Teaching Note: REDISCOVERING LANCASTERS CONSUMPTION TECHNOLOGY

Siddhartha K. Rastogi
Assistant Professor Economics
Indian Institute of Management Indore
Background and Motivation
The classical demand theory is one of the most robust theories across different disciplines.
Over the years, it developed with important contributions from economists, mathematicians, and
statisticians alike. Some of the main contributors are Adam Smith, Jeremy Bentham, Jules Dupuit,
Edgeworth, Fisher, Alfred Marshall, David Ricardo, Walras, Pigou, Allen Hicks, Slutsky, Paul
Samuelson, Laplace, and Roy Harrod among others. However, despite all the strong theoretical
foundations, there are some problems of measurement and operationalization with the traditional
demand analysis.
The traditional theory addresses the problem of choice between two goods without
actually distinguishing the two goods. In words of Johnson (1958), it assumes that goods are
goods. Elaborating further, Lancaster (1966,a) asserts that those properties that make a diamond
different from a loaf of bread have been omitted from the theory and the only property, which the
theory can build on is the property shared by all the goods, which is simply that they all are
goods. Since the traditional theory begins with the preference diagram, there is no possibility left
for considering the properties or characteristics of goods, as they have already been swallowed up
in the preferences even before the analysis commences (Lancaster, 1971). With no theoretical
scope of how the properties or a change in properties may affect the preference map, traditional
analysis fails to provide any predictions as to how preferences may alter with a change in
characteristics of goods. Any change of any single property leads us to a whole new preference
map, implying we must throw away the previous analysis having a different set of goods on
preference map.
Another shortcoming of the traditional theory is the assumption of a representative
consumer, consuming the market basket. Therefore, variations in consumers tastes and
preferences are not accommodated and only a representative consumer deals with the whole
market. However, there is no consumer consuming all the goods in the market, which implies that
everyone is on a corner solution point and there is no tangency point. If that is the case, we cannot
have Marginal rate of substitution equating the price ratio of good X and good Y type situation,
since some consumers have basket X only and some have basket Y only. To avoid this, the
traditional theory assumes everybody consumes everything, which may not be the case.
Further, case of complete independence of goods, i.e. zero cross elasticity is possible in
reality but not under the ambit of traditional theory. It is not explained by the theory as why the
goods are substitutes or compliments for each other. In the traditional theory, it is taken as given
by the consumers preferences rather than an inherent property of the goods themselves. This is a
subjective determination of relative goods, whereas we require an objective criterion because
complement goods for one consumer may be substitute goods for another and completely
unrelated for another.
Gravelle & Rees (1998) point out another shortcoming of the traditional theory by
pointing out the role of advertising. They assert that in the traditional theory, if advertising
changes a consumers demand function, it must do so by changing the preferences of the
consumer in some way. This then means that it is impossible to say whether the consumer is
better off or worse off as a result of advertising, since we can make welfare comparisons for a

consumer with reference to a fixed set of preferences. This implies that we cannot discuss the
resource allocation implications of advertising.
These shortcomings of the traditional theory render the measurement, operationalization,
and comparisons nearly impossible. This gave rise to some new approaches for demand analysis.
For example, consideration of time as a consumption good, entering the preference map of
consumers (Becker, 1965) and Lancasters consumption technology, which is based on choosing
the characteristics of goods rather than assuming goods as goods. In this paper, we look into
Lancasters approach in detail.
Lancasters Consumption Technology
The major technical novelty of this approach lies in breaking away from the traditional
approach of treating goods as direct object of utility and supposing that it is the properties or
characteristics of the goods from which utility is derived. Lancaster (1966,a) puts consumption as
an activity in which goods, singly or in combination, are inputs and in which the output is a
collection of characteristics.
Since all the limitations of the traditional approach are based upon the information content
of products, the key here is to define the product independent of a consumer and his tastes and
preferences. Although it implies a backdoor entry of the consumers tastes and preferences, as we
try to assess the relevant characteristics for a group of consumers, for consumer preferences
define which attributes of goods may properly be considered characteristics (Triplett, 1973). Also
that if we consider more number of consumers, the characteristic relevance vector changes;
however, within the framework, we need not to change anything every time a new product is
added to the consumption basket. Although this theory would face the similar problems in dealing
with new characteristics as the traditional theory faces with new goods but one of the basic
observations is that characteristics are much more stable and unvarying than goods.
Assumptions
The basic assumptions of this approach are quite simple and need not any elaboration.
These four assumptions are a linear relationship between goods and characteristics; an additive
relationship between goods and characteristics; all characteristics are quantitative and objectively
measurable, and; every characteristics has a non-negative marginal utility. As we can observe,
these assumptions are perfectly valid in the classical demand theory as well. Further, these
assumptions do not create any curtain between theory and empirical analysis and rather facilitate
such analysis.
The Basic Model
Ratchford (1975) define the Lancaster Model very succinctly in the following words A
consumer maximizes an ordinal preference function for characteristics, U(z), where z is a vector
of characteristics 1,2,r, subject to the usual budget constraint pxK, where p is a vector of
prices for each of these goods and K is income. Goods, x, are transformed into characteristics, z,
through the relation z = Bx, where B is an rXn matrix which transforms the n goods into r
characteristics.
In this model, the transformation matrix B defines the consumption technology, which is
assumed to be objective in the sense that it is the same for all consumers. The flexibility is more
in Lancasters approach than in the traditional demand analysis framework, as the transformation

