Demand System Estimation

:
A Literature Review
Hong-Giang Le
September 1, 2003

1

Introduction

Estimating demand is generally conducted in two distinctive ways: single-equation and
demand-system methods. The first is simple econometric estimation without or with very
limited resourcing to consumer theory. It is usually a regression of quantity on a set of
explanatory variables such as prices, income, other economic variables, and demographic
or geographic factors. The set of explanatory variables is selected based mostly on the researchers’ experiences and intuitions. Data employed are usually time series of a particular
commodity and the result will be a demand function for that commodity. The main requirement for this type of estimation is good econometric techniques to handle various estimating
problems like identification, zero-observation, or discrete-choice. Although single-equation
estimation is very popular for business and administration purposes, it is not the focus of
this paper since it deals only with a single commodity.
The second type of demand estimation depends heavily on the consumer theory, which generates additional complications. First, explanatory variables are no longer an arbitrary set.
They must strictly come from the utility maximization problem (or its duality) and strictly
relate with each other in predefined relationships. In the technical jargon, the estimating specifications must be theoretically plausible. Second, estimated parameters must satisfy
restrictions derived from utility maximization. For example, P
Walras’ law (or adding-up property of any demand system) requires the Engel aggregation ni=1 si ηi = 11 to hold in theory,
therefore the estimated parameters must comply with this restriction. Third, the data employed usually come from household expenditure surveys, ie at the household level. That
gives an opportunity to introduce demographic characteristics of each household into the
demand system, but it comes with a price of more complicated structure. Finally, extra care
must be taken when introducing disturbance (error) terms into the estimating equations so
that they do not break the theoretical plausibility of the whole system.
This literature review will briefly look at consumer theory and its implications for demand
1

Where si is income share for good i, ηi is income elasticity for the same good.

1

system estimation, ie the restrictions to the estimating specifications (section 2). Then it will
review the way demographic variables can be incorporates into the specifications (section 3).
The final section will give summaries for some empirical studies.

2

Consumer Theory and Its Implications

This section is a summary of some chapters from the following books:
• Applied Consumption Analysis (Phlips 1983)
• Economics and Consumer Behavior (Deaton & Muellbauer 1980b)
• Demand System Specification and Estimation (Pollak & Wales 1992)

2.1

Utility maximization and restrictions

In demand system analysis, the utility maximization problem (UMP) starts with a specific functional form of the direct utility function U = U (q1 , ..., qn ). The function selected
must guarantee the compliance of the underlying preferences with the consumer theory basic axioms, ie rationality (or regularity), local non-satiation, continuity and convexity. Then
Marshallian demand functions qi = q(p, I) will be the optimum solutions to the UMP subject
to a budget constraint. For any UMP, regardless of the functional form of the direct utility
function, the following common restrictions on the resulting demand system must hold:
• Homogeneity of degree zero in prices and income
P
• Walras law or adding-up property, ni pi qi = I

• Slutsky symmetry and negative semi-definiteness (or negativity)
Alternatively, one can start with a specific functional form of the indirect utility functions
of prices and income V = V (p, I). Then the demand can be derived using Roy’s identity2 .
This approach has an advantage that the desirable properties of a demand system can be
built into the indirect utility functions more easily. The indirect utility function must satisfy
the following properties:
• Homogeneity of degree zero in prices and income
• Strictly increasing in income and decreasing in prices
• Quasiconvex in prices and income
2

/∂pi
Roy’s Identity: qi = − ∂V
∂V /∂I .

2

With a particular functional form, further specific restrictions must hold. For example, if the
direct utility function takes the Cobb-Douglas form, constant expenditure shares or unitary
elasticities are forthcoming. Obviously, actual data do not support simple functional forms
such as Cobb-Douglas, Leontief, or CES because they are too restrictive in terms of elasticities and expenditure shares. Therefore the search for more flexible forms has been the major
topic in the demand system analysis theory. But the more flexible the demand system is, the
more parameters need to be estimated, which significantly reduces the degree of freedom.
One way to save some degree of freedom is to use theoretical restrictions from the consumer
theory (eg homogeneity, adding-up and symmetry) to eliminate some parameters from the
estimated equations3 . But using direct or indirect utility functions to derive more flexible
demands and their restrictions is extremely difficult. The quest has become less cumbersome only after a new method was proposed by Diewert (1971). It starts with a functional
form for the expenditure functions e = e(p, U ). Then Hicksian demands qih = qih (p, U )
are derived by Shephard’s Lemma4 . Using duality, Marshallian demands qi = qi (p, I) can
be found by replacing parameter U in the Hicksian demands by the corresponding indirect
utility function V = V (p, I), which is the inversion of the original expenditure function,
ie qih = qi (p, V (p, I)). This approach allows researchers to build almost absolutely flexible
demand systems such as translog or AIDS5 without specifying the corresponding direct or
indirect utility functions at the beginning6 . In fact, many authors refer to their systems
as the second order approximation to any true utility functions. Additional restrictions on
expenditure functions are:
• Homogeneous of degree one in prices
• Increasing in U and non-decreasing in prices
• Concave in prices
Since then, efforts have been concentrated on refining the flexible forms and increasing the
degree of freedom.

