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The Welfare Implications of Unobserved Heterogeneity

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  • Sarantis Tsiaplias

    (Melbourne Institute: Applied Economic & Social Research and Department of Economics, The University of Melbourne)

Abstract

Conditions are derived for relating household well-being functions to household utility. In particular, an isomorphic relationship between the equivalent incomes stemming from subsistence-based utility functions and well-being functions is established. This allows estimates from standard models of well-being based on a CDF (eg. probit and logit models) to be given a formal welfare interpretation. New measures of the welfare distortion due to unobserved heterogeneity are also derived. An Australian household-level dataset is used as a case study for exploring the proposed measures of distortion. The results indicate that the failure to account for unobserved heterogeneity produces significant welfare distortions (primarily in the form of under-compensation). A unique welfare sensitivity curve is also estimated that indicates the presence of non-linearities that impair the typically monotonic relationship between household income, the household’s capacity to adjust its income and its marginal utility of consumption. The results are significant for better understanding the welfare implications of tax and transfer policies.

Suggested Citation

  • Sarantis Tsiaplias, 2017. "The Welfare Implications of Unobserved Heterogeneity," Melbourne Institute Working Paper Series wp2017n21, Melbourne Institute of Applied Economic and Social Research, The University of Melbourne.
    • Handle: RePEc:iae:iaewps:wp2017n21
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    More about this item

    Keywords

    Household expenditure; social welfare; consumption; heterogeneity; equivalence scales; income;
    All these keywords.

    JEL classification:

    • D12 - Microeconomics - - Household Behavior - - - Consumer Economics: Empirical Analysis
    • D10 - Microeconomics - - Household Behavior - - - General
    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • C35 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Discrete Regression and Qualitative Choice Models; Discrete Regressors; Proportions
    • D60 - Microeconomics - - Welfare Economics - - - General

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