Characteristics demand theory

Characteristics demand theory states that consumers derive utility not from the actual contents of the
basket but from the characteristics of the goods in it. This theory was developed by Kelvin Lancaster in
1966 in his working paper “A New Approach to Consumer Theory”.

This approach allows us to predict how preferences will change when we change the options or baskets
presented to consumers by studying how these vary according to the change in the characteristics that
make them up. With conventional theory, the introduction of a new option meant that we could not
reliably predict how this would slot into the consumer’s preference map. However, by relying on a study
of the characteristics rather than the goods or service involved, we can predict how changes will affect a
consumer’s behaviour without needing to start once again empirically.

This allows us to calculate ‘shadow prices’ for different attributes without having a price for the good
itself by associating utility to the characteristics that make up the good rather than the good itself. With
these ‘shadow prices’, we can solve utility maximisation problems for baskets or options for which we
do not have empirical evidence, as Lancaster demand also lends itself to building utility functions (based
on the amount of each type of characteristic rather than the amount of each type of good in a particular

basket).
Characteristic demand theory also helps justify the existence of brands. Luxury brands are able to charge
a surprice for their products by differentiating themselves from competitors that sell similar goods. In
the first diagram, if we suppose that both brands have the same characteristics and are perfect
competitors, then we will choose the basket that maximises our total consumption. This means will tend
to opt for the cheaper brand, which allows us to reach the highest utility curve: for a given amount of
money, we are able to buy either a certain amount of brand 1 (point B) or a certain amount of brand 2
(point A). We choose A since it’s on a higher indifference curve. Point C represents a higher utility curve
achieved by a drop in the price of brand 1. However, even though brand 1 got cheaper, we’ll still
consume A, since it remains on a higher indifference curve.

In the second diagram, if we look at Lancaster demand, our utility functions will be based on the
characteristics that each basket contains rather than on the amount of each type of good. Here, it is no
longer ‘all or nothing’- we can allow for convex demand curves that represent our preference for variety
in consumption: point C. This time, if the price of one brand drops, we will change our outcome: we can
opt for point D.