Estimation of income elasticities and their use in a CGE model for Palestine

A popular functional form for modeling the consumption block of a computable general equilibrium model (CGE) is the Linear Expenditure System (LES) for which the Engel curves are straight lines. The LES does not allow for the existence of inferior commodities, for elastic demand and does not allow gross substitution. To calibrate the parameters outside information on income elasticities and the Frisch parameter is needed. In this paper we propose to use the Indirect Addilog System (IAS) that allows for non-straight Engel curves, inferior commodities, elastic demand and gross substitution, and for which the outside data requirement is the same as for LES. The income elasticities of the IAS can easily be estimated from a budget survey. In the empirical part we estimate the income elasticities of the IAS from the 1998 Palestinian Expenditure and Consumption Survey (PECS). We replace the LES consumption block with a priori fixed income elasticities of the CGE model, that we previously constructed for Palestine based on the 1998 Social Accounting Matrix (SAM), by the IAS with estimated income elasticities and perform a sensitivity analysis for the choice of the Frisch parameter or, equivalently, of the own price elasticity of the reference commodity. A comparison between the results obtained with a LES-model and a IAS-model makes it possible to further clarify the importance of using a IAS to represent consumption behaviors.