Download CHAPTER 6 CONSUMPTION AND THE COST OF LIVING I. Socially

CHAPTER 6
CONSUMPTION AND THE COST OF LIVING
I. Socially necessary consumption
The socially necessary level of consumption represents the minimal level of expenditure
required to participate as an on-going member of society. It represents the money that must be
spent to purchase the food, clothing, and shelter needed for physical sustenance, as well as the
various commodities that are deemed necessary by society as a whole. It is determined by
technology, the institutional structure of society, and broad cultural factors. The individual
views the socially necessary standard as an objective condition of life, a pattern of consumption
that must be adopted if he or she is to participate in the system.
A large component of socially necessary consumption - particularly in advanced
capitalist societies - reflects the technological structure of society. The technology embedded in
transportation systems, housing, food delivery, and so on, sets parameters to the type of
transportation, housing, and food the individual can consume. The individual has to adopt the
consumption patterns consistent with a society's technology if he or she is to work in that system.
Thus, in Southern California the economic geography is such that workers are obligated to
purchase or rent an automobile. Other modes of transportation, such as bicycling or public
transportation, are generally inadequate. The cities and work environments of Southern
California were built on the assumption that workers would own automobiles. Similarly, the
housing, communication, and food delivery systems of American capitalism assume that the
worker will purchase or rent a vacuum cleaner, telephone, refrigerator, and stove or microwave
oven.
The Political Economics of Capitalism
The socially necessary level of consumption is also constrained by the institutional
structure of society. Quite apart from the technology of consumption, the institutional structure
of society sets boundaries to the type of consumption workers are obligated to undertake. For
example, firms expect their employees to be on time. Failure to do so can mean the loss of a job.
As a result, workers are obligated to purchase a clock or wristwatch. Similarly, firms generally
impose constraints on the kind of work attire expected of their employees. Workers must
conform to this requirement if they wish to retain their jobs.
In short, the technological and institutional structure of society requires that workers
purchase specific categories of goods. These are objective material conditions that are imposed
on the worker regardless of his or her feelings on the matter. That is, many of the goods in the
socially necessary bundle are not the result of subjective or cultural factors. They are instead the
result of objective material conditions. This is perhaps best illustrated by noting that recent
immigrants quickly realize what must be purchased if they are to participate in the system, even
though they have not been acculturated. The recent immigrant quickly discovers the
commodities that must be purchased to navigate through the technological and institutional
structure of society, despite the fact that he or she may be ignorant of the dominant culture.
Of course, broad cultural factors also play a role in the consumption of goods thought to
be socially necessary. Humans are socialized into accepting, or at the very least understanding,
the forms of consumption thought to be minimally adequate and proper. The kind of housing,
clothing, and transportation thought to be necessary of full participants is a learned response.
The fully socialized individual understands the type of consumption that is minimally expected
of good citizens. This is learned through such agents of socialization as the educational system,
family networks, mass media, and business.
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Consumption and the Cost of Living
The socially necessary standard is not a measure of the average, or per capita, level of
consumption. This latter figure may differ from the socially necessary amount. It instead
measures the minimal level of expenditures that must be undertaken to participate in the
reproduction of the economy. The concept originated within the context of a theory addressing
the long term viability of economic systems. It refers, not to the average consumption level at a
moment in time, but rather to the amount that workers must consume if the institutional structure
of society is to remain viable over time. In this sense, socially necessary consumption occupies a
position that is analogous to depreciation. They both represent expenditures that must be
undertaken to insure that, at a minimum, the gross product be sufficient to cover the necessary
income of society as a whole.
This last comment implies that the idea of a socially necessary consumption is tied to the
productivity of labor. That is, there is some minimal level of consumption that must be attained
if workers are to continue providing the same level of productivity. One version of this idea
involves an extension of the efficiency wage model. This theory claims that labor productivity
tends to decline when the real wage that is earned by a worker falls below what can be
reasonably captured by working for another firm.1 By extension, if workers find their
consumption falling below the socially necessary standard, as a result of declining real wages,
their productivity will also tend to decline. As they lose a sense of participation in the system,
which is provided through socially necessary consumption, workers also lose the motivation to
contribute to it through their labor. Thus, from this perspective, the socially necessary standard
represents the minimal level of consumption that will maintain the productivity of the labor
force, and thus the viability of the economic system.
