Assignment of Agricultural marketing and price

Analysis
Market Demand Analysis: Almost Ideal Demand System (AIDS).
College: Agricultural and Environmental Sciences
School: Agricultural Economics and Agribusiness
Program: Agriculture and Applied Economics (CMAAE)

By: Taju Aman

Submitted to: Fresenbet Zeleke (PhD)
The Almost Ideal Demand
System

1. Introduction
Demand
 willingness and ability of consumers’ to purchase a given amount of a
good or service at a given price

 Explained by using graph, function or theory

 Determined by own price, price of related good ,income etc.

 It represented in demand function in the form of equation

 The models of demand are represented by system of equation

3
 Cont…
 A demand system is a group of demand equations that can be
estimated simultaneously

 Demand equations were some of the earliest economic

relationships to be analyzed using statistical techniques.

 From an econometric point of view, these models are interesting in

that they involve nonlinearity and complete system estimation
methods.
4
Cont….
 Estimation of systems of demand functions was at the
forefront of applied economic research .

 Attention was also given to the measurement of elasticities

and to the problem of specifying flexible and easily testable
functional forms consistent with utility theory.

 Estimation of demand systems, which rely on duality theory,

have become common.
5
Cont.
 Methodologically, two approaches can be followed to estimate the
parameters of demand equations:

 Single-equation demand functions, and

 Theory of demand as a guideline for the choice of functional

forms and variables.

 Single-equation demand functions is one consists in specifying

estimable single-equation demand functions in a pragmatic fashion
without recourse to economic theory. 6
Cont…
 A typical situation, for instance, is to estimate from time series
data the income and price elasticities for a commodity i in a
constant elasticity demand equation.

 An alternative approach to the estimation of demand equation

parameters uses the theory of demand as a guideline for the choice
of functional forms and variables to be included.

7
 Cont…
 In particular, the theory allows
(1)the derivation of estimable functional forms of demand
equations from mathematically specified models of consumer
choice and
(2) the imposition of constraints on demand parameters to reduce
the number of independent parameters to be estimated to
manageable numbers relative to the data available
 Estimation of single demand functions is inadequate for use
in complete models such as multi-markets and CGEs.
8
 Cont…
 For this purpose, complete systems of demand equations which are able to
take into account consistently the mutual interdependence of large numbers
of commodities in the choices made by consumers need to be specified and
estimated.

 Complete demand systems usually generate estimates of all own-price

elasticities, marginal budget shares of all aggregate consumption categories
and individual goods, and all Slutsky or income compensated own-price
and cross-price elasticities. 9
Cont…
 Demand systems can be estimated using methods such as Simultaneous Equation
Systems, and Seemingly Unrelated Regression (SUR)
 SUR consists of equations with specific independent and dependent variables,
which are linked by a common unknown error. The most popular demand systems
are;
 Linear expenditure system
 Translog model
 The Rotterdam model
 The linear approximate Almost Ideal Demand System model
10

 Nonlinear Almost Ideal Demand System model (AIDS).

 Almost Ideal Demand system
 AIDS) of Deaton and Muellbauer is one of the most widely used flexible
demand specifications.

 The AIDS derives from a utility function specified as a second order

approximation to any utility function. The demand functions are derived
in budget share .

 possesses a functional form consistent with household budget data

 While the AIDS possesses many desirable properties, it may be difficult

11

to estimate.
Cont…
 To simplify the estimation problem, Deaton and Muellbauer suggested
using a linear approximation.
 The linear approximate almost ideal demand system (LA/AIDS) has
been employed in the vast majority of empirical applications of the
AIDS model, with a variety of formulas to compute elasticities.

 dynamic linear approximate AID system incorporating habits is

preferred to the other specifications (with the exception of the error-
correction model). 12
Cont…

 However, the evidence indicates that the homogeneous static linear

approximate AID system is the only specification that;
 (i) does not suffer from lack of precisely estimated parameters
and
(ii) yields results that are interpretable and empirically plausible

13
 2.Theoretical framework
 Consumer theory is the theory of the consumers’ demand and choice.
 It deals with how and why consumers make a decision or make choice
regarding the consumption quantity of a particular good or set of
goods, at a given price and other circumstances.
 In consumer theory, we study the money spending decision of people
on various goods based on their taste and preference and they are
constrained by the given budget.

