Aggregate Consumer Behavior and the Measurement of Social Welfare

Abstract

This paper describes a new approach to normative economics, combining the theory of social choice with econometric modeling of aggregate consumer behavior. We first derive a system of aggregate demand functions by exact aggregation over individual demand functions. We then construct measures of individual welfare from systems of individual demand functions. Finally, we incorporate these measures into a social welfare function, introducing ethical assumptions based on horizontal and vertical equity. To illustrate the application of this approach, we consider the U.S. standard of living and its cost over the period 1947-1985. THE PURPOSE OF THIS PAPER is to describe a remarkable convergence that has occurred between economic theory and econometrics over the past decade. This conjunction has taken place between the theory of social choice and econometric modeling of aggregate consumer behavior. The confluence of these two streams of research has produced a new approach to normative economics. This approach has been successfully applied to the evaluation of economic policy, the measurement of poverty and inequality, and the assessment of the standard of living and its cost. A common problem in the modeling of consumer behavior and social choice is the representation of individual preferences. In the econometric modeling of aggregate consumer behavior, the primary emphasis has been on simplifying aggregate demand functions. The most familiar approach to this problem is the model of a representative consumer. This model is required to justify applications of the theory of individual consumer behavior to aggregate data on prices and quantities consumed. The simplest version of the model is based on identical homothetic preferences for all individuals. Under identical homothetic preferences aggregate quantities consumed are functions of aggregate expenditure and prices. These functions have precisely the same properties as demand functions in the theory of individual consumer behavior. The condition of identical homothetic preferences was weakened by Gorman (1953) to permit displacements from the origin for individual demand functions. Gorman showed that a necessary and sufficient condition for aggregate demand functions to depend on aggregate expenditure is that all individu