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A unified approach to estimating demand and welfare

Redding, Stephen J. and Weinstein, David E. (2016) A unified approach to estimating demand and welfare. CEP Discussion Paper (1445). Centre for Economic Performance, London School of Economics and Political Science, London, UK.

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Abstract

The measurement of price changes, economic welfare, and demand parameters is currently based on three disjoint approaches: macroeconomic models derived from time-invariant utility functions, microeconomic estimation based on time-varying utility (demand) systems, and actual price and real output data constructed using formulas that differ from either approach. The inconsistencies are so deep that the same assumptions that form the foundation of demand-system estimation can be used to prove that standard price indexes are incorrect, and the assumptions underlying standard exact and superlative price indexes invalidate demand-system estimation. In other words, we show that extant micro and macro welfare estimates are biased and inconsistent with each other as well as the data. We develop a unified approach to demand and price measurement that exactly rationalizes observed micro data on prices and expenditure shares while permitting exact aggregation and meaningful macro comparisons of welfare over time. We show that all standard price indexes are special cases of our approach for particular values of the elasticity of substitution, constant preferences for each good, and a constant set of goods. In contrast to these standard index numbers, our approach allows us to compute changes in the cost of living that take into account both changes in the preferences for individual goods and the entry and exit of goods over time. Using barcode data for the U.S. consumer goods industry, we show that allowing for the entry and exit of products, changing preferences for individual goods, and a value for the elasticity of substitution estimated from the data yields substantially different conclusions for changes in the cost of living from standard index numbers.

Item Type: Monograph (Discussion Paper)
Official URL: http://cep.lse.ac.uk/
Additional Information: © 2016 The Authors
Divisions: Centre for Economic Performance
Subjects: H Social Sciences > HN Social history and conditions. Social problems. Social reform
JEL classification: D - Microeconomics > D1 - Household Behavior and Family Economics > D11 - Consumer Economics: Theory
D - Microeconomics > D1 - Household Behavior and Family Economics > D12 - Consumer Economics: Empirical Analysis
E - Macroeconomics and Monetary Economics > E0 - General > E01 - Measurement and Data on National Income and Product Accounts and Wealth
E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level; Inflation; Deflation
Sets: Research centres and groups > Centre for Economic Performance (CEP)
Date Deposited: 09 Sep 2016 14:39
Last Modified: 15 Oct 2019 23:28
Funders: Economic and Social Research Council, Economic and Social Research Council
URI: http://eprints.lse.ac.uk/id/eprint/67681

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