2.2

Various functional forms

As mentioned in the previous section, simple functional forms such as Cobb-Douglas or CES
are not suitable for applied demand system estimation because they are too restrictive on
demand behavior. This section will only review some functional forms that have actual application in empirical works.
One common feature in the literature in this area is that all authors use total expenditure x instead of income I in all demand and utility functions. Although the primary reason
3

Another way proposed by Stone (1954) is to eliminate parameters related to cross-price effects of unrelated
goods
)
4
Shephard’s Lemma: qih = ∂e(p,U
∂pi .
5
This unfortunate acronym stands for Almost Ideal Demand System
6
Although Christesen, Jorgenson & Lau (1975) derive their famous translog direct utility function first,
it is much easier and intuitively appealing to start with an expenditure function and then apply duality to
find Marshallian demands (see Phlips (1983)).

3

is practical: data on total expenditure are usually observed rather than data on income, it
also has theoretical grounds. First, if saving is treated as a commodity, total expenditure
equals income. Second, if the consumer plans her income spending in several stages (multistage budgeting), total expenditure in each stage is equivalent to income in the consumer
theory. Hereafter, wherever total expenditure x is used, it plays the same role as income in
the consumer theory.

2.2.1

Linear Expenditure System (LES)

As the name suggests, the expenditure on good i pi qi depends linearly on all prices and total
expenditure. But to be theoretically plausible, it must only be in the following form:
!
n
X
p i qi = p i bi + a i x −
p k bk
(1)
k=1

The underlying direct utility function that yields this system is:
U (q) =

n
X

ak ln(qk − bk ),

ak > 0,

(qk − bk ) > 0,

n
X

ak = 1

(2)

k=1

k=1

P
and the budget constraint is
pk qk = x. This utility function is widely known as the StoneGeary utility function (sometimes the LES is also called the Stone-Geary system). The
function is additive in all goods, therefore they must all be gross substitutes. As a result, the
LES imposes a specific restriction that all cross-price elasticities must be positive and all income elasticities must be positive (no inferior goods). Although there is no requirement that
bk must be positive, it is usually assumed to be so. That implies another specific restriction:
all goods must be inelastic in their own price7 .
This system has 2n-1 parameters to be estimated (n is the number of commodities)8 . As
Pollak & Wales (1992) point out, it needs at least two period household data, ie two price
sets, to fully identify all parameters of this model. This contradicts the common belief that
too few variations in prices cannot adequately identify the price effects.
The LES has been widely used since it was proposed by Stone (1954). It is often thought of
as the only functional form that is both theoretically and empirically tractable9 . However,
very strict specific restrictions limit its application to only highly aggregated consumption
data, ie goods should be grouped into broad sets such as food, clothing, and housing. For
finer disaggregation of commodities, LES does not work well.
7

As Deaton & Muellbauer (1980b) show, the LES belongs to a family of functional forms which have an
additional property that own-price elasticities are close to minus one half of income elasticity.
8
This number is significantly less than the number of (n+1)2 parameters for a linear system of n equations
of all price and income effects had we not imposed restrictions from the consumer theory.
9
In the sense that it can be solved algebraically easily and each parameter represents a clear economic
intuition. At the same time, it is easy to estimate and the parameters are quite robust against empirical
tests.

4

2.2.2

Extensions of LES

QES:
There are many extensions of LES in which the basic functional form is generalized, i.e
LES is a special case given special values of some specific parameters. One approach is to
add a quadratic term of total expenditure into LES, which results in a functional form called
the quadratic expenditure system (QES). The following is one of the theoretically plausible
forms of the QES family:
p i qi = p i bi + a i

x−

n
X

p k qk

k=1

!

