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Testing non-nested demand relations: linear expenditure system versus indirect addilog

  • Paul de Boer
  • Richard Paap

In applied economic research computable general equilibrium [CGE] models in which the behavior of economic agents are modeled, are widely used. In many CGE models, the Linear Expenditure System [LES] is used to model behavior of the household sector. The disadvantage of LES is that the Engel curves, describing the relationship between expenditure on a certain commodity and total expenditure, are straight lines. Moreover, the LES does not allow for the existence of inferior commodities, elastic demand and gross substitution. An alternative model for the household block is the Indirect Addilog System [IAS] which is as simple to implement as LES, but which does not suffer from these theoretical deficiencies. Consequently, IAS provides a theoretically richer description of household behavior than LES, while it is as easy to implement. In this paper we test the LES specification against the IAS specification in case one disposes of a budget survey. It is not possible to use a standard likelihood ratio test as both models are not nested. We propose to use the likelihood ratio test for non-nested hypotheses due to Vuong (1989), or, alternatively, the distribution-free test due to Clarke (2007). We apply both tests to the Palestinian Expenditure and Consumption Survey (PECS, 2005) and find that there is overwhelming evidence that the IAS specification is to be preferred to the LES specification.

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Article provided by Netherlands Society for Statistics and Operations Research in its journal Statistica Neerlandica.

Volume (Year): 63 (2009)
Issue (Month): 3 ()
Pages: 368-384

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Handle: RePEc:bla:stanee:v:63:y:2009:i:3:p:368-384
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  1. Henk Don & Johan Verbruggen, 2006. "Models and methods for economic policy; 60 years of evolution at CPB," CPB Discussion Paper 55, CPB Netherlands Bureau for Economic Policy Analysis.
  2. Arjan Lejour & Paul Veenendaal & Gerard Verweij & Nico van Leeuwen, 2006. "Worldscan; a model for international economic policy analysis," CPB Document 111, CPB Netherlands Bureau for Economic Policy Analysis.
  3. Murty, K N, 1982. "Theoretical Restrictions on the Parameters of Indirect Addilog Demand Equations-A Comment," Econometrica, Econometric Society, vol. 50(1), pages 225-27, January.
  4. Lejour, Arjan & Rojas-Romagosa, Hugo & Verweij, Gerard, 2008. "Opening services markets within Europe: Modelling foreign establishments in a CGE framework," Economic Modelling, Elsevier, vol. 25(5), pages 1022-1039, September.
  5. Somermeyer, W. H. & Langhout, A., 1972. "Shapes of Engel curves and demand curves: Implications of the expenditure allocation model, applied to Dutch data," European Economic Review, Elsevier, vol. 3(3), pages 351-386, November.
  6. Jeffrey Reimer & Thomas Hertel, 2004. "Estimation of International Demand Behaviour for Use with Input-Output Based Data," Economic Systems Research, Taylor & Francis Journals, vol. 16(4), pages 347-366.
  7. Hanoch, Giora, 1975. "Production and Demand Models with Direct or Indirect Implicit Additivity," Econometrica, Econometric Society, vol. 43(3), pages 395-419, May.
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