Must-Read: Stephen J. Redding and David E. Weinstein>: What Big Data Tells Us About Real Income Growth

Must-Read: I think this by Stephen J. Redding and David E. Weinstein looks likely to be brilliant!

The difference between the cluster of standard price indices and the CG-UPI is the wedge produced by what Redding and Weinstein call “consumer valuation bias”–the fact that standard price indices miss the fact that when a commodity’s price rises because of a demand shift the fact of that demand shift means that the commodity is delivering more utility. The difference between the CG-UPI and the Unified Price Index itself is, if I understand what is going on, the effects of Feenstra (1994) variety-adjustment terms.

2%/year of consumer valuation bias and 4%/year of Feenstra variety-adjustment terms are not too shabby…

Of course, the foundations of this are built on sand. The assumption is that a taste change does not diminish your true utility, but rather opens up opportunities to increase your utility above its previous level by shifting consumption toward the commodities you know like more. Thus if today you decide you like cheeseburgers more than lapin au vin and shift consumption toward cheeseburgers your utility goes up, and then if tomorrow you decide you like lapin au vin more than cheeseburgers and shift consumption toward lapin au vin your utility goes up again, leaving you the day after tomorrow with the same consumption bundle you had yesterday, but with higher utility.

Taste shifts that bring your preferences into better accord with ευδαιμοια might bear such an interpretation. Taste shifts that random-walk or mean-revert, I believe, cannot.

Stephen J. Redding and David E. Weinstein: What Big Data Tells Us About Real Income Growth:

The problem is not that we don’t know how to convert nominal expenditures into welfare; it is that we know too many ways of doing it…

Macroeconomists typically assume… taste parameters never shift, so the utility function is constant… in order to derive a ‘money-metric’ utility function…. Applied microeconomists… assum[ed] that there are time-varying demand and supply curves…. The existence of these time-varying demand curves is inconsistent with the macroeconomist’s idea that taste parameters are fixed…. Actual price and real output data is constructed by statistical agencies using formulas that differ from either approach…. 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 price indexes invalidate demand-system estimation….

Our index enables us to identify a novel form of bias that arises from the assumption of time-invariant demand…. ‘Consumer valuation bias’ arises whenever expenditure shares respond to demand shifts…. If higher consumer demand causes prices to rise, a conventional index will overstate cost-of-living changes because it will not adjust for the fact that some of the price increase is offset by the higher utility per unit associated with the demand shift…. The consumer valuation biases in existing indexes appear to be quite substantial, suggesting that allowing for demand shifts is an economically important force in understanding price and real income changes. We can see these differences at the aggregate level in Figure 2….

The Fisher, Törnqvist and Sato-Vartia result in almost identical changes in the cost of living that are bounded by the Paasche and Laspeyres indexes…. All assume no demand shifts for any good. The distance between the Sato-Vartia index and the Common-Goods Unified Price Index tells us the importance of the consumer valuation bias…. The distance between the Sato-Vartia and the Feenstra-CPI indicates the value of the adjustment for changes in variety…