+ (ci − ai )λ

n
Y

k
p−c
k

k=1

Clearly, if ci = ai the system reduces to an LES.

x−

n
X
k=1

p k qk

!2

(3)

PIGL:
Similarly, higher order polynomial terms can be added to generalize LES and QES. Given
the structure similar to equation (3), this family of functional forms has a common property
that marginal budget shares are independent of prices, therefore it is named PIGL (Price
Independent Generalized Linearity). However, as Gorman (1981) proved, to be theoretically
plausible the higher order polynomial terms have to be very restrictive, which makes higher
order generalizations add little explanatory power. This reason and the additional loss of
degree of freedom restrict the use of higher order generalizations of LES in practice.
PIGLOG:
Another way of extending LES and QES is that logarithmic terms of total expenditure are
added to LES and QES (and possibly to other higher polynomials). This results in a class of
functional forms called PIGLOG, which covers many important subclasses such as translog
and AIDS (discussed later). To be theoretically plausible, any PIGLOG system must have
the following form:
qi (P, x) =

gi
Gi
x − (logx − logg)x
g
G

(4)

where g(P ) is homogeneous of degree 1, G(P ) is homogeneous of degree zero, gi and Gi are
partial derivatives with respect to the i-price.
Rotterdam:
Another approach of extending linear systems is proposed by Theil (1967). Taking total
differential of both sides of a linear demand system and using logarithmic forms for all variables yield the famous Rotterdam model:
!
X
X
wi dlogqi = bi dlogx −
wk logpk +
cik dlogpk
(5)
k

k

5

The most interesting feature of the Rotterdam model is that it allows estimation of the Slutsky matrix directly. Hence its primary use is to test the validity of the consumer theory, ie
the homogeneity and symmetry.
Although this is not an exhausted list of LES extensions, later literature on this subject
mainly focuses on some specific forms under PIGLOG10 , which are commonly known as the
flexible functional forms. We will now turn to discuss them in more details.

2.2.3

Flexible functional forms

This family of functional forms is called flexible because it can mimic any true unknown
demand systems at a neighborhood of a particular price-expenditure point. The idea is that
instead of using a particular direct/indirect utility function or expenditure function to derive
the demand system, the second order logarithmic Taylor approximation is used. This technique has two advantages: (i) it is an extension (in the PIGLOG direction) of the well-studied
LES, thus it keeps some sort of linearity in the estimating equations (but without tying them
up with additivity as in the case of LES); and (ii) it brings in additional parameters to increase the flexibility of the system but still keeps the compliance with the basic axioms for
the underlying preferences according to the consumer theory.
Since the second order logarithmic Taylor approximation involves all the products of logarithmic cross prices, in principle all flexible functional forms must belong to the family
of translog functions. However, all but Pollak & Wales (1992) refer translog function only
to a subcategory of the family. Pollak & Wales (1992) classify translog family into four
subcategories: homothetic translog (HTL), linear translog (LTL), basic translog (BTL), and
generalized translog (GTL). The basic translog (or ordinary translog) is the one that the literature refers to as translog function. Under the BTL, there is a special case commonly known
as the almost ideal demand system (AIDS). We will look at (basic) translog and AIDS below.
Translog:
The underlying indirect utility function of the (basic) translog system is:
ψ(P, x) = α0 −

X

αk log 

p 
k 

p  
p 
1 XX
k
k
βkj log
log
2 k j
x
x

(6)
x
P
Two specific restrictions are βik = βki and k αk = 1. The resulting demand system in share
form is: 

P
αi + k βik log pxk 

PP
(7)
wi (P, x) =
1+
βik log pxk
k

This system has n(n − 1)/2 + 2n − 1 parameters to be estimated, one parameter more than
the minimum number of parameter of a flexible system which is capable of mimicking an
10

There are still attempts to generalize LES in other directions, for example Conniffe (2002).

6

arbitrary true demand system11 . P
If we
P impose 12one more restriction on the parameters of the
(basic) translog system, namely
βik = 0 , then the system becomes a special case of
BTL called log translog (log TL). Log translog is a parsimonious flexible form since it has
exactly n(n − 1)/2 + 2n − 2 parameters which need to be estimated. On the other hand,
unlike LES and QES, the number of cross-section (M) needed to fully identify all parameters
of a translog system is determined by this inequality: n + 1 + M (n − 1) ≥ n(n − 1)/2 + 2n − 1.
AIDS:
AIDS is a special case of log TL when logx and logpk are separable. Unlike Christesen
et al. (1975), Deaton & Muellbauer (1980a) derive the AIDS from an expenditure (cost)
function, which highlights the duality approach proposed by Diewert (1971). They start
with an expenditure function:

logc(P, u) = a(P ) + ub(P )

(8)

where:
a(P ) = α0 +

1 XX
γki logpk logpi
2 k i
k
Y β
b(P ) = β0
pk k

X

logpk +

The resulting demand system in share form is:
X
wi = α i +
γik logpk + βi log(x/P¯ )

(9)
(10)

(11)

k

where:
P¯ = α0 +

X

αk logpk +

k



and γki
= 1/2(γki + γik ) = γik
.

