Welfare and Output with Income Effects and Taste Shocks

Abstract

We present a unified treatment of how welfare responds to changes in budget sets or technologies with taste shocks and non-homothetic preferences. We propose a welfare metric that ranks production possibility frontiers that differs from one that ranks budget sets, and characterize it using a general equilibrium generalization of Hicksian demand. This extends Hulten’s theorem, the basis for constructing aggregate quantity indices, to environments with non-homothetic and unstable preferences. We illustrate our results using both long- and short-run applications. In the long run, we show that if structural transformation is caused by income effects or changes in tastes, rather than substitution effects, then Baumol’s cost disease is twice as important for our preferred measure of welfare. In the short run, we show that standard chain-weighted deflators understate welfare-relevant inflation for current tastes. Finally, using the Covid-19 recession we illustrate that chain-weighted real consumption and real GDP are unreliable metrics for measuring welfare or production when there are taste shocks.