1
The efficiency wage theory is explained in more detail in chapter 10.
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The Political Economics of Capitalism
In the extreme, when the real consumption of vast numbers of workers is consistently
below the socially necessary standard, workers will seek to resolve the crisis through political
means. Depending on the nature of the existing political economic regime this may or may not
result in its resolution. The existing set of institutions can be destroyed through class warfare or
amended through the creation of a new set of institutions that address the declining living
standards of workers. In either case however, the point is that the socially necessary
consumption standard represents the minimal level that must be achieved if the system is to
remain viable over the long-term.
The socially necessary level of consumption represents the standard by which the
individual's participation in the system is measured. It serves as a yardstick, a target, by which
the individual gauges his or her acceptance in society. In the United States this version of the
concept is often expressed as having achieved the American dream; and while many American
workers do share in this dream, many others do not. However, as long as the economy is
growing and the existing political economic institutions retain legitimacy among the workers,
those who are not capturing the socially necessary standard will not necessarily reduce their
productivity or seek to alter the existing set of institutions.
The reason for this is that, in general, those who are not currently capturing the socially
necessary standard often view their condition as temporary and/or not the result of a systemic
effort to be excluded from the system. Young workers, just starting off on their careers,
generally earn less than the socially necessary standard. So do mature workers who find
themselves unemployed as a result of a temporary economic downturn. However, such workers
seldom lose their ability for hard work or seek to alter the existing institutional structure. They
tend to view their condition as temporary or the result of normal, and thus understandable but
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Consumption and the Cost of Living
unfortunate, circumstances. The young worker fully expects to capture, and perhaps even
exceed, the socially necessary standard over the course of his or her lifetime. The mature
unemployed worker expects to find alternative employment within a reasonable period of time.
The socially necessary standard of consumption reflects the socio-political criteria by
which society determines who is, or is not, a legitimate member of the system. It provides the
minimal standard by which the social worth of the individual is determined. It measures the
extent to which the power structure views various classes of people as necessary to the
maintenance of the existing institutional arrangement. This can be seen in the political debates
over the amount and type of income support programs that should be offered to "worthy"
contributors to the system. It can also be seen in the political debates over measures of poverty
and the cost of living, and the amount that government should spend on medical care, public
housing, public transportation, and so on. In each case, the question is: what is the minimally
adequate level of consumption that must be achieved before a worker can fully participate, or
contribute to, the system?
II. The consumption function2
Imagine that we could arrange consumer goods along a continuum that measured the
importance of these goods to the reproduction of a socially necessary lifestyle. Those goods that
reproduce this lifestyle would be referred to as necessities, while those that do not would be
viewed as luxuries or superfluous.3 Assuming that the ranking of these goods, along with their
2
This section builds on the ideas introduced by E. Ray Canterbery in his book The Making of Economics, 3rd
ed Belmont, California: Wadsworth Publishing Company, 1976, pp. 289-293.
3
Of course, there would be many goods that would fall in between these two extremes and could not, therefore,
be considered to be pure necessities or pure luxuries. Moreover, some goods that might be considered luxuries at
one level of income often come to be seen as necessities at another level of income. These are secondary
complications that do not detract from the central argument being pursued here.
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The Political Economics of Capitalism
prices, remains fixed, what one would find is that at very low income levels all of the consumer's
income would go toward the purchase of necessities. But as income increases the fraction
allocated toward the purchase of necessities decreases, while the fraction allocated toward
luxuries increases. However, even in the case of luxuries, the fraction allocated toward their
purchase will also eventually decline as income continues rising.
Humans, in short, have a hierarchy of needs that determines the sequence in which goods
are bought. At relatively low income levels all of the income goes toward the purchase of
necessities, whereas at relatively high income levels the fraction spent on necessities falls. Those
goods that are deemed to be more necessary than others are bought first, while the other less
necessary goods are purchased at higher income levels. Moreover, as income increases the
amount spent on necessities tends to level off, while the amount spent on luxuries tends to
increase. But even in the case of luxuries, the amount consumed per time period tends to level
off as income continues to increase.4
This behavior is represented in Figure 6.1. The horizontal axis measures income, while
the vertical axis measures consumption expenditures. The diagonal line displays all points where
consumption spending exactly matches income. The line labeled Cn represents the expenditures
that would have to be undertaken to purchase a socially necessary bundle of goods. Because this
is a socially determined standard it remains fixed in the short-term, regardless of the current
income level of the individual or household.
