Simple Analytics of Productive Consumption

Author(s): Wing Suen and Pak Hung Mo

Source: Journal of Political Economy , Apr., 1994, Vol. 102, No. 2 (Apr., 1994), pp. 372-
383
Published by: The University of Chicago Press

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 Simple Analytics of Productive Consumption

Wing Suen
University of Hong Kong

Pak Hung Mo
Hong Kong Baptist College

Productive consumption adds to utility and income at the same time.

The shadow price of a productive good is equal to its money price
less its marginal product. As more of the good is consumed, its
shadow price rises because of diminishing productivity, and the con-
sumer's full income also rises because the marginal product is posi-
tive. This paper uses a simple method to derive the comparative
statics of the demand system when shadow prices and full income
are endogenous. The direction of the overall bias induced by endog-
enous prices and income is found to be determinate. We demon-
strate that the demand for productive goods tends to be relatively
unresponsive to exogenous changes in prices and income. We also
show that labor supply will be relatively unresponsive to wage and
unearned income if market work causes fatigue.

Preferences and technology are the two basic building blocks of neo-
classical economics. Yet consumption and production activities are
not always easy to separate. As Becker (1965) makes clear, a lot of the
commodities people consume are produced at the household level.
Equally important but less widely recognized is the fact that the com-
modities households consume often contribute to production at mar-
ket work. An example that easily comes to mind is the effect of nutri-

We would like to thank Doug Allen, Leigh Anderson, Yoram Barzel, Dean Lueck,
Eugene Silberberg, Alan Siu, Daniel Wang, Richard Wong, and Xiaokai Yang for
useful suggestions. Julia Cheung offered able research assistance.

[Journal of Political Economy, 1994, vol. 102, no. 2]

? 1994 by The University of Chicago. All rights reserved. 0022-3808/94/0202-0006$01.50

372

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 PRODUCTIVE CONSUMPTION 373

tion on productivity. Some efficiency wage models (e.g., Stiglitz 1976)

are based on the premise that better nutrition raises productivity;
Strauss (1986) has found strong evidence of such an effect using data
from Sierra Leone. Closer to home, academic economists probably
regard reading journal articles a consumption activity and a produc-
tion activity at the same time. Lazear (1977) argues that education is
ajoint product that produces utility (or disutility) and enhanced earn-
ing power; health enters into both the production function and the
utility function (e.g., Grossman 1972); children contribute to parents'
satisfaction as well as income security at old age (e.g., Ehrlich and
Lui 1991); expensive clothes are valued for consumption as well as
for career concerns; the list could continue.
Since productive commodities appear nonlinearly in the budget
constraint, the effect of prices and income on the demand for these
commodities is tangled. Suppose, for example, that consuming food
can contribute to productivity and hence income. The true cost of
food is its money price less its marginal value product. When there
is an exogenous increase in the consumer's money income, there are
two contradictory effects. (1) Higher income leads to the consumption
of more food (food is assumed to be a normal good, to be specific).
The law of diminishing marginal product implies that the true cost
of food will then rise. This tends to mitigate the initial effect of in-
come on consumption. (2) As food consumption raises consumers'
income, they will demand still more food (food is assumed to be
normal). This will tend to reinforce the initial effect. It appears that
the balance of these forces is indeterminate. This paper develops a
very simple method of analyzing the demand for productive com-
modities. In the example on food, we demonstrate that the former
effect (a rise in true cost) always dominates the latter effect (a rise in
earned income) so that the effect of exogenous income on consump-
tion will be smaller than what preferences alone imply. This conclu-
sion holds regardless of whether food is a normal good or an inferior
good. We also show that the effect of prices on consumption is smaller
in the presence of productive consumption than in a pure consump-
tion model.
The theory of productive consumption can also be applied to labor
supply and leisure choice. We model leisure as a commodity that
raises both productivity and utility. Our model explains why the
shadow value of leisure is lower than the market wage. Moreover, if
long hours of work lower productivity, the shadow price of leisure will
fall whenever the worker increases work hours. The model therefore
suggests that labor supply will be relatively unresponsive to wage and
income when the productive role of leisure is an important consider-
ation.

