Variable Elasticity of Substitution Utility Function: Literature Review and Its Application
Wang Congcong1, Zeng Daozhi2, Zhu Xiwei3
1.School of Tourism and Urban-Rural Planning, Zhejiang Gongshang University, Hangzhou 310018, China 2.Faculty of Global Management, Chuo University, Tokyo 192-0393, Japan 3.Center for Research for Private Economy, Zhejiang University, Hangzhou 310058, China
Abstract：Nowadays, Chinese economy enters into a new stage of high-quality development. Consumption plays an important supporting role of building a new development diagram. Previous studies have systematically explained the importance of consumption from the perspective of influencing factors at the macro level as well as its overall effects. However, there has been little research on heterogeneous consumption behaviors. In a long time period, researchers are inclined to use Constant Elasticity of Substitution (CES) utility function to describe consumers’ behaviors. Since it assumes that the elasticity of substitution between any two varieties is constant, an increase in a consumer’s consumption of one product does not affect his preference for other products, and thus the transformation and upgrading of the consumption caused by an increase in income can not be explored.In order to fill the inefficiency of CES utility function, foreign researchers revised the assumptions and proposed Variable Elasticity of Substitution (VES) utility function. Such utility functions can not only describe consumers’ preference of “love for variety”, but also reflect the variable mark-ups in equilibrium. The pro-competitive effect provides new ideas for analyzing resource allocation, welfare gains from trade, and structural transformation. Unfortunately, existing literature has not reached a consensus on establishing a unified analytical framework covering various types of VES utility functions. In terms of research methods, it is still mainly about developing different types of VES utility functions. Thus, understanding the characteristics and applications of mainstream VES utility functions not only provides a reference for expanding the discussion on VES utility functions from specific to broad contexts, but also lays the groundwork for future research in this area.Therefore, this paper firstly reviews the theoretical evolutions of the VES utility function. By comparing the mechanisms difference between the VES and the CES utility from consumer preference, firm behavior, and welfare analysis, it further generalizes the types and features of mainstream VES utility function. Then, this paper introduces the latest research and summarizes their results from the perspective of resource allocation, welfare gains from trade, and structural transformation. In addition, this paper returns to the research question of consumption and discusses the advantages of using VES utility functions in terms of its income effect and pro-competitive effect to analyze consumption upgrading and diversification. Finally, this paper prospects the directions for future research: establishing a multi-regional and multi-sectoral research framework with VES utility functions to explore the impacts of new types of consumption such as green consumption; building a dynamic framework to study consumption behavior and explore the mechanism of variable elasticity of substitution in a long-term session.The innovation of this paper involves the following two aspects on the one hand, this paper collects and summarizes the viewpoints of VES utility function and points out its theoretical evolution progress and research question expansions; on the other hand, considering the decision: “accelerating the development of a complete system of domestic demand and improving the long-term mechanism for expanding consumption”, this paper analyzes the advantages of using VES utility functions to investigate the upgrading and diversification of consumption, which further provides theoretical insights for exploring such research questions as consumption inequality.
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