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How to measure living standards and productivity

Oulton, Nicholas (2009) How to measure living standards and productivity. CEP Discussion Paper, No. 949. Centre for Economic Performance, London School of Economics and Political Science, London, UK.

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Abstract

This paper sets out a general algorithm for calculating true cost-of-living indices or true producer price indices when demand is not homothetic, i.e. when not all expenditure elasticities are equal to one. In principle, economic theory tells us how we should calculate a true cost-of-living index or Konüs price index: first estimate the consumer's expenditure function (cost function) econometrically and then calculate the Konüs price index directly from that. Unfortunately this is impossible in practice since real life consumer (producer) price indices contain hundreds of components, which means that there are many more parameters than observations. Index number theory has solved this problem, at least when demand is homothetic (all income elasticities equal to one). Superlative index numbers are second order approximations to any acceptable expenditure (cost) function. These index numbers require data only on prices and quantities over the time period or cross section under study. Unfortunately, there is overwhelming evidence that consumer demand is not homothetic (Engel's Law). The purpose of the present paper is to set out a general algorithm for the nonhomothetic case. The solution is to construct a chain index number using compensated, not actual, expenditure shares as weights. The compensated shares are the actual shares, adjusted for changes in real income. These adjustments are made via an econometric model, where only the responses of demand to income changes need to be estimated, not the responses to price changes. This makes the algorithm perfectly feasible in practice.

Item Type: Monograph (Discussion Paper)
Official URL: http://cep.lse.ac.uk/
Additional Information: © 2009 The author
Library of Congress subject classification: H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: C - Mathematical and Quantitative Methods > C4 - Econometric and Statistical Methods: Special Topics > C43 - Index Numbers and Aggregation
D - Microeconomics > D1 - Household Behavior and Family Economics > D12 - Consumer Economics: Empirical Analysis
O - Economic Development, Technological Change, and Growth > O4 - Economic Growth and Aggregate Productivity > O47 - Measurement of Economic Growth; Aggregate Productivity; Cross-Country Output (Income) Convergence
E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level; Inflation; Deflation
D - Microeconomics > D2 - Production and Organizations > D24 - Production; Cost; Capital and Total Factor Productivity; Capacity
D - Microeconomics > D1 - Household Behavior and Family Economics > D11 - Consumer Economics: Theory
I - Health, Education, and Welfare > I3 - Welfare and Poverty > I31 - General Welfare; Basic Needs; Living Standards; Quality of Life; Happiness
Sets: Collections > Economists Online
Research centres and groups > Centre for Economic Performance (CEP)
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: No. 949
Date Deposited: 16 Jul 2010 15:01
URL: http://eprints.lse.ac.uk/28678/

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