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374 JOURNAL OF POLITICAL ECONOMY

Economists have no theory about the size of income and price elas-
ticities. Engel's law on the income elasticity of demand for food, for
instance, is an empirical regularity in search of an explanation.' Even
within the commodity category labeled "food," the demand elasticities
for "taste" and "nutrition" are systematically different (Silberberg
1985). We hope that bringing in a workable model of productive
consumption will be a step toward understanding the determinants of
the size of demand elasticities. In the development literature, several
authors (e.g., Singh, Squire, and Strauss 1986) have modeled produc-
tion/consumption decisions in agricultural households. In those mod-
els, an increase in crop prices will raise farm income, thereby produc-
ing an income effect that counteracts the substitution effect. Such
models are recursive: production and consumption can be analyzed
in a two-stage manner via the separation theorem. In our model, on
the other hand, such separation is impossible because goods jointly
produce utility and income. Pollak and Wachter's (1975) comment
on the household production approach notwithstanding, our model
exhibits properties of joint production and nonconstant returns to
scale but still gives definite results.
While our analysis focuses on productive consumption, similar
techniques can be applied to situations involving, say, quantity dis-
counts or progressive taxes. The methods we develop here are consid-
erably simpler than the comparative static analysis of nonlinear con-
straints in Edlefsen (1981) or the analysis of endogenous prices in
Diewert (1981). In fact this paper falls under Blomquist's (1989) gen-
eral theory of nonlinear budget constraints, but we are able to derive
strong results under our specifications.

I. The Basic Model

In the simplest case, all commodities except one are pure consump-
tion goods. Labor supply is exogenous. (Labor-leisure choice is dis-
cussed in Sec. II; the case of many productive goods is dealt with
in the Appendix.) The consumer's income consists of two parts: an
exogenous unearned income M and earned income E. Earned income
depends on the amount of productive commodity xl consumed: E =
E (x1).2 We assume that xl has a positive but diminishing marginal
product, that is, E1 2 0 and E II < O.
Note that xl is a commodity that jointly produces income and utility.

1 See Houthakker (1957) for international evidence on Engel's law.

2 Earned income also depends on a host of other factors (e.g., talent or the state of
the business cycle) that are exogenous to the individual. The functional dependence
of E on these other factors is suppressed for notational economy.
3 See, e.g., Strauss (1986) for evidence of diminishing returns to nutrition.

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 PRODUCTIVE CONSUMPTION 375

The case in which xl has to be allocated between production and

consumption does not require elaborate analysis. If xl = xa + xlj,
where xJ enters in the production function and xl enters in the uti
function, then the separation theorem ensures that the consumer's
decision problem can be described by a two-stage method in which
xP is chosen to maximize income and then xl is chosen to maximize
utility.
With standard notation, the consumer's choice problem can be writ-
ten as

maximize U(x1, *. *,x) (1)

n
subject to Zpixi 'Z M + E(xi1) (2)

The budget constraint (2) is a convex set, so this is a concave problem.

Let A be the Lagrange multiplier for the budget constraint. Then the
first-order conditions are

U1 = X(PI -E);

Ui = Xpi, i = 2, ... ...,n; (3)

n
(PI - EI)x1 + pixi=M + E - x1E1.
2

Let xr(pl, . * ., pn M), i = 1, * . , n, be the solution to the choice

problem. Also let x (7r1,.. ., 7Tn, F) be the demand functions resulting
from maximizing (1) subject to a standard budget constraint without
productive consumption: XTn -rrX c F. The form of the function
xlq() depends on preferences alone, and that of x8{() depends on the
production side as well.
We define the shadow prices ITI = PI - El and -ri = pi for i =A
Full income is F = M + E - xIE1. Since xI is a joint product, we
can think of PI -E E as the Lindahl price for consumption and E I a
the Lindahl price for production (Samuelson 1954). At input price
E1, profits to the person as a producer are E - xI E1; hence fu
income is unearned income plus profits. It is also important to note
that n I and F are themselves functions of the amount of xI chos
that is, full income and shadow prices are endogenous in this model.
With the relevant price and income variables defined, the functions
x$( ) and xQ( ) are related by the identity

xI(P1,P2, ... Pn, M) x? II(xl ( )), T2, 2 , n, F(xt ))) (4)