1 XX ∗
γ logpk logpi
2 k i ki

(12)

AIDS has several advantages over other functional forms. First, since it belongs to the
log TL family, it is also parsimonious, ie it has the minimum number of parameters (n(n −
1)/2+2n−2) that are needed to mimic any true demand system. Second, like the Rotterdam
model, it embeds almost all common theoretical restrictions13 into its structure,
which can be
P
tested directly. Third, if log P¯ (AIDS price index) above is replaced by k wk logpk (Stone’s
price index), then the system is linear in prices and expenditure. That would significantly
simplify the estimation of the whole system14 . In fact, AIDS is often estimated in that way
and it is dubbed a linear approximate AIDS (LA-AIDS). Finally, unlike other translog forms,
11

Pollak & Wales (1992) show that any true demand system can be characterized by n(n − 1)/2 + 2n − 2
independent
P P shares and elasticities.
12
Or
βik = B, where B is an arbitrary constant.
13
They are: homogeneity, adding-up and symmetry. The only restriction that has to rely on a specific data
set is the negativity
14
Deaton & Muellbauer (1980b) estimate LA-AIDS equation by equation using OLS.

7

the parameters of AIDS carry some meaningful economic intuitions. For example, α0 can
be thought as a cost of subsistence, while β0 is the difference of income between bliss and
subsistence.

3

Demographic factors

Demographic factors such as household composition and age of household members are important determinants of the underlying preferences that yield corresponding demand systems.
Therefore, introducing demographic variables into demand systems is almost compulsory. In
single-equation estimation, demographic variables are usually added to the estimating specification in a straightforward way, ie q = αI + βP + γη where η is a vector of demographic
variables. When it comes to a demand system, it is not that simple because the structure of
any estimating equation is predetermined by the consumer theory. Therefore, simply adding
demographic variables into the demand systems may make them theoretically implausible15 .
To avoid that, the added variables could be combined with the existing variables (ie prices
and expenditure) in certain ways16 . Pollak & Wales (1992) introduce five possible methods
of doing that. This paper will review the first two basic methods, namely the translating and
scaling procedures. The other three are just generalizations or modifications of the first two 17 .
In addition to translating and scaling, we will also briefly discuss two alternative methods
proposed by Blundell, Pashardes & Weber (1993) and Lau, Lin & Yotopoulos (1978). These
methods make changes directly to the utility function instead of to the budget constraints as
in the case of translating and scaling. Although they are theoretically appropriate, we will
show that these latter techniques have a disadvantage to the former two.
Before proceeding to describe translating and scaling in detail, it is worth noting that the
scaling procedure was initially developed and is still widely used for another purpose: to
compare welfare of households with different demographic characteristics (see for example
Deaton & Muellbauer (1980b) or Bradbury (1996)). The idea is that different households
with exactly the same pattern of consumption but with different demographic characteristics
can be ranked in terms of welfare by an index called ”equivalence scales”. This index is a
deflater to scale up (or down) other economic variables in the demand system to make them
become ”per-equivalent-adult variables”. To obtain the ”scales” in this context, a demand
system with demographic variables should be estimated and the scales will be derived from
the system parameters. Although the original purpose is to compare welfare, the technique
also improves the quality of demand system estimations and gives insights to the demographic
influences.
15

This is perhaps a deficiency of the consumer theory, which models human behaviors (although economic
ones) by economic variables only, ie prices and income.
16
Similarly, to turn a theoretical demand system into a system of stochastic equations, ie incorporating
disturbance terms i , must also preserve the theoretically predefined structure of the system.
17
They are: Gorman specifications, Reverse Gorman specifications, and Modified Prais-Houthakker procedure.

8

3.1

Translating

Suppose the original demand system and its underlying utility function are:
qi (P, x) = q¯i (P, x) U (q) = U¯ (q)

(13)

Demographic translating replaces the demand system with:
X
qi (P, x) = di + q¯i (P, x −
pk dk )

(14)

where di is the translation parameter that depends on demographic variables: di = D i (η).
This structure of the demand function is similar to the LES, except the second term may not
be linear as in LES18 . Therefore, the translation parameters can be interpreted as the subsistence level of consumption given the household characteristics. Since the LES is theoretically
plausible, this system is also theoretically plausible, at least for di close to zero19 . The direct
¯ (q-d). In
utility function also has a similar form to the Stone-Geary function, ie U (q) = U
the expenditure form, the translating demand system looks like:
X
pi qi (P, x) = pi di + pi q¯i (P, x −
pk dk )
(15)
Taking the derivative of both sides with respect to ηj :
∂pi qi (P, x)
∂pi D i (η) ∂pi q¯i (P, x −
=

