Prices and Welfare

An Introduction to the Measurement of Well-being when Prices Change

Abdelkrim Araar, Paolo Verme

• Publisher: Palgrave Pivot
• Year: 2019
• Print ISBN:
  9783030174224
• eBook ISBN:
  9783030174231
• Topic: Economics
• Subtopic: Development Economics
• Index: Economics

This book provides a general framework for the use of theoretical contributions in empirical works, addressing the question of what is the effect of a price change on household well-being. This simple question is one of the most relevant and controversial questions in microeconomic theory and one of the main sources of errors in empirical economics. In particular, this book aims to 1) Review the essential microeconomics literature since the first seminal papers by Hicks in the 1930s; 2) Organize and simplify this literature in a way that can be easily used by analysts with different backgrounds providing algebraic, geometric and computational illustrations; 3) identify and measure the essential differences across methods and test how these differences affect empirical results; 4) Provide guidelines for the use of alternative approaches under imperfect information on utility, demand systems, elasticities and more generally incomes and quantities; 5) Provide computational codes in Statafor the application of all methods. The focus of the book is on developing economies and the poor, and the assumptions made will relate primarily to these countries and group of people, presumably the main policy focus of international organizations and national governments.

© The Author(s) 2019

Abdelkrim Araar and Paolo VermePrices and Welfarehttps://doi.org/10.1007/978-3-030-17423-1_1

Begin Abstract

1. Introduction

Abdelkrim Araar¹ and Paolo Verme²

(1)

Pavillon J. A. De Sève, Office 2190, Laval University, Quebec, QC, Canada

(2)

The World Bank, Washington DC, USA

Paolo Verme

Email: [email protected]

Keywords

Consumer pricesWelfare measurementsCost of living indexes

End Abstract

In economics, there are two established traditions for the measurement of individual utility, well-being or welfare.¹ The first tradition pioneered by Edgeworth (1881) argues that utility can be measured directly with a “hedonimeter” capable of capturing the physiological phenomenon of happiness. This tradition enjoyed very few followers until the emergence and establishment of happiness economics and prospect theory, two relatively new strands of the economics literature that attempt, in different ways, to directly measure utility. The happiness literature tends to measure happiness with subjective questions on happiness and life satisfaction. The prospect theory literature has measured utility, for example, with the measurement of physiological pain.

The second tradition pioneered by Fisher (1892) argues that utility cannot be measured directly in any sensible way and that it is necessary to derive utility indirectly from the observation of behavioral choices.² If we assimilate Paul Samuelson’s theory of revealed preferences with this tradition, we can then argue that this has been the prevalent welfare theory taught in economics over the past century. Interestingly, while Bentham himself equated happiness with utility (as in the happiness literature), he also thought that utility was embedded in objects (as in the revealed preferences literature):

By utility is meant that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or happiness, (all this in the present case comes to the same thing) or (what comes again to the same thing) to prevent the happening of mischief, pain, evil, or unhappiness to the party whose interest is considered (p. 2, Bentham ([1789]1907)).

This book focuses on changes in welfare derived from changes in prices following the second tradition of indirect welfare measurement. The main purpose is to estimate the difference in welfare that derives from the choice of different welfare measures and clarify the key factors that determine such differences. We consider five measures (henceforth called “welfare measures”) that have been proposed by the microeconomics literature to measure welfare changes since the seminal paper by Hicks (1942): (1) consumer’s surplus variation (CS for short), (2) compensating variation (CV ), (3) equivalent variation (EV ), (4) Laspeyres variation (LV ) and (5) Paasche variation (PV ).

Building on previous contributions, we aim to (1) review the essential microeconomics literature; (2) organize and simplify this literature in a way that can be easily understood by researchers and practitioners with different backgrounds providing algebraic, geometric, computational and empirical illustrations; (3) identify and measure the essential differences across methods and test how these differences affect empirical results; (4) provide guidelines for the use of alternative approaches under imperfect information on utility, demand systems, elasticities and more generally incomes and quantities; and (5) provide computational codes in Stata for the application of all welfare measures and computational methods.

