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A Unified Approach To Estimating Demand And Welfare Changes

Speaker(s) **
Prof. David E Weinstein, Columbia University and NBER**
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ABSTRACT
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The measurement of price changes, economic welfare, aggregate parameters, and demand patterns 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 mutually inconsistent, and neither is consistent with 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 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 demand 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, changes in demand 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.

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