The curve labeled C represents the expenditure on consumer goods. Because the prices
of consumer goods are assumed fixed, the rising level of consumption spending, depicted by the
C curve, represents an increase in real consumption. That is, a greater amount of consumer
4
Compare to A. H. Maslow, Motivation and Personality (New York, N.Y.: Harper, 1954).
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Consumption and the Cost of Living
goods, and/or a better quality of consumer goods, is purchased as income levels rise. However,
the purchase of consumer goods grows at a slower pace than the growth in income. The C curve
is referred to as the household, or individual, consumption function.
Figure 6.1
Note that, with the exception of point a, the consumption function does not coincide with
the Cn line. This is in keeping with the idea that the amount the individual consumes may or may
not coincide with the socially necessary amount. At very low income levels, the individual will
spend all of his/her income on the purchase of necessities. In fact, it is not uncommon to find
expenditures exceeding income levels over these low ranges - as shown in Figure 6.1. At Y1 the
individual is earning the socially necessary level of income, the amount that is just sufficient to
purchase a socially necessary bundle of goods. At income levels beyond the socially necessary
amount, the individual is consuming a greater than socially necessary amount, that is, surplus
consumption is taking place.
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The Political Economics of Capitalism
Beyond a certain point, in this case point a, the expenditure on necessities levels off. As
soon as the household has achieved the socially necessary standard of living, it will continue to
spend the amount needed to sustain that standard. It will also be able to engage in surplus
consumption through the purchase of luxuries or superfluous goods. Even here, however,
surplus consumption will eventually level off beyond a certain point. Moreover, as shown by the
growing gap between the diagonal line and the consumption function, an increasingly larger
fraction of income will begin to flow into savings. As income levels increase and the household
moves beyond the socially necessary level of consumption an increasingly larger proportion of
income is saved. Unlike the consumption of necessities or luxuries, saving increases in both
absolute and relative terms as income increases.
Economists frequently analyze the above behavior in terms of the propensity to consume
(c), that is, the fraction of income spent on consumer goods (the ratio of consumption (C) to
income (Y)). As suggested above, the propensity to consume decreases as income levels
increase, that is, the fraction of income spent on consumption decreases as income levels rise.
Moreover, the propensity to consume necessities tends to fall more quickly than the propensity to
consume luxuries.
Because the propensity to consume declines as income levels increase, the proportion of
income saved increases as income rises. The fraction of income saved is referred to as the
propensity to save.5 The thing to note about this is that saving is primarily a function of income.
Higher income families and individuals save more than lower income families and individuals,
and for any one household, saving increases as income increases.
5
In algebraic terms since income can only be consumed or saved it must be the case that the difference
between the propensity to consume and unity is the propensity to save. That is, it must be that C/Y + S/Y = 1 or, c +
s = 1 or, c*Y + s*Y = Y, where c is the propensity to consume (C/Y) and s is the propensity to save (S/Y).
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Consumption and the Cost of Living
Working class households have a higher consumption propensity than do middle class
households; and the latter have a higher consumption propensity than do capitalist households.
In short, workers consume a larger fraction of their income than do middle class professionals
and capitalists. Of course, the flip side of this is that the middle class and the capitalist class
have a higher saving propensity than the working class.
The shape and position of the consumption function is determined by the set of consumer
goods generally thought of as socially necessary. In the short-term, the set of socially necessary
goods is stable and, as a result, so too is the C curve. However, over the long-term the set of
goods deemed socially necessary tends to change. An increase in the number of socially
necessary goods, or an increase in the amount of a given set of necessary goods, causes the Cn
line and thus the C curve to shift up. A decrease in the number of socially necessary goods, or a
decrease in the amount of a given set of socially necessary goods, would cause the Cn line and
thus the C curve to shift down.
Likewise, the consumption function would shift upward, if the price of socially necessary
goods where to increase, assuming no change in income. The monetary value of necessities
would rise. Without a change in income or the ability to rely on income subsidies or borrowed
money, this would entail a decline in real consumption; the quantity and/or quality of consumer
goods that could be purchased would decline.
