Constructing the Welfare Aggregate Part 1: Aggregation Issues Bosnia and Herzegovina Poverty Analysis Workshop September 17-21, 2007

Overview and Outline Introduction: pros and cons of using a consumption rather than income-based measure of welfare 1.Aggregation Issues: What is typically included, what is not, and why? 2.Adjusting for differences across individuals: equivalence scales and cost-of-living indices Concluding Observations - sensitivity analysis - supplementing analysis with other indicators

Introduction: Poverty & Inequality Analysis There are three basic introductory steps that need to be taken when analyzing poverty or inequality for a population of interest: 1.Define and generate an indicator of welfare 2.Establish a minimum standard (poverty line) / choose the measure (e.g. Gini coefficient) 3.Generate a summary statistic for the population. These two presentations (i.e. this morning and tomorrow) focus on the first step.

The ideal indicator of welfare … would be comprehensive, and … … would be measured in a consistent way across households, space and time

Alternatives for Welfare Aggregate: Income or consumption? (1) Income based measures: add up income from all sources (employment, social transfers, home production, informal support). or (2) Consumption/expenditure based measures: add up expenditures on all commodities consumed (with imputed values at local market prices)

Income or consumption (continued) 1. Over a lifetime: Life-Cycle Hypothesis The short term fluctuations of income are typically smoothed and consumption is more representative of “permanent” income.

Income or consumption? (cont.) 2.Over the year: seasonality or “accidents” (casual work, unemployment, illness, etc.) Income Consumption Time (months)

Income or consumption? (cont.) They each have advantages (+) and disadvantages (-): Income: (+) limited number of sources of income, less than items for consumption; makes it easier to collect the information. (+) income measures the degree of “command” households have over resources. They are free to exert that command as they like (e.g. a high-income individual may choose to consume little: most would agree that he/she should still be treated as non-poor).

Income or consumption? (cont.) (-) likely to be under-reported (forgetting, reluctance to disclose, difficult to measure, etc.). (-) may be affected by short-term fluctuations (e.g. seasonal fluctuations in rural areas); (-) Some parts of income are difficult to observe (for instance, income from informal labor activity, from home agricultural production) (-) The link between individual welfare and income is not always clear (as seen earlier, for instance, not all income may be used for consumption) (-) The reporting period might not capture “average” income of the household.

Income or consumption? (cont.) Consumption: (+) shows current standard of living, since utility is assumed to depend directly on consumption, not on income per se; (+) shows long-term average well-being, taking both consumption smoothing and insurance opportunities into account. (+) It is typically easier to recall expenditure and consumption (assuming survey questionnaires are indeed well-designed).

Income or consumption? (cont.) BUT (-) households may not be able to smooth consumption (e.g., borrowing, insurance, social networks) (-) Consumption choices made by households might be misleading (e.g. a rich individual may choose to consume little: most would agree he/she is not poor) (-) Some expenses are not made regularly (typically, different recall periods are used to ensure coverage)

Income or consumption? (cont.) Summary: Both income and consumption-based indicators have advantages and disadvantages. The use of both may be beneficial for specific policy decisions. Generally, consumption-based measures are preferred since they provide a more adequate picture of well- being, especially in low or middle income countries. Here, we focus on the objective, monetary, consumption-based measure.

1. Aggregation Issues Two major types of issues arise when calculating a consumption-based welfare indicator: Analytical issues: how to find the best approximates of consumption? (what to include, what not, & why) 2.1. Aggregation issues 2.2. Price variation issues 2.3. Household size and composition issues Design issues: how to make sure that instruments and the process of data collection capture the information needed? 2.4. Data and Survey design issues

What to include? Issue: which components of consumption to include and how to measure them? Consumption is estimated as: + Total expenditure for goods and services purchased + Total value of consumed goods and services that were not purchased: + Received as gifts + Produced by the household itself + Result of assets and durable owned

What to include? (cont.) Issues arise on which items to include and how, and on general difficulties in calculations. Some are more important than others for our countries: What and how? Prices of durable goods Prices of housing services Unusual large expenses Home production Input and investment Cost of public goods Cost of time and leisure General difficulties? Missing information Differences in prices at one point in time Seasonality Inflation Rationing Underreporting

(i) Price of durable goods Problem: Durable goods are typically bought at one point in time and then consumed over a period of several years. How to account for the “portion” of the good that is “consumed” over the period of reference? Solution: There are two components to the cost of using the good over the period: The loss in value of the good (e.g. the re-sale value of the car decreases over the period) The loss in income due to the fact that the money was “locked up” in the asset (e.g. we could have invested the money somewhere else).

