A Definition of Luxury and Necessity for Cardinal Utility Functions

Author(s): Timothy Besley

Source: The Economic Journal, Vol. 99, No. 397 (Sep., 1989), pp. 844-849
Published by: Oxford University Press on behalf of the Royal Economic Society
Stable URL: https://www.jstor.org/stable/2233775
Accessed: 11-10-2019 06:14 UTC

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 The Economic Journal, 99 (September I989), 844-849

Printed in Great Britain

A DEFINITION OF LUXURY AND NECESSITY FOR

CARDINAL UTILITY FUNCTIONS*

Timothy Besley

This note suggests a definition of luxury and necessity available when using
cardinal utility functions. These arise frequently in analysing problems
involving time and/or risk, since additive separability is often assumed in such
contexts. We shall introduce our different notion of luxury and necessity by
considering the profit function representation of preferences which was
suggested in Gorman (I 976). This representation of preferences enables one to
work simply with Frischian demands, i.e. demands at a constant marginal
utility of income (see Frisch, I959). These demands have been applied
empirically by Browning et al. (I985) and in the literature on life cycle labour
supply by Heckman and MaCurdy (I980), amongst others. Browning (I982)
gives an extensive theoretical analysis.
The definition we propose is applicable to Frisch demand systems and we
point to a number of contexts in which it naturally arises. The note is structur
as follows: in the next section we introduce and motivate the definition of
luxury and necessity and apply it to an intertemporal model. In Section II we
suggest some further applications.

I. THE MODEL

Consider a consumer with the direct utility function

U = U(x), (I)

where x is a vector of goods. The profit function for these preferences (see
Gorman, I976) is defined by

g(p,r) = sup[rU(x)-px], (2)

x

where p is the price vector corresponding to x and

the reciprocal of the marginal utility of income. The properties of profit
functions in general are well known (see, for example, McFadden, I 978). In the
context of consumer theory, Browning (I982) gives an extensive discussion of
its properties. In addition to the usual properties of convexity and linear
homogeneity, we shall assume that it is twice continuously differentiable. Using
Hotelling's lemma, we can then derive the Frisch demand function:

(p,r) =-xF (p, r), (3)

api 3
* I am grateful to Martin Browning, Angus Deaton, Terence Gorman and David Newbery for
discussions, comments and encouragement. Errors are mine.

[ 844 ]

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 [SEPTEMBER I989] LUXURY AND NECESSITY 845

where the superscript F reminds us that we are considering Frischian demands.

Hotelling's lemma also implies that the derivative of the profit function with
respect to the price of utility gives the consumer's utility level. We shall be
interested in the following elasticity:

8logxf(p, r)
"' log r 4
We shall say that a good is a luxury if jt > I and a necessity if 4ti < i. Some
motivation for this is offered shortly. Consider first the link between this
definition of luxury and necessity and the normal one that is defined using
Marshallian demands. In order to do this, take the indirect utility function
corresponding to (i), which is defined by

V(p, W) = sup[U(x) I px < W], (5)

x

where W denotes lump-sum income. The Frischian and Marshallian demands

are related by -p, [ W) )x[p, VW ( W ], (6)

where w ((PW)
VW * W aVp W)

Differentiating the identity (6) with respect to W, we have

i= Rti, (7)
where vi is the Marshallian income elasticity of demand and R is the coefficient
of relative risk aversion or the reciprocal of Frisch's intertemporal substitution
parameter Ct (see also Deaton, I974). Whether interpreting the definition in
terms of intertemporal substitution or risk aversion is appropriate will vary
according to context. Below, we give examples of both cases. It is apparent from
(7) that
jt > I=# > I if R> I

and > => > if R <I.

The Marshallian and Frischian definitions of luxury and necessity coincide

globally only if preferences are logarithmic, in which case yj = Iui = R = I f
each i.
The Marshallian definition of luxury and necessity is motivated by
considering how budget shares (/Jl for commodity i) are altered by ch
lump sum incomes, i.e.

Off Z o as qj < I. (8)

While useful in many contexts, the conventional definition of luxury and
necessity is naturally applicable in static contexts. The motivation for the
Frischian definition is quite different. Consider an agent who has enough liquid
assets or good enough insurance to keep his price of utility constant across time

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846 THE ECONOMIC JOURNAL [SEPTEMBER

and states of nature. When prices are p we can use the profit function to define
how much he must spend to do this. Specifically, he requires an amount'

m (p, r)- rgr (p, r) - g(p, r). (9)

Note that W- m(p, r) is the net addition to resources (i.e. savings) required to
do this. Consider now a rise in the price of good i. We might ask whether the
agent now needs more or less resources to stay at a fixed marginal utility of
income. To ascertain this, differentiate (9) logarithmically with respect to
yield

alogm(p , r )f=l(Ii6)* (IO)

8 logpj

If an agent requires more resources to stay at a fixed r, the good is a necessity

in the sense introduced in this paper; if he requires less, it is a luxury.
Equivalently, luxuries are goods, an increase in the price of which raises an
agent's marginal utility of income, while necessities are those goods for which a
price increase lowers an agent's marginal utility of income.
Further motivation for the definition can be obtained by considering a model
with intertemporally additive preferences. Bewley (I977) demonstrated that
under quite weak assumptions, an agent's accumulation of assets will tend to
a solution in which r is kept constant over time and across states of the world.
Furthermore, he argues that this gives meaningful content to the permanent
income hypothesis. When agents behave in this way, then the price of utility at
time t, rt, is a sufficient statistic for lifetime wealth (see also Browning et al.
I985). An agent with higher lifetime wealth ceteris paribus will have a higher
price of utility. This gives the interpretation of luxury and necessity in the
present context as applying to changes in lifetime wealth when such changes
are smoothed across time by saving and dissaving.
We can further develop this notion of luxury and necessity to obtain a
decomposition of the demand derivative, analogous to the Slutsky de-
composition, for application to the permanent income model. In such a model,
the lifetime time price of utility is obtained from the equation :2

rE T= 1 g' (pt, r)- T 1 gt(pt, r) = (II)

where Q is lifetime wealth. Define

r -rt=lgtr (pt er)

and note that

Or = -1 ( I 2)