While the theoretical literature regularly offers excellent review papers on the topic (see, e.g. Harberger (1971); King (1983); Slesnick (1998) and Fleurbaey (2009)), we believe that this literature remains short of providing simple guidelines for practitioners. On the other hand, the empirical literature, which is very rich and varied, remains short of explaining clearly the microeconomic foundations that justify the choice of one welfare measure over another. Our main goal is to bridge these two traditions and fill these gaps in an effort to serve practitioners working with micro data, particularly those focusing on poor countries and poor people. Presumably, measuring the impact on welfare due to price changes is of interest to the policy maker for social and distributive policies. The impact of price changes on the rich is typically small in relative terms and less of a concern than the impact on the middle class or the poor. Hence, our focus on the poor.

We will follow what is sometimes called the “marginal approach”. This is the estimation of direct effect of a price change on welfare keeping the nominal budget constraint or income constant. Price changes can eventually affect incomes of producers and other agents, and these effects can be important (see, e.g. Ravallion (1990) and Jacoby (2015)). However, this complicates substantially our analysis, and we opted to exclude income, supply, partial or general equilibrium effects from the book. We will therefore follow the more common tradition of the marginal approach as in Ahmad and Stern (1984, 1991), Creedy (1998, 2001), Deaton (1989), Minot and Dewina (2013) and Ferreira et al. (2011). See also Creedy and van de Ven (1997) on the impact of marginal changes in food subsidies on Foster, Greer and Thorbecke (FGT) poverty indexes.

The book will cover a range of computation methods (henceforth called “welfare computations”) that have been proposed by the literature over the years including methods based on different demand systems, Taylor approximations, the Vartia method, the Breslaw and Smith method, ordinary differential equations methods and a simple method based on knowledge of elasticity. There are of course many more methods proposed by the literature and evidence on how these methods perform. Hausman and Newey (1995), for example, derive estimates of demand curves and the consumer surplus applying non-parametric regression models. Banks et al. (1996) derive second-order approximations of welfare effects and show how first-order approximations can produce large biases by ignoring the distribution of substitution effects. In this book, we restrict the analysis to the most popular methods cited above.

With respect to computation methods, our contribution is to clarify the relation between the five measures initially introduced by Hicks and their computation methods. Some authors may argue that some of the computation methods we discuss such as Taylor’s approximations of a certain degree are welfare measures themselves and different from the five measures listed above. In this work, we will clarify the distinction between core measures and computation methods. In addition, we clarify the decomposition of higher-order Taylor’s approximations in substitution and income effects and propose a simple computation method based on known elasticities.

The book does not focus on the analysis or construction of demand systems. This literature is rather vast and offers several alternatives. One of the critiques to simple linear expenditure systems was that they fail to consider the Engel law, the variation of the income-expenditure relation across the income distribution. Muellbauer (1976), Deaton and Muellbauer (1980a,b) and Jorgenson et al. (1982) contributions helped to place the Working-Leser Engel curve specification within integrable consumer theory, thereby starting to address this issue. Recent empirical work has shown that the popular AID system does not take into consideration the full curvature of the Engel curve. Banks et al. (1997) showed that Working-Leser Engel types of curves may be insufficient to describe consumption behavior across income groups. They derive a demand model based on an integrable quadratic logarithmic expenditure share system and show that this model fits UK data better than the Working-Leser Engel types of models, particularly for selected commodities. Blundell et al. (2007) later showed that behavior changes across different types of goods with some goods approaching a linear or quadratic shape while others having different forms. More recently, Lewbel and Penda...

Table of contents

• Cover
• Front Matter
• 1. Introduction
• 2. Assumptions and Measures
• 3. Theory and Computation
• 4. Empirical Applications
• 5. Conclusion
• Back Matter