The point at which the consumption function intercepts the vertical axis, labeled Cno,
represents the minimal level of consumption that can be carried out through the purchase of
goods. Even at a zero income level the individual may still be able to buy consumer goods,
albeit way below the socially necessary amount, by using money given to him or her by friends,
family, or the state, or through the use of a temporary loan or credit. If these alternatives are not
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The Political Economics of Capitalism
available, then the purchase of consumption goods could only take place by having the
individual steal or beg for the necessary money. It is also possible for the individual to steal the
consumption goods directly or obtain them as a gift or a subsidy; but this would no longer be
represented through the consumption function because the latter only explains the purchase of
consumer goods through the exchange of money.
The Cno point on the consumption function can be thought of as a measure of the extent
to which individuals will resort to illegal activities and/or begging to obtain the necessary
consumer goods. In the absence of state aid or extremely low levels of aid individuals may be
forced to beg or steal. The inverse of course suggests that greater levels of state aid will
diminish illegal or uncivil behavior.6
It should be noted that while income levels below Y1 represent conditions of poverty we
cannot identify it as a specific point on the C curve. That is, while its clear that Cno represents a
state of poverty, we have refrained from mentioning where poverty begins and where it ends.
Poverty can only be defined by reference to some standard. One is either poor or well off in
relation to a standard of living that is considered adequate. Since the socially necessary level of
consumption represents the minimally adequate level of consumption, it cannot be thought of as
representing a state of poverty. Thus, poverty occurs not all at once, but rather in incremental
steps as one falls below the socially necessary standard.
Before closing this section it should be kept in mind that we have been assuming a shortterm scenario in which the socially necessary standard of consumption is given. However, as
already noted, it is the case that the socially necessary standard changes over the long term. The
major factor accounting for a change in the socially necessary standard is the rate at which the
6
This, of course, is only true in the context of illegal activities undertaken because of economic necessity. It
will not resolve those forms of illegal, or uncivil, behavior motivated by other factors.
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Consumption and the Cost of Living
economy grows over time. A growing economy allows real income levels to rise; and as real
income levels increase, consumption items that previously were thought of as luxuries gradually
come to be thought of as necessities.
The impact this has on the propensity to consume will depend on the rate at which
income grows over the long-term, in relation to the rate at which the socially necessary standard
grows. A distinction needs to be made between the short-term consumption propensity and the
long-term consumption propensity. The short-term consumption propensity represents the
fraction of income that is consumed in the context of a stable socially necessary consumption
standard. The long-term consumption propensity represents the fraction of income that is
consumed in a context where the consumption standard changes over time. In the short-term,
when the socially necessary standard is fixed, increases in income will bring about a reduction in
the propensity to consume. This is the case depicted in Figure 6.1. But over the long-term, the
propensity to consume may remain constant if the socially necessary standard rises at the same
pace as income. The long-term consumption propensity will remain fixed if the C function shifts
up by the same proportion as the rise in income.
For society as a whole, and in the context of a stable social structure of accumulation, a
growing economy will bring about a rising level of income for all economic classes. At the same
time, the socially necessary standard will be growing at the same pace. This will have the effect
of keeping the consumption propensity of the various economic classes stable over the longterm. As long as the social structure of accumulation remains stable and the income of each
economic class grows at the same rate, the relative standing of each economic class will remain
unaffected. This will insure that the long-term consumption propensity of each economic class
remains stable. However, if the social structure of accumulation were to change and/or the long-
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The Political Economics of Capitalism
term rate of economic growth were to change then the consumption propensities of these
economic classes would change.
The individual household's long-term income need not grow at the same pace as the
socially necessary standard. If the household's income grows at a faster pace than the socially
necessary standard, the long-term consumption propensity will gradually fall. This occurs in the
case of upwardly mobile households. If, instead, the household's income grows at a slower pace
than the socially necessary standard, then the long-term consumption propensity will gradually
rise. This is characteristic of households that become poorer over time. Obviously, households
whose relative economic position remains unchanged over time are those for which income
grows at the same pace as the socially necessary standard. The consumption propensity of such
households remains stable over the long-term.
III. Consumption recipes and relative prices
In this section we examine the manner in which the worker's consumption pattern is
changed as a result of a change in the wage rate. Much of this discussion is similar to what was
mentioned in the previous section, the difference is that in this section we pay more attention to
the specific bundle of goods making up a socially necessary standard. The worker is chosen as
the representative consumer since it is the consumption behavior of the worker, and in particular
the manner in which he or she responds to a change in the cost of living, that sets limits to the
viability of the system.
