6 The welfare effects of price changes
In the first parts of this section we measure the welfare effects of the price changes that occurred over the recession. Whilst not all price changes are directly attributable to the recession, in the period between 2006/07 and 2009/10 there were large price changes in expenditure categories that typically receive a large share of the household budget; namely there were large increases in food and fuel prices, insurance, energy, local authority rates and rents, whilst there were falls in mortgage rates. The varying proportion of these goods in different households expenditure bundles will therefore generate different welfare changes amongst households.[32]
In Subsection 6.4 we aggregate the welfare changes owing to both expenditure and price changes to examine the total welfare effects of the recession for the different household types.
6.1 Equivalent variation as a measure of welfare
We follow the approach of Creedy (1998), who uses the Linear Expenditure System (LES) to derive the equivalent variation (EV) measure. This approach explicitly assumes preference heterogeneity between household types and clusters, and assumes households within the same group (where household types are split on hard dimensions) or the same cluster have the same preferences. This assumption motivated the first part of this paper: establishing household types that could be assumed to be internally homogeneous but heterogeneous from each other.[33]
The technical details of the EV measure and how it is derived are available in Appendix E. The equivalent variation can be expressed in terms of the expenditure function (E(.,.)) as:[34]
p0 and p1 are the old and new prices respectively, and U0 is the new utility level post price changes. Equivalent variation is the maximum amount the individual would be prepared to pay, in the presence of new prices, to return to the old prices and hence can be thought of as the welfare loss associated with price changes in the economy. We also normalise the EV by 2006/07 expenditure to examine the proportionate change in EV relative to total spending (hereafter EV/Exp) and get a sense of how progressive or regressive the welfare impact of the price changes are.
Notes
- [32] Table A.3 in Appendix A shows the price changes (as measured by the CPI) over the period by expenditure component.
- [33]The use of a LES does give rise to potential well known problems with additivity (see Deaton (1974)), although the level of aggregation we generally use on the expenditure groups may mean these issues are less severe.
- [34]The expenditure function is the minimum expenditure required to reach a level of utility at current prices.