∂ηj
∂ηj
∂x

P

pk dk ) X

pk

∂D k (η)
∂ηj

(16)

Thus, the marginal impact of a change in a demographic variable ηj on the expenditure on
good i can be decomposed into specific and general effects. The specific effect is the direct
effect of a change in demographic variable, eg if the number of adults doubles, the amount of
certain foods would also double. The general effect is the rearrangement of the total expenditure among different goods when a demographic change occurs. Having modeled this effect
is an advantage of estimating a whole demand system over the single-equation estimation. In
the latter case, no one would include a variable of the number of under five year old children
in the estimation of the demand for cigarettes20 .
The last point of this procedure is to specify the form of D i . The simplest form would
be the linear demographic translating:
i

D (η) =

N
X

δij ηj

(17)

j=1

3.2

Scaling

Demographic scaling replaces the original demand system by:
qi (P, x) = mi q¯i (p1 m1 , p2 m2 , ..., pn mn , x)
18

(18)

In fact, LES can be derived from the standard Cobb-Douglas function using this translating technique
with constant di . In the same token, CES can be translated into generalized CES.
19
Because we can always approximately linearize q¯i around di = 0.
20
Deaton, Ruiz-Castillo & Thomas (1989) show that this property of translating can be used to test demographic separability, ie the independence of certain commodities to a group of demographic characteristics.

9

where mi is the scaling parameter that depends on the demographic variables: mi = M i (η).
The corresponding utility function
becomes U (q) = U¯ (q1 /m1 , q2 /m2 , ..., qn /mn ). Since the
P
budget constraint becomes (pi mi )(qi /mi ) = x, which is exactly the original budget constraint, the utility maximization problem is unchanged and the solutions qi /mi should be
theoretically plausible. Therefore, for mi close to one, qi is also theoretically plausible. Prais
& Houthakker (1955) proposed a similar specification qi = mi q¯i (p1 , p2 , ..., pn , x/m0 ) where
m0 is a weighted average of mi which scales up (or down) total expenditure according to the
household demographic characteristics. It turns out that this specification is a special case
of (18) where the demand system has no substitution effects.
Take the logarithm of both sides of (18) and differentiate with respect to log(mk ), we obtain
the marginal impact of a change in a demographic variable in elasticity form:
X 
ik = Mki +
ξji Mkj
(19)
which also has two parts: specific and general effects similar to the translating case. But
unlike translating, where the general effect is the rearrangement of the budget constraint, the
general effect in this case is the substitution away from goods which become relatively more
expensive because of the demographic change21 . For example, icecream may become more
expensive if a family has one more child under five year old, hence the equivalent adults in
this household may shift away from icecream to other foods.
Scaling parameters may also take a linear form, ie:
i

M (η) = 1 +

N
X 

ij ηj

(20)

j=1

Some authors also use ”log linear demographic scaling”:
i

M (η) =

N
Y

(ηj )ij

(21)

j=1

3.3

Alternative approaches

Translating and scaling make changes to prices and incomes according to certain rules defined by demographic characteristics of households. In order words, they change the budget
constraints that households face but leave the preferences untouched. Alternatively, we can
change the parameters of the underlying preferences by making them become functions of
the demographic variables. That is if the original indirect utility function is V = V (P, x; θ),
where θ is the vector of the parameters of the preferences (the utility function), then the
modifying function will be V = V (P, x; θ(η)). The resulting demand equations will become
qi = qi (P, x; θ(η)).
This method (Blundell et al. 1993), which we tentatively call ”parameter modification”,
seems to be more intuitive and easy to implement. However, it has a major disadvantage
compared to translating and scaling: if we treat demographic variables as independent (which
21

Note that the Prais & Houthakker (1955) specification does not have the general effects.

10

is almost always the case), all theoretical restrictions now become dependent not only on the
model parameters but also on demographic data. This does not really matter if we use this
method just to test the consumer theory, ie test the restrictions using the results of the
unrestricted estimation. But if we want to estimate elasticities, which requires performing
restricted estimation, then the econometric procedure becomes much more complicated, even
impossible to implement in many cases.
Another slightly modified procedure, which we tentatively call ”variable inclusion”, is proposed by Lau et al. (1978). This approach includes demographic variables directly into the
indirect utility function, which makes them play the same role as prices22 . Since demands
are the first order derivatives of indirect utility with respect to prices (Roy’s Identity), only
cross terms between prices and demographic variables will be retained in demand equations,
which makes this approach equivalent to a special case of parameter modification. Therefore
the weakness of parameter modification is also applied here.