Let's start by imagining that the worker is receiving a wage rate that is just enough to
purchase a socially necessary bundle of goods, so that all of wages are being spent on
consumption. This can be depicted in the following terms:
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Consumption and the Cost of Living
6.1
where w represents the wage rate, the p's represent the prices of the various goods, and the q's
represent the amount of the various goods that are purchased per time period. There are a total
of n goods.
The specific combination of goods (the q's in the above equation) that is chosen by the
worker reflects the socially necessary standard. This does not mean however that the attainment
of a socially necessary standard requires the consumption of a specific combination of goods. In
general, there are a variety of commodities, and combinations of commodities - call them
consumption recipes, that can satisfy this requirement. The consumer views the attainment of a
socially necessary standard in terms of consumption categories that must be fulfilled. That is,
the consumer has a relatively clear idea of the minimal amount of food, clothing, shelter,
transportation, health care, and so on, that must be attained to participate in the system. But the
specific set of commodities that are chosen within any one consumption category can vary from
individual to individual. Thus, while we all need to eat, the specific types of foods that we eat
will vary from one person to the next.
The consumption hierarchy pertains not only to goods within specific consumption
categories, but also to the categories themselves. That is, while there is a balance that must be
achieved between food, clothing, shelter, and such, it is also the case that some consumption
categories are more important than others. This becomes apparent when income falls and the
worker is forced to determine which categories of expenditure to retain and which ones to drop.
There is a ranking of consumption categories as well as a ranking of commodities within any one
category. Moreover, while the goods within any one consumption category can be substituted
for each other, the goods across consumption categories cannot. Thus, while a hamburger and
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The Political Economics of Capitalism
fries might substitute for a burrito, neither can substitute for clothing or shelter. Food is in a
consumption category separate from clothing and shelter.
The attainment of a socially necessary standard requires that the worker chose from
among the various consumption categories those commodities that satisfy the attainment of the
corresponding need. Within each category the consumer picks a consumption recipe that fits his
or her needs and desires. For some categories, such as food or clothing, there is generally a wide
enough range of goods and providers that the specific bundle of goods chosen will vary from one
working class household to the next. But for other consumption categories, such as electricity or
telephone service, there is only one available good and one available provider. In these cases,
every worker ends up purchasing the same commodity.
It's important to note that even though for some categories there is a variety of goods
from which to chose, the consumption recipe is, nevertheless, quite similar. One need not be a
social anthropologist to be aware of the fact that the consumption recipes of individuals within a
specific culture, say Latino workers in the San Gabriel valley, are similar. Despite the professed
allegiance to individualism, the consumption patterns of different households within the working
class, or within any class, are remarkably similar.
With this as background imagine that the combination of goods, the q's, that have been
chosen by the worker are the minimal amounts needed to attain a socially necessary standard of
living. The worker's wage is just enough to afford him or her the minimally adequate
consumption standard. Dividing equation 6.1 by the wage rate provides us with the fraction of
income that is spent on the purchase of the various socially necessary goods. The resulting
expression, equation 6.2, would provide us with a measure of the propensity to consume these
various goods. Thus,
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Consumption and the Cost of Living
6.2
where
represents the propensity to consume good i.
The ratio of the price of any one good to the wage rate (pi/w) is a relative price. It
measures the relative price of a good in terms of labor. Stated differently, it provides a measure
of the amount of labor that must be offered in return for the good. Because the nominal price of
a good represents the amount of money that must be offered for one unit of a good (pi = $/qi,
where $ represents the amount of money), and the wage rate represents the amount of money that
is paid for one unit of labor time (w = $/L, where L represents one unit of labor time), the
relative price of a good in terms of labor (pi/w = ($/qi)/($/L) = L/qi) represents the amount of
labor time that must be offered for one unit of the good. For example, if the price of good 1 were
$5 and the wage rate were $10, then the relative price of good 1 in terms of labor would be 0.5.
Half of a unit of labor time, namely half an hour, would have to be given up to purchase one unit
of good 1.
Another way to interpret equation 6.2 is that it displays the fraction of total labor time
that the worker must allocate to the consumption of various commodities. This idea is depicted
in the following set of equations.