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376 JOURNAL OF POLITICAL ECONOMY

y
U

0M" M' F' X

FIG. 1

The relationship in equation (4) is illustrated in figure 1. In the

figure, X is the productive good and MM' is the budget constraint
(MM" would be the budget constraint if X were not productive). Max-
imizing utility subject to MM' (the x*(.) function) yields the same
solution value as maximizing utility subject to the virtual budget con-
straint FF' (the x0(Q) function). The virtual budget constraint FF' is
flatter than MM" because the shadow price of X is only Px - E'(X*).
The vertical distance FM represents the "profits" from using X* units
of productive input, E(X*) -X*E'(X*).4
To determine the effect of an exogenous increase in unearned
income, we differentiate equation (4) with respect to M:

ax*I ax'l a I ax~ *i &xlF ax *Iax'

ax, ax, dw~dxt + dx1 dF dxt + dx1 (5)
aM aTl ax1 IM &F axOM aF
Now, lx-Idxl = -El, > 0 and aFIax, = -xlEll > 0. An increase
in consumption of the productive commodity raises its shadow price
and raises the full income. It appears that nothing definite can be said
about the overall bias from these two effects. However, substitution of
the partial derivatives into (5) yields

4 If the marginal product were constant rather than diminishing, MM' would be
linear and the virtual budget constraint FF' would coincide with it. The analysis here
assumes a strictly diminishing marginal product.

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 PRODUCTIVE CONSUMPTION 377

ax* dax, ax* dx*dxI a x

-= -E11 d dM-Xlx1E11- + -
dxl~d &Fl
axi* ax,
= -1E11 (6)

_ 1 dxo
1 + S01E11 &F

In (6), Sol = (ax~l/ul) + (xlax~lIF) is the negative Slutsky substitu-

tion effect for the standard demand function x l(). Thus 1/(1 +
S01E11) < 1. Consumption of the productive commodity is less
sponsive to changes in income than what a pure consumption model
implies.5 This conclusion holds regardless of the relative size of the
income and substitution effects, and the conclusion applies to both
normal and inferior goods.
It is straightforward to follow equations (4)-(6) to show that the
demand for the productive commodity is also less responsive to
changes in its money price than that in a pure consumption model.
In particular, we have

ax* _ 1
dxt 1 dX, ~~~~~~~~(7)
ap1 1 + S1E11all1l(

Thus laxlIapl| < laxo/darn1 .6 If the marginal productivity of, say

declines and then remains flat, an implication of the analysis is that
the demand for food by low-income people will be less responsive to
prices and income than the demand by the high-income group.

II. Leisure as a Productive Good

Fatigue is a problem that affects the workplace. Factories and offices

often have scheduled breaks to deal with worker fatigue. Over the
longer horizon, vacations and holidays may serve a similar purpose.
At the same time, these breaks and holidays directly add to utility. It
is then appropriate to model leisure as a joint product that enhances
both productivity and utility. Biddle and Hamermesh (1990), for ex-
ample, use this approach to analyze sleep.

5 We are comparing changes in demand rather than the level of demand. Since
productive consumption increases income and lowers price, the level of demand for
the productive commodity will be higher than that suggested by a pure consumption
model.
6 This conclusion depends on the assumption that earned income E is strictly concave
in xl. If E is linear, the magnitudes of the partial derivatives of xQ( ) and xq(Q) will be
equal. If E is locally convex, the inequality will be reversed. Also note that the inequality
applies to Giffen goods as well. If ax'/ala is positive, axt/ap, will be less positive.

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 378 JOURNAL OF POLITICAL ECONOMY

We assume that total time, T, is allocated between leisure, 1, and

market work, h. The market wage is W = w + f(l). If the person
consumes more leisure, his productivity in market work increases, so
f > 0. Also assume ' 0.7 The optimization problem can then be
written as

maximize U(x1, * . , x. , 1) (8)

n
subject to Zpixi ' M + [w + f(l)](T - 1). (9)