matrix of this model can be used to represent cases in which several goods are capable of
producing one characteristic (more than one element in each row of B may be nonzero), and
several characteristics are produced by one good (more than one element in each column of B
may be nonzero).
Represented geometrically through Figure 1, we show characteristics z1 and z2 on the
axis and 3 goods, x1, x2, x3, as different rays, depicting different amounts of those characteristics.
Mapping the budget constraint into characteristics space using the consumption technology
matrix, B, and the prices of goods gives us an efficiency frontier like x1, x2, x3 in Figure 1. For
an indifference map defined on characteristics z1 and z2, the optimal budget allocation may occur
on any of the extreme points x1, x2, x3, suggesting consumption of only one of the three goods or
on either of the facets [x1, x2] or [x2, x3]. The slopes of the facets are interpreted as implicit prices
for characteristics.

Figure 1: Indifference Map of Characteristics of Goods

Analysis and Interpretations
Note that no consumer would consume a combination of [x1, x3] as that leaves him on a
sub-optimal efficiency frontier. This is shown in Figure 2. Since consuming any combination of
positive amounts of [x1, x3] leaves the consumer on a lower efficiency frontier of dfc as compared
to the higher efficiency frontier dec, no rational individual would make such a choice. Figure 2
also shows that if good z becomes dearer while

Figure 2: Discovering Consumers Choices

other goods remain at the previous price level, the amount of characteristics that can be bought
through x2 by the budget constraint reduces and the consumer reaches a new alternative efficiency
frontier, shown in Figure 2 by the dotted line, dgc. In this changed scenario, the consumer
would again choose any combination of [x1, x3] or any corner point between x1 or x3. The
difference here from the previous case is that the consumer was unwilling to buy [x1, x3]
combination previously due to sub-optimality; whereas now, good x2 has fallen out of the
consideration set.
The above interpretation has substantive implications. It implies that individual preference
will determine consumers equilibrium point on the objective efficiency frontier. As described by
Hendler (1975), the existence of objective frontier makes it possible to distinguish between two
separate effects of any change in income or relative prices: 1) the efficiency substitution effect
resulting from a shift in the efficiency frontier, which is objective and independent of the
individual consumers preference function, and 2) the personal substitution effect which depends
on the individual preference function and is similar to the traditional substitution effect.
The first effect is universal and objective, is independent of the shapes of individual
consumers preference functions, and hence of the effects of income distribution. An aggregately
compensated relative price change combined with a redistribution of income may result in no
substitution effect in the aggregate. These two substitution effects are independent but their
effects might be reinforcing.
One fine point in the model is that number of goods in the consideration set can be at most
equal to the number of characteristics considered. This is simply in line with maintaining
orthogonality of the dimensions. In matrix terms, it is necessary to have a full rank matrix, to
make the inversion possible.
A major advantage of Lancasters model is that we need not to draw separate maps for all
the consumers. One mapping suffices for all consumers facing the same market conditions. The
universality condition of mapping, as proved by Lancaster (1971) is a consequence of the
following:
1. For consumers facing the same market conditions, the individual budget constraints pxK
differ only in the value of K, the income.
2. The goods characteristics relationship z = Bx is the same for all consumers.
3. Since linearity is one of the basic assumptions, it implies that the feasible sets of different
consumers are related by scalar expansion or contraction in proportion to the ratios of their
incomes.
Contributions
The above model makes many important contributions to the economic theory of
consumer behavior. Apart from providing some basic improvements over the traditional demand
analysis framework, such as handling the introduction of new goods or the disappearance of old
ones, and explaining the phenomena of goods being substitutes or complement to each other, the
following contributions are of major interest, especially from a multi-disciplinary point of view of
economics, marketing, and consumer-behavior:
1. The model explains the role of price in determining the demand for differentiated products,
which is not addressed by the traditional framework.

