PURCHASING POWER

In economics, 'purchasing power' refers to the amount money — or, more generally, liquid assets — can buy. As Adam Smith noted, having money gives one the ability to "command" others' labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money.
If money income stays the same, but the price level increases, the purchasing power of that income falls. Inflation does not ''always'' imply falling purchasing power of one's real income, since one's money income may rise faster than inflation.
For a price index, its value in the base year is usually normalized to a value of 100 in the base year. The formula for purchasing power of a unit of money, say a dollar, relative to a standard price index ''P'' in a given year is 1/(P/100). So, by definition the purchasing power of a dollar decreases as the price level rises.

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Allocation of goods by purchasing power

See also

Allocation of goods by purchasing power

Relative purchasing power is the basis of the market allocation of goods underlying Capitalism. This should be contrasted with possible non-market allocation mechanisms such as rationing, needs-based allocation, or corrupt favouritism (cronyism and no-bid contracts).
As an example suppose a country produces enough food to supply 3200 kcal/day per person (the per capita energy intake needed to avoid malnutrition is about 2500 kcal/day), and the upper, middle and lower classes comprise 5%, 15% and 80% of the population with per capita relative food purchasing powers of 10, 2 and 1 respectively. If the government decides to allow market forces to control distribution, the resulting allocation will be:

'Allocation of food by purchasing power'

Class	Fraction of population	Class purchasing power	Food value per person
Upper	5%	50	20,000 kcal/day
Middle	15%	30	4,000 kcal/day
Lower	80%	80	2,000 kcal/day
Overall	100%	160	3,200 kcal/day

Where the upper class would tend to consume higher-quality or luxury items (which use more resources and displaces other agriculture) rather than much larger amounts of staple foods. With a deficit of 500 kcal/day the lower class would be very malnourished, with starvation common. Even though the country has the potential to feed itself it will suffer a Malthusian crisis, inter-ethnic violence or even civil war unless the government or relief agencies intervene; however government intervention beyond minor post-disaster palliatives would "violate the free market" and might be forbidden by the IMF or the indigenous elite.
In the modern world this self-contained scenario is rarer since most economies are part of a wider international trading network. This brings even larger purchasing power inequalities into the (enlarged) marketplace and without protectionist measures the country may end up exporting cash crops while even the former middle class become malnourished. Because of these disastrous outcomes, even governments promoting the most radical free market policies implement agricultural or price subsidies or controls, or other socialist measures, for critical goods and services.

See also

★ Purchasing power parity

★ Consumer Price Index

★ Fair Trade

★ Free Trade