Abstract

We study the fundamental links between two popular approaches to consumer choice: the multinomial logit model of individual discrete choice and the CES utility function, which describes a diversified choice of a representative consumer. We base our analysis on the rational inattention (RI) model and show that the demand system of RI agents, each of which chooses a single option, coincides with the demand system of a fictitious representative agent with CES utility function. Thus, the diversified choice of the representative agent may be explained by the heterogeneity in signals received by the RI agents. We obtain a new interpretation for the elasticity of substitution and the weighting coefficients of the CES utility function. Specifically, we provide a correspondence between parameters of the CES utility function, prior knowledge and marginal cost of information.

Highlights

  • People choose varieties of products for various reasons, and, perhaps, the two main reasons are variation in preferences and in information

  • In the present paper we broaden the approach to the microfoundation of the constant elasticity of substitution (CES) utility function and show that this functional form might be obtained by aggregation of choices of rationally inattentive (RI) consumers who make a discrete choice with costly information acquisition

  • In the following proposition we show that an outside observer would see the demand of the aggregate of rational inattention (RI) agents as if there was a fictitious representative consumer maximizing the CES utility function under full information

Read more

Summary

Introduction

People choose varieties of products for various reasons, and, perhaps, the two main reasons are variation in preferences and in information. The present paper, in contrast, uses rational inattention (RI) as a microfoundation and reveals the link between the parameters of the RI model, the multinomial logit, and the elasticity of substitution and weighting coefficients of the CES utility function. The relation between the logit model of discrete choice and the CES utility function of representative consumer was first explored by Anderson et al (1987, 1988). They use a random utility model as a foundation for logit and show that the demand system derived from a nested logit model is generated by the CES utility function.

The model
Choice of the good
The link between rational inattention and the CES utility function
The case of a priori homogeneous options
Simple example on a priori heterogeneous options
CES utility based on the Mattsson-Weibull model
Conclusion
Proof of the Proposition 1
Derivation of weighting coefficients in the Example
Full Text

Published Version (Free)

Talk to us

Join us for a 30 min session where you can share your feedback and ask us any queries you have

Schedule a call

Disclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.