4

Some empirical studies

Given a theoretically plausible demand system with properly incorporated demographic variables and a set of household expenditure data, there are still some practical issues that one
must consider before starting an empirical work:
• Which form of the demand system will be used: quantity, expenditure or share
• How stochastic specifications from theoretical equations should be set up
• What assumptions on the disturbance terms should be taken
• What econometric technique will be employed
• How theoretical restrictions should be imposed into estimation procedures
In the following, we will review some empirical works emphasizing those issues as well as
their major findings. Although there is a vast amount of literature on this topic, we limit our
review to some papers that use household level data and have demographic characteristics
embodied in the specifications.

4.1

Pollak & Wales (1978)

This paper is a good starting point since it intends to give a guideline on how to empirically
estimate a demand system from household budget data. The authors use LES and QES as
the theoretical frameworks and linear demographic translating to introduce one demographic
variable into the system: the number of children in each household. Data used are the 19661972 UK Family Expenditure Survey, which are grouped into three consumption goods: food,
22

In this approach total expenditure is usually normalized to one, hence the demand functions depend only
on prices. This implicitly imposes homogeneity into the demand equations, hence there is no need to test
this restriction.

11

clothing, and miscellaneous.
The stochastic specifications are obtained by simply adding standard disturbance terms into
share equations. The reasoning of using share instead of other demand forms is to avoid
heteroskedasticity. Although the paper does not discuss the compliance of the stochastic
specifications with restrictions from the consumer theory, the authors use the result from
their earlier work (Pollak & Wales 1969) to impose a restriction on the disturbance terms, ie
P
j ij = 0 where ij is the disturbance term for observation i and good j. To implement this
restriction the authors drop one equation (for good n) from the system. Parameters of the
omitted equation are calculated using adding-up property after other equations have been
estimated.
Using maximum likelihood estimation, the paper finds all price and income elasticities for
each good and each household type. The values are consistent with the consumer theory, ie
negative own-price elasticities and negativeness of the Slutsky matrix23 . The paper also finds
out that QES seems to give better estimation in terms of likelihood ratio and flexibility of
estimated results24 . By the same token, including demographic variables is also superior to
ignoring them.
Michelini (2001) uses AIDS and QUAIDS (see section 4.2 below), and demographic scaling on the New Zealand 1994/95 Household Economic Survey to estimate a demand system
of six commodity groups and five demographic variables. The results are used to construct
equivalent scales to measure the costs of having children. The findings are unexpected:
the costs of younger children are higher than for older ones. Meenakshi & Ray (2002) use
QUAIDS and a combination of demographic scaling and parameter modification to estimate
a demand system for India25 .

4.2

Blundell et al. (1993)

This paper is widely cited for its major contribution: it shows the advantage of using household level data over aggregate data and it also lays out a clear procedure for parameter
modification. But despite its popularity, this paper also has several weak points. First, the
selection of the theoretical specification is unclear. The authors do not explain the reason
and the advantage of using the quadratic extension of Deaton & Muellbauer’s (1980a) AIDS,
which they call QUAIDS26 . There is also no explanation for the choice of share form over the
others.
23

However the authors did not mentioned about symmetry and homogeneity.
The latter is intrinsic because QES has more parameters than LES.
25
In an earlier paper, Ray (1980) also estimates a demand system for India using AIDS and demographic
scaling.
26
Although the paper argues for the inclusion of the quadratic term and the exclusion of higher order
polynomial terms on statistical grounds, it gives no theoretical explanation. Not until Banks, Blundell &
Lewbel (1997) give fuller discussion on QUAIDS, are its advantages clearly identified: adding a quadratic
term creates curvature for the implied Engel curve, which replicates reality more accurately (implied Engel
curves for AIDS and translog are both linear). Michelini (2001) gives further intuition: it is more flexible than
AIDS as it can represent non-monotonic preferences, which allows goods to switch from normal to inferior
at different levels of income.
24

12

Second, the paper uses the parameter modification procedure but does not adequately discuss the implied theoretical restrictions. Although the paper intends to test homogeneity and
symmetry empirically to compare with other studies27 , there is no explanation of why demographic variables should enter the estimating specifications in that way. In addition, there
is no clarification for the properties of the disturbance terms and the selection of stochastic
specifications.
The authors do not discuss the econometric technique in detail, just say that they use IV
and GMM for estimation and minimum-chi-square (minimum distance) procedure for crossequation restrictions because OLS yields biased estimators due to measurement errors. The
data are from the British Family Expenditure Survey 1970-1984. The resulting elasticities
are all significant and compliant with theory. The test for homogeneity fails to reject the null
hypothesis, which is an important finding of this paper28 . However, the major contribution of
this paper is that it derives the conditions for the equivalence of using aggregate data versus
micro (household level) data and shows possible biases if these conditions do not hold.
Banks et al. (1997) and Brannlund & Nordstrom (2001) use a similar framework, ie QUAIDS
and parameter modification, to estimate demand systems in their papers.

