Welfare and Output with Income Effects and Taste Shocks

92 Pages Posted: 10 May 2021 Last revised: 5 Feb 2022

See all articles by David Baqaee

David Baqaee

London School of Economics and Political Science, Department of International Development, Students

Ariel T. Burstein

University of California, Los Angeles (UCLA) - Department of Economics

Date Written: May 2021

Abstract

We characterize how welfare responds to changes in budget sets and technologies when preferences are non-homothetic or subject to shocks, in both partial and general equilibrium. We generalize Hulten’s theorem, the basis for constructing aggregate quantity indices, to this context using a general-equilibrium formulation of Hicksian demand. We show how to calculate the response of welfare to a shock using only knowledge of expenditure shares and elasticities of substitution (and not of income elasticities and taste shocks). We also characterize the gap between welfare and chain-weighted indices. We apply our results to long- and short-run phenomena. 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 (equivalent variation at final preferences). In the short-run, we show that standard deflators understate welfare-relevant inflation because product-level demand shocks are positively correlated with price changes. Finally, using the Covid-19 recession we illustrate the differences between partial and general equilibrium notions of welfare, and show that real consumption and real GDP are unreliable metrics for measuring welfare or production.

Suggested Citation

Baqaee, David and Burstein, Ariel T., Welfare and Output with Income Effects and Taste Shocks (May 2021). NBER Working Paper No. w28754, Available at SSRN: https://ssrn.com/abstract=3842729

David Baqaee (Contact Author)

London School of Economics and Political Science, Department of International Development, Students ( email )

London
United Kingdom

HOME PAGE: http://sites.google.com/site/davidbaqaee/

Ariel T. Burstein

University of California, Los Angeles (UCLA) - Department of Economics ( email )

Box 951477
Bunche Hall 8365
Los Angeles, CA 90095-1477
United States
310-206-6732 (Phone)
310-825-9528 (Fax)

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