Prices and welfare
What is the welfare effect of a price change? This simple question is one of the most relevant and controversial questions in microeconomic theory and its different answers can lead to severe heterogeneity in empirical results. This paper returns t...
| Main Authors: | , |
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| Format: | Working Paper |
| Language: | English en_US |
| Published: |
World Bank, Washington, DC
2016
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| Subjects: | |
| Online Access: | http://documents.worldbank.org/curated/en/2016/02/25927341/prices-welfare http://hdl.handle.net/10986/23897 |
| Summary: | What is the welfare effect of a price
change? This simple question is one of the most relevant and
controversial questions in microeconomic theory and its
different answers can lead to severe heterogeneity in
empirical results. This paper returns to this question with
the objective of providing a general framework for the use
of theoretical contributions in empirical works, with a
particular focus on poor people and poor countries. Welfare
measures (such as Equivalent Variation or Consumer's
Surplus) and computational methods (such as Taylor's
approximations or the Vartia method) are compared to test
how these choices result in different welfare measurement
under different price shock scenarios. As a rule of thumb
and irrespective of parameter choices, welfare measures
converge to approximately the same result for price changes
below 10 percent. Above this threshold, these measures start
to diverge significantly. Budget shares play an important
role in explaining such divergence, whereas the choice of
demand system has a minor role. Under standard utility
assumptions, the Laspeyers and Paasche variations are always
the outer bounds of welfare estimates and consumer surplus
is always the median estimate. The paper also introduces a
new simple welfare approximation, clarifies the relation
between Taylor's approximations and the income and
substitution effects, and provides an example for treating
nonlinear pricing. Stata codes for all computations are
provided in annex. |
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