to C is the income effect, where part of this increased days is consumed
as holidays. Therefore, due to the income the number of holidays enjoyed increases from l’ to l1.
Overall due to an increase in wages, the number of days of holidays enjoyed decreases from l0 to
l1 days. 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 w0, T- l0 days of labor are
supplied, it increases to T- l1 when wage rate increases to w1 and the labor supply curve is upward
sloping since the substitution effect dominates the income effect. 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

w2 w1

w1 B

w0 A

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 T-𝑙𝑜 T-𝑙1 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

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 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.

Deciding how much we save: Saving and Interest Rate Relationship

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 sighted
it looks at the options today and the next year, which we term as period 0 and period 1. It expects
an income of y0 in period 0 and y1 in period 1. We assume that households can borrow or lend at
an interest rate rA. Thus, its consumption in money terms c0A in period 0 and c1A in period 1, and
need not exactly be y0 in period 0 and and y1 in period 1. If the household wishes to use up all its
income of period 0 and period 1, in period 0 itself, the maximum it can consume in money terms
is y1 + y2/+(1 + rA). If it wants to use all of the income of period 0 and period 1 in period 1 only,
the maximum that it can consume in money terms in period 1 is y0(1 + rA) + y1. Therefore the
budget line of available choices of spending in period 0 and period 1 are given in figure 2.18, the
slope of the budget line being (1+rA) which is the opportunity cost of consumption in period one.
The endowment point in figure 31 is at point E, but the household chooses to consume in period
zero at point A where it enjoys a higher utility. Therefore the savings in period 1 is y0 – c0A. This
is how an individual household will decide on savings.

Figure 2.18: Inter-temporal consumption and savings

Period 1 consumption

U0
{y1 + y0(1+rA)} P
c1A A

y1 E
Q
c0A y0 Period 0 consumption
s0=y0-c0A
y0+{y1/(1+rA)}

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The next question is how will savings rise or fall with a rise in interest rate. Let the interest rate
rise from rA to rB. The new budget line is RS passing through the point E, since the person has
the option of consuming y0 in period 0 and y1 in period 1. The person now becomes richer,
instead of consuming the bundle A, he/she can now consume the bundle D. In the bundle D the
person is richer by c’’-c0 in period 0. The max that he can consume in period 0 is y0+{y1/(1+rA)}.
The maximum that the person can consume in period 1 is {y1 + y0(1+rB)}.

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

{y1 + y0(1+rB)} R
Period 1 consumption

U0
{y1 + y0(1+rA)} P
c1 A D
y1 E
S Q
c0 c’’ y0 Period 0 consumption
s0=y0-c0
y0+{y1/(1+rB)}
y0+{y1/(1+rA)}

With a rise in the interest rate RS is the new budget line. If the extra income of period 0, (c’’-
c0A), the real income of the consumer is the same as in the initial situation, and the compensated
budget line is TV.

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 Period 1 consumption

R
U0
T

P c’’- c0

c1A A
E
V S Q
c0A c’’ Period 0 consumption

With a rise in the interest rate, it has become relatively more costly to consume in period 0 and
relatively cheaper to consume in period 1. Due to the substitution effect the consumer moves from
point A to point C on the compensated budget line TV. He/She now consumes c0c in period 0, that
is saves more. Due to the income effect, the consumer shifts from point C to point B, consuming
c0B in period 0 and c1B in period 1. Due to the income effect he therefore saves less. Since the
substitution effect dominates the income effect savings rise by (c0A- c0B).
Period 1 consumption

R UC UB
T

C1B P B
C1C C
c1A A UA
E
Managerial Economics V S Q Page 36
c0C c0B c0A Period 0 consumption
From this analysis we get an upward sloping savings and interest rate schedule, giving us the
behaviour of savings with changes in interest rate.

Interest
Rate

Savings

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

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 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 H0, but he has to rent an accommodation
outside which will cost him an amount pr per square feet per month, plus an additional
amount of transportation cost of T per month, (T < H0, 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.

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 (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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Managerial Economics Page 40