4.3

Lau et al. (1978)

This is a typical paper that explicitly uses the variable inclusion. It uses a (homothetic)
translog indirect utility function and introduces demographic variables directly into the
translog specification. In that sense, the demographic variables and prices are exactly equivalent (total expenditure has been normalized to one). But not all parameters associated with
demographic variables in the original translog utility function are retained in the resulting
demand equations, only those with interaction with prices are. The authors use two demographic variables: the number of working persons and the number of dependents in each
household. No explanation is given for the use of the expenditure form of demands rather
than the other two forms. Perhaps the expenditure form is linear in log, which has a great
econometric advantage.
To set up stochastic specifications, the authors incorporate disturbance terms additively into
demand equations. Using GLS and data from the Report of Farm Record-Keeping Families
in Taiwan, 1967-1968, they estimate for three broad groups of commodities: agricultural and
non-agricultural products, and leisure. They only estimate two equations for the first two
commodities because of adding-up. Remember that homogeneity has been incorporated into
the system through the normalization of the total expenditure to one. Hence, they only need
to check for symmetry and negativity. The estimated parameters do not reject any of those
restrictions. In addition, the authors find out that number of workers in each household has
significant impact on the demand system. All elasticities comply with general theory.
27

In fact, statistical results do not reject homogeneity but do reject symmetry. The negativity of the
Slutsky matrix is not mentioned, while the authors claim that adding-up is automatically satisfy given the
structure of the system. In fact, dropping one equation could be a solution but the authors never mention
that.
28
Rejection of homogeneity and symmetry is commonly reported in other empirical works that use aggregate
consumption data (see (Deaton & Muellbauer 1980a)).

13

4.4

Browning & Meghir (1991)

This is also a popular paper in demand analysis. The authors introduce what they call
a conditional demand system, where conditional means the demand system for a group of
commodities is derived with a condition that all other commodities and demographic factors
are fixed and known a priori. In this study seven groups of non-durable commodities are
estimated conditional on male and female labor supplies and 19 demographic variables (16
are dummies) using UK Family Expenditure Surveys 1979-1984. The authors use parameter
modification to condition the demand system. This is the central point of the paper, which
makes the demand system different from those that use variable inclusion.
The authors use the share form of the AIDS system and IV technique to estimate since
labor supply is endogenous. The instruments are asset income and education (wages have
also been tried but the authors choose not to report). To impose symmetry, the authors
use minimum-chi-square technique. They also drop one equation to impose adding up. The
results as expected confirm the significance of labor supply and labor participation in consumption estimation. However, the separability test rejects the hypothesis that labor supply
is weakly separable, which means the conditional specification may not be the appropriate
one.
Using a similar framework, Kalwij, Alessie & Fontein (1997) investigate the female labor
supply effect on the demand system of the Netherlands.

4.5

Denton, Mountain & Spencer (2002)

This paper is an example of how one may misspecify demographic variables into demand systems. The author choose the share form of AIDS and simply put some dummies, demographic
variables, and disturbance terms additively into the theoretical equations. Luckily, the way of
setting up their system is equivalent to parameter modification because they misspecify the
original AIDS in the first place. Since they drop the constant term αi from equation (11), the
added variables just act as though they are the parameter modification for that constant term.
Using data from the Statistics Canada Family Expenditure Survey 1969-1996, the authors
estimate all elasticities of the demand system. The estimation is restricted for adding-up,
symmetry, and homogeneity. They do not report the technique of imposing the restrictions.
Then the authors do several forecasting using the estimated parameters. The forecasting results are the major finding of this paper: retirement does not change people’s preferences very
much, it only impacts on people’s consumption patterns through income effects. This conclusion is questionable on methodological grounds, ie the way they forecast the consumption
patterns after retirement. It also seems to contradict the concept of parameter modification,
since what they did precisely is change the parameters of the preferences given a change in
demographic variables, but their conclusion denies that.