6.3
or,
6.4
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The Political Economics of Capitalism
where
represents the fraction of total labor time that must allocated to the
consumption of good i.
The thing to note is that the consumption of goods can be viewed in terms of the amount
of time that must be worked to purchase various goods. The commodities that take up a large
fraction of the total budget take up a large fraction of total labor time. The commodities that take
up a small fraction of the worker's budget take up a small fraction of the worker's labor time.
What if the wage rate were to fall? This would have the immediate effect of increasing
the relative price of all the possible goods the worker could purchase. The existing consumption
recipe could only be maintained by working more hours. In the case of working class
households this is indeed a common response. An increase in the cost of living is often
responded to by having a growing proportion of the household seeking employment. However,
the offer of employment is not the same thing as obtaining employment. The ability to capture
more work depends on the extent to which firms need more workers, or hours of work. If more
employment cannot be found the only alternative to a decrease in the wage rate is to cut back on
the consumption of some of the socially necessary goods. The worker will be forced to cut back
on the consumption of those commodities thought to be the least necessary. A growing
proportion of total labor time will go to meet the consumption of absolute necessities.
Indeed, if the wage rate were to continue falling, the worker would begin to move into the
consumption of goods that previously were not purchased because they were viewed as inferior.
As the wage rate continues to fall, the proportion of income allocated to inferior goods will start
rising until most of the worker's income is allocated to the purchase of inferior goods.
The same scenario is played out, though in reverse, in the case of an increase in the wage
rate. A rising wage rate will allow the worker to move out of the consumption of inferior goods
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Consumption and the Cost of Living
and into normal necessities. Indeed, as the wage rate continues to rise, the worker will
eventually be able to afford luxuries and some saving. Saving is a type of luxury that can only
be afforded after a socially necessary bundle of goods has been purchased.
A rising wage rate might also lead to a reduction in the offer of employment. While the
major breadwinner of the household will seldom cut back on his or her offer of work, the
proportion of the household that is seeking employment may decline as the income of the
remaining employed members rises sufficiently to compensate for the reduction in income
brought on by those quitting their jobs. However, this reaction is more problematic than the
reaction of the worker to a decrease in the wage rate. Part of the reason for this is that the terms
of employment are much more contingent on the needs of the employer than they are on the
needs of the employee. More importantly, an increase in the wage rate in the absence of a
change in employment hours means more income. Workers, as do all income seekers, prefer
more income to less. Thus, while there may be a reduction in the number of people within any
one household seeking employment as a result of steady increase in the wage rate, there is a
lower limit to this response that is reached rather quickly.
IV. Income and substitution effects, saving and borrowing
What if, instead of a change in the wage rate, there is a change in the price of one of the
goods? What happens when the price of one socially necessary item of consumption increases?
If the price of one good were to rise while other things remained unchanged, the worker's real
income would fall. The real wage rate would fall. Therefore, it would seem that the manner in
which a worker responds to an increase in the price of a good should be similar to the manner in
which he or she responds to a decrease in the wage rate. There is, however, an important
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difference. The extent to which real income falls as a result of an increase in the price of a good
will depend on the fraction of income that is already being spent on that good. A one percent
increase in the price of a good occupying a small fraction of total spending will have a much
smaller impact on real income than a one percent increase in the price of a good that takes up a
large fraction of total consumption.
The income effect refers to the manner in which consumption changes as a result of a
change in real income brought about by a change in the price of a good. If the good whose price
has changed occupies a large fraction of total spending, then the income effect will be relatively
large; whereas if the good occupies a small fraction of total spending, the income effect will be
rather small. For example, the income effect of an increase in the price of bread is very small,
simply because it generally constitutes a minute part of the worker's total expenditures. In
contrast, the income effect of a change in the price of housing is quite strong because it generally
constitutes a large fraction of total spending. Thus, a one percent increase in the price of bread
will clearly have a smaller impact on the worker's real income than a one percent increase in the
price of housing.
In either case real income will be decreased and this decrease in real income will
motivate the worker to alter his or her consumption pattern. Those goods that are the least
necessary will be cut back first, leaving the consumption of the stronger necessities unaffected,
unless the drop in income has been sufficiently severe. Indeed, as already noted, the worker may
begin to purchase inferior goods.
