PART II - DISTRIBUTION

Summary

Correctly conceived, changes in real income are changes in the level of subjective well-being. Since this well-being cannot be observed, the obvious measure has been changes in the goods and services that can be consumed. The increase in real income consequent upon a fall in the price of a good or service is then the amount by which money income can be reduced while leaving unchanged well-being as measured by a particular bundle of consumption goods. This figure is the original money income minus the product of the original money income and a price index.

The Laspeyres price index (chapter 6) evaluates the reduced cost of buying the former consumption basket at the new prices relative to the old. The Paasche price index measures the reduced cost of buying the new bundle of goods. In general these two indices will give different results. When prices move in opposite directions, the two indices can also move inversely.

In figure II.1 the fall in the price of X shifts the budget constraint outwards along the X axis. Consumption bundle A is replaced by consumption bundle B. The Laspeyres index is represented by the broken line drawn through A, parallel to the new budget line.