It is easy to see that the shadow price of leisure, ar, is equal to W -

f'(l)(T - 1). The shadow price of leisure is less than the market wage
because working long hours hurts productivity. This is consistent with
most value of time studies (e.g., Earp, Hall, and McDonald 1976) that
find the shadow value of nonmarket time to be substantially below
the market wage.
With the definition of nlr, it can easily be verified that the budget
constraint (9) can be rewritten as
n
EPixi + sel ---F, (10)

where full income F is M + WT - f'(l)(T - 1)1. Note that nrI and F

are both endogenous functions of 1. If we let l0(p , . . . , Pn, n1, F) be
the leisure demand function from maximizing (8) subject to (10),
treating -rr and F as fixed, then the optimal leisure demand is charac-
terized by the following identity:

N}P, . n . ) .,nwM) 1?(P, . ... ) Pn, iT ~}-)F(I() (1 1

To find the response of leisure demand to an exogenous increase
in wage, we differentiate (11) with respect to w:

ai* ale alTd ad* + alo aF al* + alo (12)

aw adr al aw aF al aw adar

Since d ia Il = 2f' -f"h and dFIal d = 1(2f' -f "h), equation (1 2) can

be simplified to

al* 1 al (13)
dw 1 - So (2f '-f h) (t1

Theory restricts So (the pure substitution effect for leisure) to be

negative, and our assumptions about the effect of fatigue on produc-

7 In contrast to the model in Sec. I, it is not necessary to assume that f(-) is strictly
concave. Our results will still hold if f" is positive but not too large.

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 PRODUCTIVE CONSUMPTION 379

tivity imply that 2f

When there is an exogenous increase in wage, people tend to work
more. However, as increased work causes fatigue, their productivity
falls and the opportunity cost of leisure is reduced. This will counter-
act the initial effect of a rise in wage. The presence of the fatigue
effect then makes leisure demand (and hence labor supply) less re-
sponsive to wage.9 If older workers are more prone to fatigue than
young workers, the model would predict a relatively steep labor sup-
ply curve for older workers.

III. Applications and Extensions

A. Counterproductive Consumption

Consumption of commodities such as cigarettes and drugs may re-

duce rather than increase earnings. The analysis of consumption be-
havior in the presence of these counterproductive commodities, how-
ever, does not pose any new problems. While the consumption level
of a commodity depends on whether it is productive or counterpro-
ductive, the consumption response to changes in prices and income
depends only on the curvature (i.e., the second derivatives) of the
earnings function. For example, assume that the marginal reduction
in earnings due to cigarette consumption rises as more cigarettes are
consumed. An exogenous increase in the price of cigarettes will curb
their consumption. As consumption is reduced, the marginal harm
of cigarettes falls. Thus the increase in the real price of cigarettes will
be less than the initial rise in price. As a result, the demand for
cigarettes will be less responsive to prices and income than what is
implied by a pure consumption model. For another example, if the
marginal damage of alcoholic beverages increases sharply at high
consumption levels, the model would imply that the demand for li-
quor would be highly inelastic for people who consume a lot of alco-
hol and less inelastic for mild users.

B. Joint Family Consumption

Within the household, some commodities (e.g., the dinner table) have
the attribute of a public good and others (e.g., food) are characterized
by rival consumption. The model developed in this paper can be
applied to the analysis of joint family consumption when household
decisions are made by an altruistic head.

8 If the labor supply function 1PO is backward bending, the function 1*(0) will b
so.
9See Pencavel (1986) for evidence of the inelasticity of male labor supply.

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380 JOURNAL OF POLITICAL ECONOMY

Specifically, suppose that the

Xk), where xp is the vector of public goods in the family and Xk is the
vector of private consumption goods for the child. Let Pk be the
corresponding price vector for Xk. Then we can define the condi-
tional cost function

Ck(Pk, Xp, Uk) = min {p xkU(Xp, Xk) ? uk}k. (14)

Xk

This cost function is analogous to Pollak's (1969) conditional demand

functions. Expenditure minimization implies that C(, xP, Uk) is con
vex in Pk. Moreover, C(pk, ) is convex in xP and uk if and only if th
child's utility function Uk(.) is concave. The latter assumption
amounts to a diminishing marginal rate of substitution between the
parent's consumption and the child's consumption.
If the child's income is Mk and the father wants to choose a utility
level uk for the child, his transfers will be Ck(Pk, Xp, Uk) - Mk. Thus
the father's choice problem can be written (with obvious notation) as

maximize Uf(xp, Xf, Uk) (15)

subject to pXp + p; Xf + Ck(Pk, Xp, Uk) < Mf +
Since an increase in xp raises the father's utility and reduces his neces-
sary transfers, the problem is identical to our model of productive
consumption. All our conclusions will apply as long as Ck(Pk, *)
convex in xp and uk. One implication of this analysis, for example, is
that the demand for joint family goods will be less price sensitive in
large households than in small households.

