Consumption Equivalence_Welfare analysis

Hi,

I am trying to proceed with a welfare analysis.

I have estimated the values of consumption equivalence for the 2 regimes as well as the values from the welfare equations, however i am not sure whether i need to compare the values of consumption equivalent or welfare values and determine the optimal policy.

I read in previous posts that the change of sign matters, but for example in my case both regimes have negative sign for consumption equivalent. Which is the best policy, the one with the lower negative value?

Morever, does the values of welfare or consumption equivalence have an interpretetion on their own?

Hi mikegouv,

Let superscript p denote the benchmark policy and ap denote the alternative state of policy, and E be the unconditional mathematical expectation sign and assume log utility.
Formally, \xi must satisfy

E\left\lbrace \sum_{i=0}^{\infty}\beta^{i}U\left(C_{t+i}^{p}\left(1+\xi\right),\cdot\right)\right\rbrace \equiv E\left[W_{t}^{p}\left(\xi\right)\right]=E\left[W_{t}^{ap}\right]\equiv E \left\lbrace \sum_{i=0}^{\infty}\beta^{i}U\left(C_{t+i}^{ap},\cdot\right)\right\rbrace

Solving for \xi yields

\xi=\exp\left(\left(1-\beta\right)\left(E \left[W_{t}^{ap}\right]-E\left[W_{t}^{p}\right]\right)\right)-1

In order to derive a meaningful interpretation of welfare improvement, gains and losses of the agent are expressed in terms of consumption equivalent (CE) variation, that is, the maximum fraction of consumption \xi that the agent would be willing to forgo in an economy p to join the economy in which ap is active. Or, differently worded, the amount of consumption the agent would require to be indifferent between staying in the economy p and joining the economy ap.

Imagine the alternative economy is the one with highest welfare. If this is the case, you will have a positive CE. The implication is that you would require \xi \cdot 100 percent of consumption each period to be willing to remain in the p economy.
Imagine the benchmark economy is the one with highest welfare. If this is the case, you will have a negative CE. The implication is that you would be willing to give up \xi \cdot 100 percent of consumption each period to remain in the p economy.

@cmarch thank you very much for your help, it is really supportive.

Just one more thing to clarify. In a couple of papers the consumption equivalents are expressed as:

ξ= 1- exp((1-β)(E[W_ap] - E[W_p]))

instead of ξ= exp((1-β)(E[W_ap] - E[W_p])) -1

Is there any particular reason? Because the results are quit different in terms of the sign

I am not aware of such papers, so I do not know the reason why they provided such and expression.
But start from the condition that \xi must satisfy: E[W^{p}_t(\xi)]=E[W^{ap}_t]. With log utility in consumption, you will have that
E[W^{p}_t(\xi)]=\frac{1}{1-\beta}ln(1+\xi)+E[W^{p}_t].
Hence, he condition that \xi must satisfy is
\frac{1}{1-\beta}ln(1+\xi)+E[W^{p}_t]=E[W^{ap}_t]
Re-arrange to have
ln(1+\xi)=(1-\beta)(E[W^{ap}_t]-E[W^{p}_t])
The base of the natural log is e, so
1+\xi=exp((1-\beta)(E[W^{ap}_t]-E[W^{p}_t]))
And finally
\xi=exp((1-\beta)(E[W^{ap}_t]-E[W^{p}_t]))-1
Hopefully having broken down the expression of the CE in such fashion will make it easier for you to see what is going on in those papers

@cmarch thank you very much for your help.
it is really illustrative and hopefully i will manage to solve it.

However, i would like to ask one more thing. In one of the simulations i make i get the value of consumption equivalence i.e 178.43. As discused above shouldn’t the value of ξ be less than 1 in order to multiply it with 100 and have the interpretation you where saying? Because i suppose that the 178.43 value do not have an interpretation.

In the literature, values of \xi\cdot100 percent are usually around >1 percent of consumption each period, and often far less.

A value of more than 1, i.e. 100 in percent does not make sense as consumption would be negative. So there must be a mistake in your computations.