… durables (cont.) There are different methods to value the use: 1.Most accurate method: Take the value of the good at the beginning of the period, subtract the value of the good at the end of the period. Add the value of the interest which could have been earned. In practice, it is often difficult to assess the value of the goods, unless the question is asked. 2.Other alternatives: e.g. if the value of the good is available, take a certain percentage (e.g. if the good can be used typically for 5 years, take 20% of cost each year; if the period is 10 years, take 10%), etc.

Illustration – second method (RO)

(ii) Price of housing services Problem: Owner-occupied dwelling provides housing services; should be included: but how to measure? Solution: Different ways to address the question: 1.Survey may include a question on rent that households estimate they would have to pay to occupy their dwelling. 2.use value of the rents reported by renters, build a regression which explains rent paid as a function of the dwelling’s characteristics, and use the coefficients to calculate an estimate for owner households 3.if the households report the estimated value of their dwelling, estimate the rental cost by taking some percentage of that (as for durable goods).

(iii) Unusually large expenses Problem: Some large expenses – such as expenses for weddings, dowry, or funerals – are made by households. These expenses are not regular. Should we include them in the welfare aggregate? Solution: These expenses are irregular and do not reflect household “usual” welfare. In addition, the expenses often do not contribute as such to the utility of the spender (e.g. hospitalization expenses). Such expenses therefore are usually excluded from the calculations.

(iv) Home production Problem: Many households produce themselves some goods and services they consume. How to account for these in the aggregate consumption/expenditure? This is particularly important for households engaged in agricultural production. [In such case, the computations are further complicated by the fact that expenses are also made for production (investment, inputs, seeds, etc.)]. Solution: Use local market prices to calculate the value of home production that is consumed by household.

(v) Input and investment expenditure Problem: How to count the value for input or investment made by the household for its own production (e.g. for tools, fertilizer, seeds, or water in the case of agricultural production)? Solution: These expenditure should be excluded from total household expenditure/consumption since they do not contribute to utility from consumption.

(vi) Cost of public/publicly provided goods Problem: Households “consume” public or publicly provided goods and services (e.g. public education, health, police, water, sanitation, justice, public parks, national defense, etc.); should we include the value of these goods and services in the aggregate? Solution: There are two options: Option 1. use prices of similar goods and services provided by the private sector. Option 2. ask people how much they would be prepared to pay for these goods and services – the “contingent valuation” method.

… public goods (cont.) Summary: Usually, the imputation for public goods is likely to compromise the credibility and usefulness of the measure, and it is ignored. However, it is necessary to impute for public goods if: We want to compare with other results which have imputation for public goods. We want to compare with other surveys (or countries/regions) where the same goods and services are provided through private agents.

(vii) Cost of time and leisure Problem: Households draw well-being from time spent for leisure. How to account for leisure in the calculation of consumption? Solution: The value of leisure is not usually included since it can differ significantly between individuals and there is no reliable basis for evaluating it. For example, how to estimate the value of leisure for a highly skilled unemployed individual? Use the wage for his/her skills but for a job not available?; or use the wage for lower skills, but for a job that individual could find immediately?

(viii) Missing information Problem: Sometimes, the information on the quantity or the price of some item consumed might be missing (or unreported). Solution: We can impute the price or quantity using market reference (i.e. looking at the average quantity or average price reported by other households with similar characteristics, such as place of residence, size, etc.).

(ix) Seasonality Problem: Consumption, and food consumption in particular, is subject to very high seasonality – both in quantities and in prices. In the surveys, food items are usually reported for a short recall period, and do not capture the ‘average’ value. This could bias the calculations (e.g. a household looking better off than it is if the measure is taken during high food production period). This is particularly problematic if different households are surveyed at different seasons, or if comparisons are made between surveys carried out in different seasons.

… seasonality (cont.) Solution: If the data allow, one needs to adjust for seasonal variations in consumption. This could be done by having different poverty lines for different seasons, or by increasing or decreasing the consumption indicator of various households according to the season in which they were interviewed. In practice, this is rarely possible and typically ignored.

Seasonality - illustration Multiplicative seasonality model by area and quintiles

(x) Rationing Problem: Sometimes markets for specific goods or services may be rationed or subsidized (e.g. water, electricity). In this case, the price paid by the household is lower than the marginal utility from the consumption of the good or service. Solution: One can estimate shadow prices for the goods or services and use these prices when aggregating (rather than the actual prices). However, this is difficult and typically ignored in the computations.

(xi) Under-reporting Problem: People tend to under-report the consumption of various items (e.g. they forget; they under-report on purpose because they fear consequences, etc.). Solution: To minimize the possibility of forgetting some expenditures/consumption, different recall periods are typically used for different consumption items, corresponding to the usual frequency of purchase (shorter recall period for food, medium for clothes, and longer for durable goods).

choices … Think at the BiH HBS, and decide what to do with the following: expenditures for extraordinary maintenance and repairs (section 2) expenditures for furniture (section 3)