Model – Linear expenditure system.pptx

People can use it to understand the basic of LES and AIDS

1. Course code – AGECON-601 Course title- Advance Micro Economic Analysis Submitted to Submitted by Dr. BC Jain Ankur Jaiswal Model – Linear expenditure system and Almost ideal demand system

2. Introduction Demand Model :- Primary function of demand models is to predict the future using time series related or other data we have in hand. Demand modeling uses statistical methods and business intelligence inputs to generate accurate demand forecasts and effectively address demand variability. Demand Model Linear Expenditure System (LES) Almost Ideal Demand System (AIDS)

3. Linear Expenditure System (LES) Developed by- Stone (1954) The Linear Expenditure System (LES) is an economic model used to analyze consumer behavior in terms of their spending patterns . It is a simple and classical model that assumes a linear relationship between a consumer's income and their expenditure on various goods and services. The LES is often used in microeconomics and consumer theory to understand how changes in income affect consumption.

4. Linear Expenditure System (LES) The basic idea behind the Linear Expenditure System can be summarized in the following equation : Where: E i is the expenditure on a specific good or service. Y represents the consumer's income. a i ​ is the expenditure coefficient, which indicates the proportion of income spent on that particular good or service. b ​ i is the intercept term, representing the minimum expenditure on the good or service, even if the consumer has no income. E i ​= a i Y+b i ​

5. Expenditure on a specific good or service ( E i ): This represents how much a consumer spends on a particular product or service. In the LES, it is assumed to depend on the consumer's income ( Y ) and other constants specific to that good or service. Income ( Y ): This is the total amount of money a consumer has available to spend on goods and services. Expenditure Coefficient ( a i ): This coefficient reflects the proportion of a consumer's income spent on a specific good or service. In other words, it represents how sensitive the consumer's spending on that particular item is to changes in their income. If a i is 0.2, it means that for every $1 increase in income, the consumer will spend 20 cents more on that item. Intercept Term ( b i ): This term indicates the minimum expenditure on the good or service, even if the consumer has zero income. It captures the idea that some level of consumption may occur even when income is very low or zero. For example, b i could represent the minimum amount someone spends on basic food even if they have no income.

6. The LES model assumes that the expenditure coefficients a i and intercept terms b i ​ remain constant over a certain range of income. However, in reality, consumer spending patterns may not always follow a perfectly linear relationship, especially at very low or high income levels . The LES can be used to make predictions about how changes in income or prices of goods and services will affect a consumer's spending behavior. It is a basic tool for analyzing demand and can be helpful in estimating the effects of changes in government policies, such as income taxes or subsidies, on consumer choices and welfare. Linear Expenditure System (LES)

7. ASSUMPTIONS Linearity Homogeneity Fixed Budget Stability No Time Dimension Perfect Information No External Influences Rational Behavior

8. Application of LES Demand Analysis: The LES is used to analyze and predict consumer demand for specific goods and services. By understanding how changes in income affect consumer spending on different items, it helps businesses and policymakers anticipate market behavior. Budgetary Planning: LES can be employed to estimate how individuals or households allocate their income to different categories of expenditure. This information is crucial for financial planning, budgeting, and assessing the impact of changes in income or expenses. Tax Policy Analysis: Economists and policymakers use LES to evaluate the impact of tax policies on consumer behavior. By understanding how consumers adjust their spending in response to changes in income due to taxation, policymakers can design tax structures that are both revenue-efficient and equitable.

9. Application of LES Economic Welfare Analysis: The model can be applied to assess the welfare implications of economic policies. It helps in understanding how changes in prices, income, or policies affect the well-being of various income groups and can be used to design policies that aim to reduce income inequality and improve overall welfare. Market Research: LES is a useful tool for businesses to forecast consumer behavior in response to changes in prices or income. This information is invaluable for marketing, product development, and pricing strategies. Government Subsidy Programs: It can help assess the impact of subsidy programs on the consumption of specific goods or services. Policymakers use LES to understand whether subsidies effectively encourage the consumption of targeted items, such as basic necessities.