14
 Cont…
Neo-classical Theory of Consumer Behavior

 Neo-classical consumer economics is concerned with the question of

choice that consumers make during their budget allocation activities.

 A rational consumer chooses the consumption basket, which generate the

highest level of utility.

 On the ground of this postulate, one can derive a set of demand

equations, the parameters of which an empirical researchers seek to
estimate 15
 Cont…
 Provided that the preference axioms are met and the commodity set
performs properties as described above, the utility function will also in
possession of nice properties: i.e. order preserving, monotonic, quasi
concave, real valued and continuous

Derivation of the Almost Ideal Demand System( AIDS)

 The formulation of the AIDS model assumes the commodities included

in the demand system are at least weakly separable from all other
commodities excluded from the demand system. 16
 Cont…
 The objective of the dual problem is to minimize costs, subject to a specified direct utility level.

Dual Problem: Minimize X=σ𝑛𝑗=1 𝑝𝑗𝑞𝑗 j=1,2,3,…n …………………….2.1

Subject to : V(q)= U

where x=total expenditure

p =price of goods

q=quantity of goods

V(q) = arbitrarily level utility

17
 Cont…
Min L=σ𝑛𝑗=1 𝑝𝑗𝑞𝑗-λ(V(q)-U) ………………………… 2.2

 Taking the appropriate derivatives the first order condition

𝜕𝐿
= 𝑝 𝜕𝑉 𝑞
𝜕𝑞𝑗 𝑗−𝜆
𝜕𝑞𝑗
=0

𝜕𝑉 𝑞
𝑝𝑗 = 𝜆 ……………...2.3
𝜕𝑞𝑗

𝜕𝐿
=𝑉 𝑞 −𝑈 =0
𝜕𝜆
18

V(q)=U…………………….2.4
Cont…
 Solving equations (2.3) and (2.4) simultaneously for each leads to
Hicksian demand equations.

qj= hj(p,u)………………………………………2.5

 Hicksian demand functions (income compensated demand) show the

relationship between good price and the quantity of the good
demanded when the price of all other goods and utility is fixed.

19
Cont…
 Hicksian demand functions (income compensated demand)
show the relationship between good price and the quantity of
the good demanded when the price of all other goods and
utility is fixed.

 By substituting 2.5 into 2.1 we get total expenditure function

X= C(P,U)…………………………..2.6

20
 Cont….
 Consumer preferences are the basis for the Price Independent General
Linear Logarithmic Function or PIGLOG class demand system.

 This class of function is denoted with cost or expenditure functions that

provide the minimum cost of obtaining a distinct utility level.

 The PIGLOG class is defined by

Log C (u,p) = (1-u) log{𝑎(𝑝)} +u log{𝑏(𝑝)}

=log{𝑎(𝑝)} - u log{𝑎(𝑝)} +u log{𝑏(𝑝)……………2.7

21
 Cont…
 Deaton and Muellbaur then specified the following flexible function forms for
log 𝑎(𝑝) and log 𝑏(𝑝)
1
Log 𝑎(𝑝) = 𝑎𝑖 + σ𝑛𝑖=1 𝑎𝑖 𝑙𝑜𝑔 𝑝𝑖 + σ𝑛𝑖=1 σ𝑛𝑗=1 𝛾𝑖𝑗 log 𝑝𝑖 log(𝑝𝑗 )...........2.8
2

Log 𝑏(𝑝) = log 𝑎(𝑝) + 𝛽0 ς𝑛𝑗 𝑝𝑗 𝛽𝑗

………………………… 2.9

 By inserting 2.9 into 2.7 we get the following expression

Log C (u,p) =log 𝑎(𝑝) - u log 𝑎(𝑝) +u log 𝑎(𝑝) +u𝛽0 ς𝑛𝑗 𝑝𝑗 𝛽𝑗
= log 𝑎(𝑝) + 𝑢𝛽0 ς𝑛𝑗 𝑝𝑗 𝛽𝑗 ….……….2.10