The thing to note about this is that the consumption of all of the goods within the socially
necessary bundle might be altered as a result of a change in the price of any one of them. But the
extent to which this occurs depends on the magnitude of the income effect and on the relative
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Consumption and the Cost of Living
necessity of the commodity. Moreover, it is not necessarily the case that the consumption of the
good whose price has been increased will decrease. If the good is considered a strong necessity,
then its consumption may remain unaltered. It will be the other goods whose consumption will
be decreased in varying amounts. If the good is a weak necessity, its consumption will tend to
fall while the consumption of other goods remains unaffected.
When responding to an increase in the price of a good the worker may also consider, in
addition to the impact it will have on his or her real income, the extent to which other goods can
be substituted for the now relatively higher priced item. In an attempt to maintain the same
standard of living, the worker, when confronted by an increase in the price of a good, may begin
to search for other less expensive versions of the same good. This response is referred to as the
substitution effect. It refers to the extent to which the consumption of a set of substitutable
goods will be altered as a result of a change in the price of any one of them.
The extent to which the substitution effect takes hold depends on the extent to which
substitutes are available. In the case of goods such as soft-drinks, bread, clothing, toothpaste,
and so on, there generally is a wide range of commodities that can satisfy a similar need. For
these types of goods an increase in the price of any one of them can induce the consumer to
purchase less of the corresponding good and substitute the relatively cheaper alternative. If the
price of Pepsi increases, while the price of all of the other possible soft-drinks remains
unchanged, the consumer may substitute some of these other soft-drinks for Pepsi. In the case of
goods for which there are no available substitutes there will be no substitution effect.
In summary, an increase in the price of a socially necessary good will bring about an
income response and possibly a substitution response. The income effect depends on the relative
necessity of the commodity. In the case of strong necessities, an increase in the price of a
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The Political Economics of Capitalism
necessity will bring about a relatively small, or no, decrease in quantity purchased. In the case of
weak necessity, a price increase will bring about a relatively large decrease in quantity
purchased. The substitution effect depends on the availability of substitutes. If there are readily
available substitutes, a price increase will bring about a decrease in quantity purchased. An
increase in the price of a commodity forces consumers to find readily available substitutes. If the
commodity has no readily available substitutes, then there is no substitution effect.
The above assumed that the worker's income was just enough to purchase a socially
necessary bundle of goods. In the case of workers whose income is above the socially necessary
amount, these responses may differ. In this case, the worker will be consuming more than the
minimal amount of social necessities, and if the income is sufficiently high, purchasing luxuries
and undertaking some saving. For such workers an increase in the price of one of the
commodities may not alter the consumption of any of them. What instead might happen is that
saving is decreased. But, if saving is viewed as more necessary than luxury consumption, it will
be the luxury good whose consumption will be cut, leaving the consumption of necessities and
saving unaffected. Of course, if the reduction in real income is severe, then saving, and
eventually necessities, will be cut back as well.
When the worker has access to borrowed money or credit, he/she is forced to estimate the
extent to which the borrowed funds may be repaid. If the worker believes that the periodic debt
payments can be made, then an increase in the price of a good may lead the worker to maintain
the existing pattern of consumption by simply borrowing more money. The debt repayment
would be financed through a reduction in saving or a greater flow of future income. This type of
response is particularly common in the case of a "big ticket" item such as housing or a car.
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Consumption and the Cost of Living
The problem with this strategy is that the worker may miscalculate the amount of future
real income he/she will be able to generate. This could occur as a result of either a lower than
expected flow of future nominal income, or because of higher than expected prices, or some
combination of the two. Either way, the worker's debt to income ratio ends up growing much
faster than anticipated. This forces the worker to cut back on the consumption of goods, with the
least necessary items going first.
V. The demand curve and elasticities
When the price of a good changes, other things equal, both of the above processes are
generally taking place, that is the income and substitution effects are influencing the consumer's
response. While consumers seldom, if ever, think through these responses with the kind of detail
presented here, it is nevertheless the case that when the price of a good changes, particularly if it
occupies a large fraction of total spending, the worker will consider the impact it has on his or
her real income and the availability of substitutes.
In general, for most commodities, most of the time, an increase in the price of the
commodity will cause its consumption to fall, and vice versa. That is the net impact of the
income and substitution effects is to bring about an inverse relationship between the price of a
commodity and the amount purchased. This is the major reason for the downward sloping
demand curve.