1 This follows by noting that profits

expenditures. Expenditures required to s
2 The argument is essentially as in f

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 I989] LUXURY AND NECESSITY 847

The effect of a price change at time

s is given by O Or

p= 8ta1 ar ap' (I3)

where &st is the Kronecker delta. This has two clearly interpretable parts. The
first -is the direct effect of the price change holding the price of utility fixed,
which operates if periods t and s are the same. The second is the permanent
income effect. This is the analogue of the income effect in static consumer
theory. A price change in any time period has an effect upon permanent
consumption, which in this model works through its effect on r. We shall now
examine this second effect more precisely. Using (I2),

Or_
=p =-i A1(rgtj 4> = _`- xit( I _ tt) (I4)

Hence, 0 O
a logpjt
OX8p! t = st Or,-jN Q@ )(I5
where xi_Xp; __ and p r =rQ

The magnitude of the permanent income effect depends upon the share of
the good (consumed at time t) in lifetime wealth. Its sign depends upon
whether the good is a luxury or a necessity in the sense that we have defined.
When a good is a necessity, an increase in its price raises the price of utility and
lowers the demand for all normal goods, for a given level of lifetime wealth.
Conversely, a rise in the price of a luxury reduces the price of utility and raises
the demand for all normal goods. Intuitively, this is explained by the fact that
if the price of necessity rises at time t, expenditures at t are increased, hence
reducing those available at all other times, whilst the rise in the price of a
luxury releases expenditures at t to be spent at other times and hence increases
the demand for goods consumed at times other than t.
The analysis can be extended to consider a price change which persists for
a number of time periods. Suppose that these time periods form a set K, then
we are interested in the impact of a change in price pt for te K. It is useful to
define a variable &sK with the property that

{I if seK
sK lo otherwise.

A price change which persists then affects the demand for good i in period s
according to a
a logpt 8K Oaj- Et.K,#j (I _x
Note that the permanent income effect now depends upon the sum of the
budget shares in lifetime wealth of the good in the time periods in which the
price has changed. The basic argument for why a rise in the price of a luxury

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 848 THE ECONOMIC JOURNAL [SEPTEMBER

increases demand for all goods through its permanent income effect, whilst a
rise in the price of a necessity reduces it, is the same as in the case where the
set K is a singleton.

II. OTHER APPLICATIONS

The definition of luxury and necessity proposed here has a number of further
useful applications. Some of them arise from considering the definition in
relation to the indirect utility function. Logarithmic differentiation of Roy's
identity yields the well-known relation

0
8 logpj lg V=I (R-) (7)
which after using (7) yields

s log I> o as jti ! i. (i8)

The need to interpret conditions such as (I 7) arises in the literature on the
theory of commodity price stabilisation, see Newbery and Stiglitz (I98I). In
particular, if we ask how much an agent is prepared to pay to eliminate price
uncertainty (the price risk premium), then how a price change affects an
agent's marginal utility of income is of importance, as is seen in Newbery and
Stiglitz (I98I), chapter 9. Our analysis facilitates an understanding of it. The
definition also finds applications in the theory of insurance (see Besley, I987).
It is also of interest in considering how utilitarian welfare weights depend upon
prices. This is so since such weights are closely related to an agent's marginal
utility of income.
To illustrate a further use, we shall consider the decision of a consumer to
buy or sell futures in a good whose price is uncertain. Whether buying or selling
is optimal depends upon whether the good concerned is a luxury or a necessity
in the sense proposed here. For simplicity, consider an unbiased futures market
so that the consumer can buy or sell units of the commodity at the mean price
A. The consumer's problem is to choose y to maximise expected utility given by

El V[p, W-)'(Pi Pi)]} ( I 9)

where E{ * } is the expectations operator taken
positive (negative), then the consumer is buying (selling) the good in the
futures market. The first order condition for the choice of y is

E[Vw(-) (pi-pi)] = o, (20)

i.e. the covariance between the consumer's marginal utility of income and the
price of the good is set equal to zero. To ascertain the likely sign of y, we shall
consider whether this covariance is positive or negative at y = o, i.e. whether

cov [VW(p, W), Pi -P] (2 I)

is positive or negative. Tchebychev's inequality

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 I989] LUXURY AND NECESSITY 849

whether the marginal utility of income is increasing in the price, which from
(i9) just depends upon whether the good is a luxury or necessity in the sense
which we have proposed here. Moreover, we are able to conclude that a
consumer is likely to buy short (hedge in) necessities and sell short (speculate
in) luxuries. This seems to be an intuitively acceptable consequence of our
definition.
This paper has proposed a definition of luxury and necessity for cardinal
utility functions. We have shown how it may sometimes enlighten models of
intertemporal choice and situations with price risk. These and, one hopes,
further applications suggest that the definition may be a useful addition to the
economist's vocabulary.

All Souls College, Oxford and Woodrow Wilson School, Princeton

Date of receipt offinal typescript: January I989

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