4.6

Summary

14

Table 1: Demand Analysis - Empirical Studies
Paper

Func.
Form
LES/QES,
share form

Goods

Michelini
(2001)

AIDS/
QUAIDS,
share form

Food,
Housing,
Apparel,
Transport,
Health and
Education,
Recreation

Meenakshi
&
Ray
(2002)

AIDS/
QUAIDS,
share form

8
food Scaling
groups
and Modiand
3 fication
non-foods

Pollak
& Wales
(1978)

Food,
Clothing,
Miscelaneous

15

Dem.
Ec-metric
technique
Technique
Translating ML

Dem.
Variables
P, x, N =
number of
children
(plus two
adults)

Scaling/
Modification

average
ages of
adult male
and female
number of
adults,
infants,
children,
teenagers
numbers of
adults and
children,
land holding,
two
dummies
of
tribe
groups

non-linear
least
squares

FIML

Demographic Effects
For LES: marginal budget share independent
from N (property of LES and translating),
average budget share for food and clothing
increasing with N.
For QES: marginal and average budget share for
food increasing with N, average budget share for
clothing decreases with N for low income group,
independent of N for higher income. LES and
QES are similar for middle range income.
Equivalence Scales for different child-type household are calculated. Supprisingly, the scale for infants is larger than for 3-8 year-old children and
for teenagers.

Equivalence scales are esitmated which show significant effect of economy of scales in family consumption and differences between adult and children consumption. The demand for cereal is used
to calculate poverty line for different states of India.

Table 1: Demand Analysis - Empirical Studies (continued)
Paper

Func.
Form
Blundell
AIDS/
et
al. QUAIDS,
(1993)
share form

Banks
AIDS and
et
al. QUAIDS,
(1997)
share form
16

Brannlund AIDS and
&
Nord- QUAIDS,
strom
share form
(2001)

Goods
Food,
Alcohol,
Fuel,
Clothing,
Transport,
Services,
Other
Food, Fuel,
Clothing,
Alcohol,
Other
Petrol,
Public
transport,
Other
transport,
Heating,
Other

Dem.
Ec-metric
technique
Technique
Modification OLS and
GMM

Dem.
Variables
More
than
80
variables

Modification GMM

9
demographic
variables
and dummies
female and
male hours
of works
and 8 dem.
var.

Modification GMM

Demographic Effects
The dem. variables are intended to improve estimation fitness only, the authors are not particularly interested in and do not report demographic
effects.

The dem. variables are intended to improve estimation fitness only, the authors are not particularly interested in and do not report demographic
effects.
Labor supply has significant effect on petrol, but
not significant on transport and other transport.
Separability between labor supply and
consumption goods rejected.
For households without children, the demand for
petrol will increase more than for those with
children. Expenditure elasticities for households
in the three largest cities are higher. Little effects
are found for uncompensated price elasticities.

Table 1: Demand Analysis - Empirical Studies (continued)
Paper

17

Func.
Form
Lau et al. Log-linear
(1978)
espenditure system (homogeneous
translog),
expenditure
form
Browning
AIDS,
& Meghir share form
(1991)

Goods

Dem.
technique
agricultural, Inclusion
nonagricutural,
leisure

Food, Alcoholic,
Beverages, Fuel,
Clothing,
Transport,
Services,
Other

Ec-metric
Technique
GLS

Modification IV, GLS

Dem.
Demographic Effects
Variables
number of Number of working family member increases labor
workers,
supply elastically.
dependents, time
dummy

children 05, children
5-18, male
and female
hours
of
work, age
of
wife,
3
age
groups,
season
and region
dummies

Labor supply significantly affects elasticities. Children (particularly young) have significant correlation with labor participation decision. Hence, ignoring labor supply would produce significant impact on children parameters.

Table 1: Demand Analysis - Empirical Studies (continued)
Paper

Func.
Form
Kalwij
AIDS,
et
al. share form
(1997)

18

Denton
LA-AIDS,
et
al. share form
(2002)

Goods
Food,
Housing,
Clothing,
Personal
Care, Education
recreation and
transport,
Other
10 groups
of goods

Dem.
Ec-metric
technique
Technique
Modification IV
and
ALS

Dem.
Variables
female employment,
couple,
number of
children
under/over
6

Modification SUR

6
age
groups,
7
region
dummies,
household
size

Demographic Effects
Expenditure share on food increases from single
family to couple and then couple with children.
Housing and food do not depends on spouse employment. Housing, Education, recreation and
transport have low children effect. Families with
employed spouse spend more on education and
clothing and less on housing and personal care.
Clothing is necessity for families with a working
spouse, while luxury for single worker family. Food
is always a necessity.
Recreation, transport, alcohol, clothing, food form
restaurant, health and personal care are elastic at
any age. They also become more elastic with age.
Food at home and shelter are necessity and become
less inelastic with age. The simulation shows the
impact of age on elasticities mainly because of expenditure shift, not because of taste change.

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20

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