The extent to which this relationship holds depends on whether the commodity is a
necessity or a luxury and on the availability of substitutes. Let us look first at the case of
necessities. We know that in the context of a price increase the income effect will bring about a
relatively small to no decrease in consumption. If there are readily available substitutes, then the
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The Political Economics of Capitalism
substitution effect will bring about a reduction in its consumption. In this case, the net impact of
both the income and substitution effects is to bring about a reduction in the purchase of the
commodity as its price is increased.
This response is characteristic of socially necessary goods for which there are number of
available substitutes. Food and clothing tend to fall into this category. In this case the worker
generally has a range of commodities and possible providers from which to choose.
If there are no readily available substitutes, then there will be no substitution effect. In
this case, an increase in price will not bring about a dramatic decrease in quantity purchased.
Indeed, quantity purchased may remain unaffected. Necessities that are produced and/or sold by
one or a few firms, as in the case of electricity or heating oil, are examples. The lack of
alternative consumption possibilities forces the worker to continue buying the necessity from the
one or small number of providers.
The case of luxuries is more straightforward. In this case, the existence of alternative
possibilities is less significant than is the case for necessities. Even if only one firm provides a
luxury, an increase in its price will still bring about a reduction in its consumption. Of course,
this tendency is reinforced if there are several firms providing alternative versions of the same
type of luxury. In this case, the decrease in consumption due to a price increase will tend to be
more dramatic.
When these responses are aggregated for consumers as a whole, the result is the market
demand curve as shown in either graph A or graph B of Figure 6.2. These two graphs show two
possible demand curves for two different types of commodities. The steepness or flatness of
these two curves is a measure of the extent to which quantity demanded changes as a result of a
change in the price of the good, other things equal.
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Consumption and the Cost of Living
The amount by which quantity demanded changes as a result of a change in the price of a
commodity is measured by the price elasticity of demand. The price elasticity of demand (ep)
measures the percentage change in quantity demanded due to a one percent change in price. A
commodity whose demand is relatively price elastic is one for which quantity demanded falls by
a greater percentage than the percentage increase in price. A commodity whose demand is
relatively price inelastic is one for which quantity demanded falls by a smaller percentage than
the percentage increase in price. These definitions are symmetrical in the case of a price
decrease.
Figure 6.2
Graph B in Figure 6.2 displays a price elastic demand curve, whereas graph A displays a
price inelastic demand curve. An equal percentage increase in the price of both commodities
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The Political Economics of Capitalism
will bring about a greater percentage decrease in the case of the price elastic commodity (graph
B) than in the case of the price inelastic commodity (graph A). The demand curve on the right is
characteristic of luxuries and necessary commodities for which there are a wide range of
alternative possibilities. Such commodities tend to have a price elastic demand. The demand
curve on the left is characteristic of necessities for which there are no readily available
substitutes. These commodities tend to be price inelastic.
The market demand curve can also be used to visualize the impact of a change in the
wages of workers (or the income of consumers as a whole). As pointed out in section III, a
decrease in the wage rate will, in the absence of an increase in employment hours, bring about a
greater reduction in the consumption of luxuries, than in the consumption of necessities. The
demand curves in graphs A and B will shift inward (to the left) as a result of decrease in wages.
They will shift outward (to the right) as a result of an increase in wages. However, the extent of
the shift will depend on the relative necessity of the commodity.
The income elasticity of demand (ey) is a way of measuring the relative necessity of a
commodity. It measures the amount by which the purchase of any one commodity will change,
in percentage terms, as a result of a one percent change in the real income of the consumer.
Necessities have a lower income elasticity than do luxuries.7 The more necessary the good, the
lower the value of its income elasticity and the smaller the amount by which its consumption
changes, in percentage terms, as a result of a percentage change in real income. A one percent
decrease in income will bring about a larger percentage drop in the consumption of luxuries than
in the consumption of necessities.
7
Necessities are generally defined to have an income elasticity that is less than one whereas luxuries have an
income elasticity that is greater than one. The income elasticity of inferior goods is negative.
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Consumption and the Cost of Living
If graph A is characteristic of a strong necessity (low income elasticity) and graph B is
characteristic of a luxury (high income elasticity), then a one percent drop in the wage rate will
bring about a greater inward shift for demand curve B than for demand curve A. The demand for
luxuries falls more readily in response to a wage decrease, than does the demand for necessities.
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