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    Phan Van Nam
    This document discusses constant elasticity of substitution (CES) preferences and how they can be used to aggregate over many goods. It shows that with a continuum of goods, the CES aggregator function can represent consumer preferences. It then derives the demand functions and shows that the elasticity of substitution between any two goods is constant. It also discusses how the CES framework can be applied to model production with intermediate goods.

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    Ces PDF

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    Phan Van Nam
    29 views3 pages
    This document discusses constant elasticity of substitution (CES) preferences and how they can be used to aggregate over many goods. It shows that with a continuum of goods, the CES aggregator function can represent consumer preferences. It then derives the demand functions and shows that the elasticity of substitution between any two goods is constant. It also discusses how the CES framework can be applied to model production with intermediate goods.

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    This document discusses constant elasticity of substitution (CES) preferences and how they can be used to aggregate over many goods. It shows that with a continuum of goods, the CES aggregator function can represent consumer preferences. It then derives the demand functions and shows that the elasticity of substitution between any two goods is constant. It also discusses how the CES framework can be applied to model production with intermediate goods.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    29 views3 pages

    Ces PDF

    Uploaded by

    Phan Van Nam
    This document discusses constant elasticity of substitution (CES) preferences and how they can be used to aggregate over many goods. It shows that with a continuum of goods, the CES aggregator function can represent consumer preferences. It then derives the demand functions and shows that the elasticity of substitution between any two goods is constant. It also discusses how the CES framework can be applied to model production with intermediate goods.

    Copyright:

    © All Rights Reserved
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    of 3

    CES Aggregation Kim J.

    Ruhl

    Constant Elasticity of Substitution Demand


    Revised: December 21, 2016

    Constant elasticity of substitution preferences will show up often in international trade; they are a
    simple way to aggregate over many goods. Consider the case with a continuum of goods.
    Z 1 1/

    max U (c) = b(i)c(i) di (1)
    0
    Z 1
    s.t. p(i)c(i)di = I
    0

    The first order conditions are


    Z 1 1/1
    b(i)c(i) di
    b(0 )c(0 )1 = p(0 ) 0 [0, 1] (2)
    0

    multiply each FOC by c(0 ) and integrate over them all


    Z 1 1/1

    b(i)c(i) di b(0 )c(0 ) = p(0 )c(0 )
    0
    Z 1 1/1 Z 1 Z 1
    b(i)c(i) di b(0 )c(0 ) d0 = p(0 )c(0 )d0
    0 0 0
    Z 1 1/ Z 1

    b(i)c(i) di = p(0 )c(0 )d0 (3)
    0 0

    It is typical to define a unit of utility as


    Z 1 1/

    C= b(i)c(i) di . (4)
    0

    Using this definition, and the budget constraint, we can write (3) as

    C1 = I, (5)

    where 1 = P has the natural interpretation as being the price of one unit of utility. To solve for
    P , return to (2) and solve for c(0 ) and multiply by b

    Z 1
    0 /(1) 0 /(1) 0 /(1)
    c( ) = b( ) p( ) b(i)c(i) di (6)
    0
    Z 1
    b(0 )c(0 ) = /(1) b(0 )1/(1) p(0 )/(1) b(i)c(i) di (7)
    0

    Subject to change. This version December 21, 2016.


    CES Aggregation Kim J. Ruhl

    Now integrate all of the FOCs again:


    Z 1 Z 1 Z 1
    0 0 0 /(1) 0 1/(1) 0 /(1) 0
    b( )c( ) d = b( ) p( ) d b(i)c(i) di (8)
    0 0 0

    to get

    Z 1  1

    1
    1 0 0 0
    P = = b( ) 1 p( ) 1 d (9)
    0

    Properties
    Elasticity of Substitution
    From (2) we have
      1   1
    c(j) b(j) 1 p(j) 1
    = (10)
    c(i) b(i) p(i)
    Taking the log of this equation and differentiating with respect to p(j)/p(i) shows that the elasticity
    of substitution between goods is = 1/(1 ).

    Demand Function and Own Price Elasticity


    If we substitute P into(2) we have the demand function
      1
    1 p(i) 1
    c(i) = b(i) 1 C, (11)
    P

    where = 1/(1 ) is the own price elasticity of good i. Note that this is only the case when good
    i is so small it has a negligible impact on P . This is true when there are a continuum of goods, and
    is also typically assumed even when the number of goods is finite. A typical assumption is that
    the number of goods is large enough that no single good can influence the aggregate price level.

    The demand function can be written in expenditure form, as well

     
    1 p(i) 1
    p(i)c(i) = b(i) 1 P C. (12)
    P

    Limiting Cases
    As 0 this is Cobb-Douglas. As 1 perfect substitutes, as Leontief.

    Two Stage Budgeting


    While some authors will model preferences exactly as (1), it is common to nest a CES group of

    Subject to change. This version December 21, 2016.


    CES Aggregation Kim J. Ruhl

    products into an economy with other goods and specify the consumers problem as
    Z 1 1/ !
    max U c0 , b(i)c(i) di (13)
    0
    Z 1
    s.t. p0 c0 + p(i)c(i)di = I
    0

    Using the derivations above, we can rewrite this as a two stage budgeting problem, where the
    first stage is

    max U (c0 , C) (14)


    s.t. p0 c0 + P C = I

    which determines the expenditure on the nummeraire good and the differentiated goods. Once
    we know P C we can solve the problem specified in (1) replacing I with P C.

    CES Production
    You will also find papers in which the i-goods are considered to be intermediate goods and the CES
    aggregator is meant to be a production function (e.g. Ethier 1982). For example, a model might
    have a feasibility constraint like
    Z 1 1/
    Ct + It b(i)y(i) di = Yt , (15)
    0

    where C is consumption of the final good and I is the amount of final good used for investment.
    In a model like this, you might be tempted to think that P is the GDP price deflator. It is not.
    The GDP deflators in the United States and Canada are chain-weighted Fisher indices. Other
    countries follow different procedures (some use chained Laspeyres indices) but, in any case, none
    of the countries use a price index that looks like (9).

    Subject to change. This version December 21, 2016.

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