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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.

References

Banks, James, Blundell, Richard & Lewbel, Arthur (1997), ‘Quadratic Engel Curve and

Consumer Demand’, The Review of Economics and Statistics 79(4), 527–539.

Blundell, Richard, Pashardes, Panos & Weber, Guglielmo (1993), ‘What do we Learn About

Consumer Demand Patterns from Micro Data?’, American Economic Review 83(3), 570–

597.

Bradbury, Bruce (1996), Household Income Sharing, Joint Consumption and the Expenditure

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Labour Supply: Welfare Effects of Increasing Carbom Taxes, Umea economic studies

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Browning, Martin & Meghir, Costas (1991), ‘The Effects of Male and Female Labor Supply

on Commodity Demands’, Econometrica 59, 925–951.

Christesen, Laurits, Jorgenson, Dale & Lau, Lawrence (1975), ‘Transcendental Logarithmic

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Deaton, Angus & Muellbauer, John (1980b), Economics and Consumer Behavior, Cambridge

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Deaton, Angus, Ruiz-Castillo, Javier & Thomas, Duncan (1989), ‘The Influence of Household Composition on Household Expenditure Patterns: Theory and Spanish Evidence’,

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19

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Phlips, Louis (1983), Applied Consumption Analysis, Vol. 5 of Advanced Textbooks in Economics, North-Holland Publishing Company.

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Pollak, Robert & Wales, Terrence (1978), ‘Estimation of Complete Demand System from

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20

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