2. The model provides a framework, for estimating the sensitivity of demand to changes in the
relative prices of a product.
3. The model provides a perspective for models of brand share determination.
4. The model provides an explanation of the phenomenon of brand loyalty.
5. The model explains the role of advertising and in addition to marking clearly the contribution
of advertising, facilitates measurement of advertising effectiveness.
6. The model enables us to assess alternate scenarios relating to product innovation,
obsolescence, and co-existence of old and new products with static as well dynamic price
structure (Lancaster, 1966,b).
Some Illustrations of Application of Lancasters Model
The Lancaster model has not been exploited well. There is not much empirical work done
on the basis of this model despite its simplicity and ease of analysis. However, we may look at
some of the applications of the model into different studies for various purposes. Roberts (1975)
points out an application of the Lancaster Model in Portfolio analysis theory and notes a special
case in which a vector of goods has two characteristics, one desirable expected return on
portfolio, and one undesirable portfolio risk. He translates the model into portfolio framework
by putting some restrictions, like focusing of expected utility rather than on certain utility of a
basket of goods; making transformation matrix, B, from security space to characteristics space
non-linear for the risk measure in general; options of borrowing and of selling short allow
negative holdings of some securities, therefore, x is not restricted to non-negative values;
existence of risk-free securities is treated apart from the efficient set as it lacks one dimension of
the undesirable characteristic.
Ratchford (1979) develops a deterministic model and extends it to stochastic framework
later to understand that how much a consumer would be willing to pay for information. He raises
the research question that how much it would cost the consumer to make a sub-optimal choice
than making an optimal choice? The measurement suggested is the payment that the consumer is
willing to make for perfect information. The measure of monetary costs derived from the
Lancaster model has at least four potential uses, as described by Ratchford (1979): (1) as a
measure if choice accuracy, (2) as a means of measuring the cost to consumers of misperceptions,
(3) as a measure of potential gains to search, and (4) as a means of determining the social benefit
of new product innovations.
Mark et al (1981) employ the Lancaster model to test the characteristics hypothesis, using
survey data on beer consumption. They set out to test the revealed relevance to beer consumers of
five characteristics: price, quality, atmosphere, amenities, and location. The hypothesis is that a
consumer, faced with a consumption decision about drinking beer, would resolve it with reference
to this vector. They obtain the data using a modification of the Likert scale technique. After
testing for correlation, variance, and predictive power of the model, they conclude that a
technique, meaningful to consumers, can be derived. The restriction, however, is the dependence
of accuracy of results on large samples size. The model is found to have predictive and
forecasting power over market, group, and individual demand.
Concluding Remarks
The model presented by Lancaster is definitely an improvement over the traditional
demand theory, making the empirical analysis simpler and comparable over different alternative

realities. Albeit there are some shortcomings with this model, yet it presents a better tool of
analysis. However, the model is not well-propagated and not exploited to its potential. Hence,
there remains ample scope of studying and extending the model into different fields of scientific
knowledge.
References
Becker, G.S. (1965) A Theory of the Allocation of Time, The Economic Journal, 75 (299),
493-517.
Gravelle, H. and Rees, R. (1998) Microeconomics, II Edition, Longman, London & New
York.
Hendler, R. (1975) Lancaster's New Approach to Consumer Demand and Its Limitations, The
American Economic Review, 65 (1), 194-199.
Johnson, H.G. (1958) Demand Theory Further Revised or Goods are Goods, Economica, 25.
Lancaster, K.J. (1966,a) A New Approach to Consumer Theory, The Journal of Political
Economy, 74 (2), 132-157.
Lancaster, K.J. (1966,b) Change and Innovation in the Technology of Consumption, The
American Economic Review, 56 (1/2), 14-23.
Lancaster, K.J. (1971) Consumer Demand: A New Approach, Columbia University Press,
New York & London.
Mark, J.; Brown, F. and Pierson, B.J. (1981) Consumer Demand Theory, Goods and
Characteristics: Breathing Empirical Content into the Lancastrian Approach,
Managerial and Decision Economics, 2 (1), 32-39.
Ratchford, B.T. (1975) The New Economic Theory of Consumer Behavior: An Interpretive
Essay, The Journal of Consumer Research, 2(2), 65-75.
Ratchford, B.T. (1979) Operationalizing Economic Models of Demand for Product
Characteristics, The Journal of Consumer Research, 6 (1), 76-85.
Roberts, G.S. (1975) Communications - Lancaster's New Demand Theory: Its Application in
Portfolio Analysis, Journal of Economic Literature, 13 (1), 45.
Triplett, J.E. (1973) Review - Consumer Demand: A New Approach. By Kelvin Lancaster,
Journal of Economic Literature, 11(1), 77-81.