Rags and Riches: Relative Prices, Non-Homothetic Preferences, and Inequality in India

It is well known that consumption patterns change with income. Relative price changes would therefore affect rich and poor consumers differently. Yet, the standard price indices are not income-specific, and hence, they cannot account for such differences. In this paper, we study consumption inequality in India, while fully allowing for non-homotheticity. We show that the relative price changes during most of the period from 1993 to 2012 were pro-poor, in the sense that they favored the poor relative to the rich. As a result, we also find that conventional measures significantly overstate the rise in real consumption inequality during this period. The main lesson from our study is the importance of accounting for non-homotheticity when measuring inequality. The price index literature has, as of yet, paid relatively little attention to this. In our application, however, it turns out that the allowance for non-homotheticity is quantitatively much more important than much discussed adjustments, such as those for substitution in consumption.