On the Normalization Condition for Cost of Living Comparisons under Time-Varying Preferences

Naohito Abe and D.S. Prasada Rao ()

No DP24-1, RCESR Discussion Paper Series from Research Center for Economic and Social Risks, Institute of Economic Research, Hitotsubashi University

Abstract: There is growing interest in measuring inflation in the presence of time-varying preferences. To make price comparisons under changing preferences, a number of studies are imposing normalization conditions on preference parameters, assuming cardinal utility functions. The resulting price indexes depend on the choice of normalization condition imposed, necessitating a careful specification of this condition. Carluccio et al. (2023) adopt a normalization where the arithmetic mean of the time-varying taste parameters remains constant, whereas Hottman et al. (2016) and Redding and Weinstein (2020) maintain a constant geometric mean. In this paper we invoke the commensurability axiom which requires the price index to be independent of units of measurement. We prove that a necessary and sufficient condition on the normalization condition that ensures commensuarability is the geometric mean-based normalization. Consequently, adopting an arithmetic meanbased normalization condition results in index values that depend on arbitrarily chosen measurement units, such as gallons or 100 milliliters.

Keywords: Cost of Living; Price Index; Preference Heterogeneity; Characterization (search for similar items in EconPapers)
JEL-codes: C43 E31 (search for similar items in EconPapers)
Pages: 18 pages
Date: 2024-01
New Economics Papers: this item is included in nep-upt
Note: 15 January, 2024
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