2015's Nobel prize-winning economist has practical punch

This year's Nobel memorial prize in economic sciences was awarded to Princeton economist Angus Deaton. The Scotland-born Deaton won the award, officially called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, based on his wide-ranging work.

It includes research on how consumers alter their spending plans in response to changes in prices or in economic policy, the factors determining how households split their income between consumption and saving, and how to measure poverty levels and well-being (what economists call "welfare") across countries with widely varying economic conditions.

Why should a typical household care about this work, which on the surface sounds rather esoteric? Consumption is an important determinant of household welfare, and Deaton's work on consumption is essential for understanding how consumers of various types will respond to a policy change such as a reduction in taxes.

Prior to Deaton's work, economists understood that the consumption of a particular good is affected by the price of other goods. For example, an increase in the price of chicken can alter the consumption of hamburger. But how to formulate a theoretical model that can account for these kinds of interactions across goods hadn't been satisfactorily resolved. Deaton, along with economist John Muellbauer, found a solution to this problem.

Deaton also showed how to reliably estimate these models and use them for policy evaluation. This important advance has allowed policymakers to make much more informed decisions about how changes in a particular policy will affect different categories of households.

Deaton's second contribution, regarding how consumers split their income between consumption and savings, follows from his work on household consumption. Changes in household saving have important consequences for business investment and homebuilding. That's because banks pool household savings and use it to fund investment projects, housing developments and other types of loans.

In addition, changes in saving -- for example, a sudden increase in saving by households worried about a recession -- can lower GDP and employment if those extra savings cannot be quickly channeled into productive investment.

Understanding how and why consumers change their saving behavior is important information for monetary and fiscal policymakers trying to stimulate consumption and lift an economy out of a recession. Deaton's contribution was in finding a way to reconcile conflicting results from studies of individual household consumption and saving and studies of aggregate consumption and saving. That might not seem like a big addition to economic thinking, but it was a key factor in allowing economists to better understand these important issues.

The last contribution the Nobel committee noted is Deaton's work on measuring and analyzing welfare, or well-being, which is particularly important for evaluating economic conditions and changes in policy in developing countries. How do you compare conditions across countries with very different consumption patterns and variables such as the percentage of the population living in poverty?

Simply comparing average consumption across countries using exchange rates to compare prices and consumption patterns is insufficient because preferences across countries differ. Just because households in the two countries consume different bundles of goods, on average, doesn't mean households in one country are necessarily better off than the other. Do the consumption patterns differ because of different preferences, or because the price of an essential good is higher in one country than the other?

Sorting this out is very difficult.

To make it even harder, some goods aren't traded at all. Exchange rates reflect only the prices of traded goods, but services -- an important component of consumption in developing countries -- generally aren't tradable.

Deaton showed how to develop price indexes that allow these comparisons to be made. His work was instrumental for answering questions about the extent of poverty and how policy interventions can best help emerging economies overcome their poverty and economic development problems.

Past Nobel prizes for economics have often been awarded for important theoretical contributions whose practical application to real-world problems hasn't been fully developed or it isn't entirely clear. Deaton has certainly made his share of theoretical contributions, but what sets him apart is how his work can be used to solve important economic and social problems in the real world.