Appendix

The case of more than one productive commodity is more complicated than
the simple case because shadow prices and full income are functions of more
than one variable. Our conclusions about the uncompensated effect of
changes in income and prices need not hold in general. Since the cross-
substitution effects are not signed, one might expect to find no definite re-
sults. However, the methods we employ in Section I still prove to be useful.
Using elementary matrix algebra, we obtain simple analytic results for the
compensated effect of price changes.
Let xp = (x . xm) be the vector of productive commodities (1 ' m
n) and let xc = (Xm+, . xn) be the pure consumption goods. The corre-
sponding price vectors are pp and p, Denote x = (xp, xc) and p = (Pp. pc).
Earned income is a strictly concave function of the quantity of the productive
commodities: E = E(xp). Subscripts of E denote partial derivatives and dou-
ble subscripts denote cross partials. We also denote E the m X m Hessian
matrix of E(-).

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 PRODUCTIVE CONSUMPTION 381

With this notation, consider the problem

minimize p'x - E(xp) (A1)

subject to U(x) 2 u. (A2)

Let s*(p, u), i = 1. n, be the solut

be the solution to minimizing A' x subject to (A2). Then the two compensated
demand functions are related by the following identity:

s*(p, U) Si(7r) I *S * r , 7rk(j (S)) , 7k+1 .I I '. u), (A3)

where Tr= P- E for i = 1, m and 7rj = p for j = m + 1, n.
Differentiating (A3) with respect to pj gives, for i, j = 1,.

as:?
aP1asq -M~a
ar1 + 7kS
. E4E aSk ak a7 (A4)
ai ai k= 1 1= 1 81rk aX1 alj'

In matrix form, let as*Iapj be the (ij)th

gously. (Both matrices have dimension m X
tion (A4) can be written compactly as

S* = So- SpES*. (A5)

Note that standard consumer theory implies that SO is negative definite; E is

also negative definite since E(-) is assumed to be strictly concave.
We shall show that S* is negative definite, so its inverse exists. If we post-
multiply (A5) by S' and premultiply it by Sol, we get

Sp-1 = S*-1 - E. (A6)

Two properties of the matrix S* can be established from equation (A6):

(1) S* is negative definite and (2) S* - So is positive definite. Property 1
follows because S* = (So' + E)- l. The sum of two negative-definite matri-
ces is negative definite. The inverse of a negative-definite matrix is also nega-
tive definite. Property 2 follows because So- S - l = - E is positive defi-
nite. Thus S* - is also positive definite (see Dhrymes [1974, pp. 581-84]
for a proof).
Let us also define S* to be the matrix of the partial derivatives as*lapp, for
i,= m + 1, . . ., n (i.e., S * is the Slutsky submatrix for the pure consumption
goods). Similarly, let S* be the matrix of the partial derivatives asMlapj, for
i = 1,...,im, j = m + 1, . n. Define So and So, analogously as the Slutsky
submatrices for the model without productive consumption. Then differenti-
ation of (A3) gives

S*= So - SpES*c (A7)

and

S* = - SO'ESp* (A8)

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382 JOURNAL OF POLITICAL ECONOMY

Equation (A7) implies Sp = (I

S* =S S" E(I + S'E)-'Ss

= So -Sps[(1 + SpE)E-'PSp.

= - SpC(E-' + S)-'So. (A9)

The term in parentheses is negative definite. Thus the second term on the
right side of (A9) is negative definite. We hence establish another property:
(3) S* - So is positive definite. Among other things, properties 2 and 3 imply
las*l/apl < | asqIanil for both the productive commodities and the pure co
sumption goods. That is, pure substitution effects are smaller in magnitude
than they are when productive consumption is absent.

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