22
Cont…
 Now let us insert 2.8 into 2.10
1
Log C (u,p) = 𝑎𝑖 + σ𝑛𝑖=1 𝑎𝑖 𝑙𝑜𝑔 𝑝𝑖 + σ𝑛𝑖=1 σ𝑛𝑗=1 𝛾𝑖𝑗 log 𝑝𝑖 log(𝑝𝑗 ) + u𝛽0 ς𝑛𝑗 𝑝𝑗 𝛽𝑗 ……..2.11
2
 This cost function which provide the minimum expenditure required to achieve a given level
of utility
 Greek letters (𝛼, 𝛽, 𝛾)represent parameters to be estimated.
 These functional forms were chosen because they are sufficiently flexible that they can
reproduce any arbitrary set of first and second derivatives of the cost function at any single point.
 It provide a means of testing theoretical restriction
 Hicksien demand expression by deriving cost function
𝜕𝐶(𝑢,𝑝)
𝑞𝑖ℎ = …………………………………………………………………………2.12
𝜕𝑝𝑖

23
 Cont…
 The share of total expenditure on a good in demand system group is calculated
𝑝𝑖 𝑞 𝑖 𝜕𝑙𝑜𝑔ሾ𝑐(𝑢,𝑝)ሿ
as: 𝜔𝑖 = = …………………………………. 2.13
𝐶(𝑢,𝑝) 𝜕𝑙𝑜𝑔𝑝𝑖
𝑋
𝜔𝑖 = 𝛼 + σ𝑛𝑗 𝛾𝑖𝑗 𝑙𝑜𝑔𝑝𝑗 + 𝛽𝑖 log ….....................2.14
𝑝
1 ∗ 𝑥 𝛽𝑗
where 𝛾𝑖𝑗= 𝛾𝑖𝑗 + 𝛾𝑗𝑖∗ , 𝑙𝑜𝑔 = log p + 𝛽0 ς𝑗 𝑝𝑗
2 𝑝

This is budget share equation

𝜔𝑖 is the amount of money spent on good i divided by total expenditure
 log{a(P)} is also called the translog price index which difficult to use is
estimated by stone price index.
24
Cont….
 Translog price index ;
1
𝑝 = 𝑙𝑜𝑔𝑎 𝑝 = 𝛼𝑜 + σ𝑛𝑖=1 𝑎𝑖 log 𝑝𝑖 + σ𝑛𝑖=1 σ𝑛𝑗=1 𝛾𝑖𝑗 log 𝑝𝑖 log(𝑝𝑗 )
2

 Stone price index;

log 𝑝∗ = σ𝑛𝑖 𝜔𝑖 log(𝑝𝑖 ) …...........................2.15
 The Stone price index is estimated before the model; therefore it is not an
endogenous calculation at each point in time.
 As a result of using the Stone price index, the AIDS model is considered a
linear approximate version. 25
 Cont…
 Certain theoretical conditions can be imposed on the AIDS model in estimations to test their theoretical
validity.

 These assumptions are:

1. Additivity σ𝑛𝑖=1 𝛼 = 1 ……………………………….. .2.16

2. Homogeneity σ𝑛𝑖=1 𝛾𝑖𝑗 = 0 and σ𝑛𝑖=1 𝛽𝑖 = 0……………2.17

3. symmetry 𝛾𝑖𝑗 = 𝛾𝑗𝑖 …………………………………….…………….2.18

 Given that these conditions hold:

 (1) the expenditure share for each good in the demand system adds up to total expenditure;

 (2) each demand equation is homogeneous of degree zero in prices and total expenditure, which
implies no money illusion
26
 (3) Slutsky symmetry is satisfied
Cont….
 calculating demand elasticities from the AIDS parameters, Marshallian or noncompensated
demand functions are used instead of the Hicksian demands

 Marshalian demand functions

 are derived from the primal problem.

 derived from the indirect utility function, where utility is a function of prices and
expenditure

 Roy’s identity is used to extract the Marshallian demand funtions for each good from
the indirect utility function

