Dear Prof. Pfeifer,
I would like to ask a question about the magnitude of the welfare effect of a policy.
When I calculate the short-run percentage decrease of steady-state consumption which makes the household indifferent between implementing and not implementing a product market reform in my model, I find this value to be about 30%.
This seems unusually high to me (most of the welfare loss values I have come across are below 5%). In addition, I find that this result is driven by the addition of a ‘disutility of labour’ term (
chi*(1-u_SS)^2/2) into a utility function of the form
log(c). In the absence of this disutility term, the short-run welfare loss is about 3%. This terms reduces the value of the period utility function enough to create this effect.
I wanted to ask for your opinion on whether this result makes sense? Many thanks
What is the economic intuition here? Are hours worked so different?
Dear Prof. Pfeifer,
Thanks for your reply. There is no hours worked. The ‘disutility of labour’ term (
chi*(1-u)^2/2) refers to disutility from employment (1 - u). I am trying to understand why the welfare effect with this term differs so drastically with a utility function of log© form which does not have this disutility from employment effect.
The result of this is that the short-run consumption loss from implementing the policy is 30% of steady-state consumption in the model with the disutility term (and about 3% in the model without).
The explanation for this appears to be that in the
utility = log(c) - chi*(1-u)^2/2 model, unemployment falls by about 1.1 percentage points in the short-run (12 quarters from implementation of the policy). This fall in unemployment affects welfare (an effect which is absent with
log (c) utility).
I just wonder whether the consumption loss when a disutility term is included in the utility function is incredible. It seems like quite a large difference owing only to the effect of unemployment.
I wondered your thoughts on this?
If all your computations are correct, then this is a feature of your economic model. I find the number a bit too high, but I am not surprised that a policy that stabilizes employment might have bigger welfare effects if unemployment is considered. Of course, results will very much depend on the weight
chi you give to employment.