Angus Deaton Paradoxes: Understanding choices, consumption & demand

At least one of the Deaton’s paradoxes was solved by me, partially.

Angus Deaton, a week back got the Nobel in Economics for his work on a range of subjects, but I have picked up his work on understanding demand and consumption and how choices are made as his most potent contribution. He was son of a miner, who had a passion for education; Deaton moved from Mathematics to Economics, but his uncanny penchant for taking a dispassionate view on mathematical models and a passionate view on looking for evidence in data to solve worldly puzzles, went a long way in his approach to Economics. Let me start with two of his paradoxes.

Two of the most famous Deaton paradoxes are related to per capita consumption of food and the framing of these were possible because of his close association with India.

The first paradox is that large joint families showed lower per capita food consumption, which is a paradox as they would have intrinsic advantage over the smaller families as some of the public goods within the families would be better positioned in the case of the bigger families as common cooking arrangement, hands for cooking, housing itself etc., would make such allowances for more food consumption with the same income. However smaller families had higher per capita consumption. This is an unsolved paradox and it is striking example of how ordinary puzzles like these cannot be modeled by economic theories that easily. I would not attempt to solve this paradox, but my early memories in joint families is replete with images of my grandmother feeding five of us from the same plate of food, when we had to wait in turns to eat from her hands. Clearly each one of us ate less than what we would have if food was given in separate plates. Also large joint families have more children than individual families, which negate the common goods that large joint families enjoy.

The second paradox is that countries coming out of poverty, like India, showed increasingly lower per capita calorie consumption in food over decades. This paradox was somewhat attempted to be solved by Deaton himself, as he found that lower physical activity with growing income, together with higher cereal consumption led to the denouement, which however has not been accepted by the Governments of these countries.

Deaton made a striking observation in one of his papers, where he gave the example of high school student reunion after twenty five years and what would be the dispersion in income levels of all the students after twenty five years of career progression. What makes such a high dispersion when the same education and almost similar backgrounds should have had some bearing on the incomes of these people going forward; perhaps the answer lies in their seeking choices that have changed their destinies far more rapidly than one would have imagined. This connection between choices, consumption and income is what is central to Deaton’s work throughout the last three decades.

Deaton challenged the Milton paradigm of consumption smoothening by resorting to what he called, “good measure”; his penchant for looking at evidence as in data rather than ideological stances came of good stead. He proved with data that actually it was income smoothening that happened while consumption remained far more volatile; people in anticipation of income make far riskier choices in consumption.

Could it be true for businesses as well, after all businesses are a conglomeration of people choices? Would an anticipation of better business prospects propel businesses to take more risks when the going is good and make them far less risky when the going gets rough? This would partially explain why business cycles tend to be prolonged in their crests and troughs.

Demand theory has a lot to be attributed to the work of Angus Deaton, as he moved from Samuelson’s Revealed Preference Theory of Demand (choice for a combination reveals consumer preference) and his fundamental argument, "any good (simple or composite) that is known always to increase in demand when money income alone rises must definitely shrink in demand when its price alone rises.” The connection of price to demand led Deaton to move the vector of ‘price-quantity’ to be paired under a number of constraints; the most potent were budget constraints and quantity constraints. But linking demand to income and the cost function, which was initially proposed by Muellbauer, was moved by Deaton to the solving of many puzzles around demand and consumption.

Deaton will be remembered for his ability to integrate many of the approaches, for example in the area of housing where the earlier work focused on linking house prices to income, while the latter approach was to regress prices over various attributes like size of rooms, heating system, proximity to shops, transport etc. Integration and aggregation are two of the distinct contributions of Deaton in the area of demand and consumption.

What does a change in price do to the consumer demand and how much of that can be attributed to the income levels and how do different sections respond to price signals is a fascinating subject, thanks to Deaton’s exploration of the puzzles. He was the first to point out that per capita consumption was a blunt tool of reference as a change in price of milk by 10% would impact the consumption for the poor but would keep it unchanged to the economically sound.

Today’s world has to deal with iPhone6 and iPhone6s, and the price of these two appeals to the sensibilities of the more economically forward. Whether the price makes the right connection is a function of many known and unknown variables. By reading Deaton’s work, one would be compelled to think that some puzzles are far trickier than we think and as consumer has a limited window of attention with a number of constraints to deal with, marketers must be careful of what the target segment is and what is their income and aspiration. Financing of campaigns would do better if some of this understanding gets better.

Differentiation of a product is an attempt to topple the apple cart of demand theory as it is primarily aimed at deviating from a paired alternative. Preference will yield to the appealing tastes of something out of the ordinary, provided it can be just proximate to the pressures of constraints largely influenced by income. Propensity to consume will rise when a product differentiates and can simultaneously clear the price barrier set intuitively by the consumer. To aggregate this over millions of consumers would require more than the heuristics that we are so familiar with.

But successes happen regardless; their limited numbers reveal that they are more by accidents than otherwise.