𝜕𝑢(𝑝.𝑥)
𝜕𝑝𝑗
𝑞𝑗𝑚 = − 𝜕𝑢(𝑝,𝑥) …………………………………………………2.19
27
𝜕𝑥
Cont….
 Primal Problem: maximize: u (q) subject to 𝑥 = σ𝑛𝑗 𝑝𝑗 𝑞𝑗 .………2.20

L= u (q) -𝜆(σ𝑛𝑗 𝑝𝑗 𝑞𝑗 − 𝑥) by taking the first order derivatives of L

𝜕𝐿 𝜕𝑢(𝑞) 𝜕𝑢(𝑞)
𝜕𝑞𝑗
= 𝜕𝑞𝑗
− 𝜆𝑝𝑗 = 0 → 𝜆𝑝𝑗 = 𝜕𝑞𝑗
……………………………………2.21

𝜕𝐿
= σ𝑛𝑗 𝑝𝑗 𝑞𝑗 − 𝑥 = 0 → 𝑥 = σ𝑛𝑗 𝑝𝑗 𝑞𝑗 …………………………………..2.22
𝜕𝜆

 Solving equations (2.21) and (2.22) simultaneously, with respect to each, results in the Marshallian demand
equation for each good j

𝑞𝑗𝑚 = 𝑚𝑗 (𝑥, 𝑝) …...................................................2.23

 Substitution of the Marshallian demands (2.23) into the direct utility function results in the indirect utility
function. Which is the maximum utility level that can be achieved for a given set of prices (P) and expenditure
level (X)
28
𝑢∗ = 𝑢(𝑥, 𝑝)…………………………………………………………… 2.24
 Cont…
Expenditure elasticity
𝜕𝑙𝑜𝑔𝑞𝑗𝑚 𝜕𝑞𝑗𝑚 𝑥 𝛽𝑖
= ∗ = + 1 …………………………………………2.25
𝜕𝑙𝑜𝑔𝑥 𝜕𝑥 𝑞𝑗𝑚 𝜔𝑖

Own and cross price elasticity

𝑥
𝜕log(𝑞𝑖) ) 𝑞𝑗𝑚 𝑝𝑗 𝛾𝑖𝑗 −𝛽𝑗 𝑤𝑗 −𝛽𝑗 log
𝑝∗
= ∗ = − 𝛿𝑖𝑗 …………………… 2.26
𝜕log(𝑝𝑗 ) 𝜕𝑝𝑗 𝑞𝑗𝑚 𝜔𝑖

𝛿𝑖𝑗 = 1 , 𝑖𝑓 𝑖 = 𝑗, ( 𝑜𝑤𝑛 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦)

𝛿𝑖𝑗 = 0 , 𝑖𝑓 𝑖 ≠ 𝑗, ( 𝑐𝑟𝑜𝑠𝑠 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 )

 Using these elasticities, the effects of a price change or expenditure change on the quantity demanded for each good in the
29
demand system can be estimated.
 3. Methodological and Analytical framework
3.1 Assumptions ( restrictions)

1. Additivity σ𝑛𝑖=1 𝛼 = 1 ……………………………….. .2.16

2. Homogeneity σ𝑛𝑖=1 𝛾𝑖𝑗 = 0 and σ𝑛𝑖=1 𝛽𝑖 = 0……………2.17

3. symmetry 𝛾𝑖𝑗 = 𝛾𝑗𝑖 ………………………………….…………….2.18

4. the assumption of separability

 If goods can be separated into different groups without the demand

for goods in other groups affecting the demand for a good in a given
group, separability of preferences holds between groups
30
Cont…
 It can be weak or strong
 Strong or additive separability of preferences implies each
good belongs in a separate demand group
 Weakly separable preferences imply consumer goods can
be grouped into subsets of goods. Weak separability of
preferences implies the marginal rate of substitution
between two goods in one group is independent of
quantities in another group

31
 cont…
Estimations technique
 In general, estimation can be carried out by substituting (2.15) in (2.14)

