The Welfare Implications of Unobserved Heterogeneity

New conditions are derived for relating household financial well-being to household utility. In particular, a one-for-one mapping between the equivalent incomes stemming from subsistence-based utility functions and probabilistic models of financial well-being is established. This is unique in the literature and enables estimates from reduced-form models based on a cumulative distribution function (e.g. probit and logit models) to be given a formal welfare interpretation. In so doing, it is possible to use reduced-form models of well-being to evaluate welfare distortions associated with unobserved heterogeneity in subsistence levels and marginal utilities of consumption. An Australian household-level data set is used as a case study for exploring the distortions associated with unobserved heterogeneity. The results are significant for better understanding the welfare implications of income and transfer policies, and indicate that the failure to account for unobserved heterogeneity results in large welfare distortions. Finally, I show that the distortions are primarily attributable to heterogeneity in subsistence requirements rather than heterogeneity in marginal utilities of consumption.