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Discrete Choice Models as Structural Models of Demand: Some Economic Implications of Common Approaches

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  • Patrick Bajari
  • Lanier Benkard
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    Abstract

    October 2001 We derive some theoretical economic properties of standard discrete choice econometric models that we believe are undesirable if the models are to be used as structural models of demand. We show that many standard models have the following properties: as the number of products increases, the compensating variation for removing all of the inside goods tends to infinity, all firms in Bertrand-Nash pricing game have markups that are bounded away from zero, and for each good there is always some consumer that is willing to pay an arbitrarily large sum for the good. These undesirable properties may lead to incorrect conclusions about many policies of interest, including calculation of price indexes, the benefits of new goods, and the welfare loss due to mergers. We demonstrate that these undesirable properties hold not only in the logit model, but also in all random utility models with the following three general properties: 1) the model includes an additive error term whose conditional support is unbounded, 2) the deterministic part of the utility function satisfies standard continuity and monotonicity conditions, and 3) the hazard rate of the error distribution is bounded above. One approach to avoiding these undesirable properties is to weaken these three restrictions. However, we also show that random utility models are not in general non-parametrically identified from market shares or individual level choice data. Our findings support the use of alternative structural approaches that have better economic properties, such as those of Bajari and Benkard (2001) and Berry and Pakes (2000). Working Papers Index

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    Bibliographic Info

    Paper provided by Stanford University, Department of Economics in its series Working Papers with number 01016.

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    Date of creation: Oct 2001
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    Handle: RePEc:wop:stanec:01016

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    1. Daniel A. Ackerberg & Marc Rysman, 2005. "Unobserved Product Differentiation in Discrete-Choice Models: Estimating Price Elasticities and Welfare Effects," RAND Journal of Economics, The RAND Corporation, vol. 36(4), pages 771-788, Winter.
    2. Nevo, Aviv, 1998. "Measuring Market Power in the Ready-To-Eat Cereal Industry," Research Reports 25164, University of Connecticut, Food Marketing Policy Center.
    3. Hendel, Igal, 1999. "Estimating Multiple-Discrete Choice Models: An Application to Computerization Returns," Review of Economic Studies, Wiley Blackwell, vol. 66(2), pages 423-46, April.
    4. Peter Davis, 2006. "Spatial competition in retail markets: movie theaters," RAND Journal of Economics, RAND Corporation, vol. 37(4), pages 964-982, December.
    5. Caplin, Andrew & Nalebuff, Barry, 1991. "Aggregation and Imperfect Competition: On the Existence of Equilibrium," Econometrica, Econometric Society, vol. 59(1), pages 25-59, January.
    6. Berry, Steven & Levinsohn, James & Pakes, Ariel, 1995. "Automobile Prices in Market Equilibrium," Econometrica, Econometric Society, vol. 63(4), pages 841-90, July.
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    Cited by:
    1. Donghun Kim, 2004. "Estimation of the Effects of New Brands on Incumbents’ Profits and Consumer Welfare: The U.S. Processed Cheese Market Case," Review of Industrial Organization, Springer, vol. 25(3), pages 275-293, 09.

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