𝑥
( 2.14) 𝑤𝑖 = 𝛼0 + σ𝑛𝑗 𝛾𝑖𝑗 log 𝑝𝑖 + 𝛽𝑖 𝑙𝑜𝑔
𝑝

1
(2.15) 𝑙𝑜𝑔𝑝 = 𝛼0 + σ𝑛𝑖=1 𝛼𝑖 log 𝑝𝑖 + 2 σ𝑖 σ𝑗 𝛾𝑖𝑗 log 𝑝𝑖 log(𝑝𝑗 )

 It gives the following equations

1
𝑤𝑖 = 𝛼𝑖 − 𝛽𝑖 𝛼0 + σ𝑗 𝛾𝑖𝑗 log(𝑝𝑖 ) + 𝛽𝑖 𝑙𝑜𝑔𝑥 − σ𝑖 𝛼𝑖 log 𝑝𝑖 − σ𝑖 σ𝑗 𝛾𝑖𝑗 log 𝑝𝑖 log(𝑝𝑗 )
2

 Estimating this non-linear system of equations by maximum likelihood or other methods with and without the restrictions

 The above equations is not particularly difficult to estimate since the first-order conditions for likelihood maximization are linear in 𝛼 𝑎𝑛𝑑 𝛾 given
𝛽.

 Stone's price index logP*=σ 𝑤𝑖 log𝑝𝑖 . If P ≅ φ𝑝∗ can be estimated as

𝑥
𝑤𝑖 =(𝛼𝑖 -𝛽𝑖 logφ )+ σ 𝛾𝑖𝑗 log𝑝𝑗 + 𝛽𝑖 log
𝑝∗
32
 Cont…
3.1.1 Aggregation Over Households

 The aggregation theory developed in Muellbauer (1975, 1976) implies

that exact aggregation is possible if, for an individual household h,
behavior is described by the generalization of (2.14):

(2.14') wih = αi + σj y ij log pj + β i log{x h /k hP}

The parameters kh can be interpreted as a sophisticated measure of household

size which, in principle, could take account of age composition, other
33

household characteristics, and economies of household size

 Cont..
Two-stage budgeting and separability

 when an external factor cannot provide consistency to relative prices in order to define
commodity groups, preferences could be used instead to structure commodities

 A two-stage budgeting procedure assumes that consumers allocate total expenditure in two
stages.

 In the first stage, total expenditure is allocated over broad groups of goods (food, shelter and
entertainment for example).

 In the second stage, group expenditures are allocated over individual commodities within
each group (Jung, 2000).

 An advantage of this two-stage budgeting procedure is that, in each stage, information

34

appropriate to that stage only is required.

Cont…
3.3 Data requirement

 The data requirements to apply these techniques are

 household expenditures by commodity,
 quantity of each commodity consumed, and
 individual characteristics

3.4 Advantage and Disadvantage including estimation problems

 Some of the advantages of this model includes
 it satisfies the axioms of choice exactly

35
Advantages;
 itaggregates perfectly over consumers without invoking parallel linear Engel
curves
 it has a functional form which is consistent with known household-budget data
 it is simple to estimate, largely avoiding the need for non-linear estimation
 itcan be used to test the restrictions of homogeneity and symmetry through
linear restrictions on fixed parameters

36
Cont…
Disadvantage

 Some of disadvantages of model ;

 If the dependent variable is thus truncated, creating a bias in the OLS

estimates.

 Demand parameters need to satisfy a number of exact restrictions

 Demand equations appear to be unrelated, since none of the endogenous

quantities or budget shares appear on the right-hand side of the equations.
37
 Empirical review
 For some policy questions the importance of empirical evidence on
consumer behaviour is indisputable

 The most appealing feature of economic research into consumer

behaviour is the close relationship between theoretical specification
and appropriate estimation technique.

 This is most apparent when empirical analysis and testing takes place
at the individual or micro level.
38
Cont….
 However, even at the macro or aggregate level, given that some notion of
consumer optimising behaviour is often assumed to underlie the evolution
of the aggregate data
 Effective assessment of the model specification requires judgment from
the theoretical as well as the empirical standpoint.
 The selected papers are critically reviewed and the similarities and
differences are identified in terms of objectives, data type and models
used to analysis.
39
 Cont…
 The selected papers are critically reviewed and the similarities and differences are
identified in terms of objectives, data type and models used to analysis.

