We also discuss how these parameters can be estimated using individual income data and econometric techniques that exploit both the longitudinal and repeated cross-section features of our data set on individual incomes from Mexico (Sections III-V).<sup>6</sup> Finally, we use a tractable consumption-saving model with labor income risk and incomplete markets (Section VI) that yields closed-form solutions for equilibrium consumption and welfare as a function of the preference and income parameters. This theoretical framework, based on the work of Constantinides and Duffie (1996) and Krebs (2007), focuses on the persistent component of labor income and abstracts from the i.i.d component, an abstraction motivated by results in the literature demonstrating that workers can effectively self-insure against transitory income shocks, as we have already mentioned.<sup>7</sup> One of the main insights of this literature is that in equilibrium consumption responds one-for-one to permanent income shocks.<sup>8</sup> In this paper, we exploit this property of equilibrium consumption to derive an explicit formula for social welfare as a function of the underlying income parameters.

The analytical framework we develop in this paper has the merit of linking income dynamics, income mobility and social welfare in a simple and transparent manner − allowing for a clearer analytical and quantitative discussion of these interrelated concepts, and specifically the role of income variability, than has generally been possible in the past. We discuss in detail how different determinants of measured income mobility may have quite different Fields and Ok (1996) discuss, however, the literature has recently made important advances in studying the “multi-faceted concept” of mobility and a number of different theoretical measures, each capturing a different aspect of mobility have been introduced. We have no contribution to make to this discussion and simply use the Hart Index as our basic measure of mobility.

> 6For an interesting exercise which compares results on poverty vulnerability (the propensity to move into poverty) obtained using panel data on incomes with those obtained from repeated cross-sections instead and finds that model parameters recovered from pseudo-panels approximate reasonably well those estimated directly from a true panel, see Bourguignon, Goh and Kim (2006)

> 7See, for example, Aiyagari (1994), Heaton and Lucas (1996), and Levine and Zame (2002) and Section III for further discussion of the issue of transitory income shocks. Clearly, in the case of measurement error there is even more compelling reason to neglect the i.i.d. component in the welfare analysis. We should also note that while we consider self-insurance against persistent income shocks, we do not model any alternative schemes that may provide insurance against variations in persistent income. We believe this characterization to be closer to that of developing economies, but this analysis would be relevant in any contexts where such (social) insurance schemes are absent.

8Moreover, Krebs (2007) shows that even in the case of persistent, but not necessarily permanent, income shocks (AR(1) process with auto-correlation coefficient less than one) consumption still responds one-forone to income shocks if there are costs of financial intermediation that generate a sufficiently large spread between borrowing rate and lending rate.

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