 Some of paper on Almost Ideal Demand System

 An Almost Ideal Demand System Analysis of Orange and Grapefruit Beverage

Consumption in the United States (Catrice D. Taylor , 2014)

 It is the study of demand for orange and grapefruit juice with the objective of
analyzing the price sensitivity and consumption of orange and grapefruit juice,
orange and grapefruit drink and citrus blend juices in the United States.
40
 Cont…
 Price and expenditure elasticities are estimated for the various citrus
juice commodities.

 The demand system for natural fruit juices and flavored citrus drinks
was estimated. Consumption and price data from the Florida
Department are used to estimate a Linear Approximate Almost Ideal
Demand System for natural fruit and fruit juice drink elasticities.

 The monthly data covers the period from October 2004 to June 2014.

 . 41
Cont…
 The demand for seven citrus beverages ( 100% orange juice, 100%
grapefruit juice, orange juice blend, grapefruit juice blend, orange drink,
orange juice blend drink, and grapefruit juice cocktail) are estimated in
the study.

 In addition, time trend variable , seasonal indicator variables and

percentage of women employed in work force are added as additional
variables
42
 Cont…
 The estimated results of own price elasticity shows 100 % orange juice is relatively inelastic while
grapefruit juice, orange juice blend, grapefruit juice cocktail, and grapefruit juice blend are all elastic. The
grapefruit products are most responsive to price, especially grapefruit juice blend

 The estimated result of cross price elasticity shows orange juice has more compliments than substitutes.
The only substitutes for orange juice are orange juice blend and grapefruit juice blend. These juices are all
100% juice, and can offer similar tastes. More of the orange beverages were expected to be substitutes for
orange juice. Orange juice blend drink and grapefruit juice cocktail are substituted by orange juice drink,
orange juice blend, and grapefruit juice blend.

 The results for expenditure elasticity shows all citrus juice products have positive expenditure elasticities.
Orange juice drink, orange juice blend, orange juice blend drink are affected the most by increases in
43
expenditure.
 Cont…
• The demand for meat in South Africa: An almost ideal estimation( PR
Taljaard et al.,2010) A Linear Approximated Almost Ideal Demand System
(LA/AIDS), estimated in first differences, was used to anticipate the demand
relations for meat (beef, chicken, pork and mutton) in South Africa from
1970 – 2000.

• Annual time series data from the NDA (2003) were used to calculate the
variables for the LA/AIDS model specified in Equation.
44
 Cont…
 Compensated own price elasticities of all four meat products are relatively inelastic,
carry negative signs as expected a priori, and are statistically significant at the 5% level.
The compensated own price elasticity for pork (-0.31) is the most elastic, followed by the
own price elasticity for mutton (-0.28), chicken (-0.19) and beef (-0.16). Except for the
cross-price elasticity between chicken demand and pork price, and vice versa, all other
cross-price elasticities carry positive signs as expected for substitute products

45
Cont…
 The uncompensated own price elasticities of beef (-0.75), chicken (-
0.35), pork (-0.37) and mutton (-0.47) are significantly lower compared
with some of the previous estimates for meat in South Africa.
 The calculated expenditure elasticities for South African meat products,
which are all positive and statistically significant at the 5% level,
indicate that all meat can be considered as normal to luxury goods, as
expected a priori Expenditure elasticities for beef (1.24) and mutton
(1.18) are greater than one, indicating that they can be considered luxury
goods. 46
 Cont…
 As for the case of the compensated own price elasticities, the
uncompensated own price elasticities also carry the a priori expected
negative signs and are statistical significant at the 5% level.

 Although the expenditure elasticity for pork (0.947) is less than one, it is
close enough to one, which is the cut-off point between luxury and
necessary products. The relative low expenditure elasticity of chicken
(0.53) indicates that chicken can be considered a necessity as a protein
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source in South African diets.
Cont…

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