10. Advantages of the Linear Expenditure System (LES): Simplicity: The LES is a straightforward model that is easy to understand and apply. It serves as a useful starting point for teaching and learning about consumer behavior in introductory economics courses. Analytical Tool: It provides a simple framework for analyzing and predicting how changes in income or prices affect consumer spending on specific goods and services. This makes it a valuable tool for examining basic demand relationships. Policy Analysis: The model can be used to evaluate the impact of changes in government policies, such as income taxes, subsidies, or welfare programs, on consumer choices and overall welfare. Useful Benchmark: While the LES may be an oversimplification of real-world consumer behavior, it can serve as a benchmark for comparing more complex demand models. It helps economists understand the implications of relaxing certain assumptions.

11. Disadvantages of the Linear Expenditure System (LES): Assumptions: The LES relies on several simplifying assumptions, such as the linearity of expenditure coefficients and constant intercept terms, which may not hold in reality. Consumer spending patterns are often more complex and nonlinear. Limited Realism: The model does not capture the full range of factors that influence consumer behavior, such as consumer preferences, substitution effects, and complementarity between goods. It oversimplifies the dynamics of real-world markets. Inflexibility: The LES assumes that the relationships between income and spending on goods are fixed over a specific income range. In reality, consumer behavior can change at different income levels, and spending patterns may vary. Lack of Precision: The LES may not provide precise predictions of consumer behavior because it doesn't consider many nuances and factors that affect spending decisions. Not Suitable for All Goods: It may work well for certain categories of goods and services that exhibit relatively stable consumption patterns but may not be appropriate for goods with highly elastic or inelastic demand. Limited Use for Long-Term Analysis: The LES is more suitable for short-term analysis and may not be effective for understanding long-term changes in consumer behavior or complex market dynamics.

12. Almost ideal demand system The Almost Ideal Demand System (AIDS) is an advanced economic model used to analyze consumer behavior and demand for various goods and services. It is an extension of the Linear Expenditure System (LES) and offers more flexibility and realism in capturing how consumers allocate their income among different goods . Developed by Angus Deaton and John Muellbauer in the 1980s.

13. K ey features and components of the Almost Ideal Demand System: The Utility Function: The AIDS model is grounded in consumer utility theory, which assumes that individuals seek to maximize their utility, a measure of well-being or satisfaction, subject to budget constraints . Consumer Preferences: Unlike the LES, which assumes linear relationships between income and spending, the AIDS model allows for non-linear demand relationships. It captures consumer preferences more accurately by considering the interdependence and substitution effects between different goods. This means that as prices and incomes change, consumers may shift their consumption patterns accordingly . Demands for Different Goods: The AIDS model typically includes a set of demand equations, one for each good or category of goods that the consumer purchases. These equations represent how consumers allocate their income to different goods based on their preferences and the prices of those goods . Price and Income Elasticities : The model provides estimates of price and income elasticities for each good. These elasticities measure how the quantity demanded of a good responds to changes in its price or the consumer's income. They are crucial for understanding the sensitivity of consumer behavior to economic changes.

14. Key features and components of the Almost Ideal Demand System: Expenditure and Engel Curves: The AIDS model allows for the estimation of expenditure and Engel curves, which illustrate how the expenditure on a good or category of goods changes with income. Engel curves provide insights into the income elasticity of demand for different goods . Estimation Methods: To apply the AIDS model, econometric techniques, such as Maximum Likelihood Estimation (MLE) or Generalized Method of Moments (GMM), are often used to estimate the parameters of the demand equations. This involves using real-world data on prices, incomes, and consumer choices . Versatility: The AIDS model is versatile and can be used to analyze various aspects of consumer behavior, including market demand, consumer welfare, the impact of tax policies, and changes in consumer spending patterns over time.

15. Equation The Almost Ideal Demand System (AIDS) model includes a set of demand equations, one for each good or category of goods that consumers purchase. The typical form of an AIDS equation is as follows : Q i = α i + β i ln ( p i ​)+ γ i ​ ln ( Y )+ ϵ i

16. Equation Where: q i ​ is the quantity demanded of the ith good. α i ​ is the intercept term, which represents the baseline demand for the ith good when prices and income are at some reference level. β i ​ is the price elasticity of demand for the ith good. It measures how the quantity demanded of the good responds to changes in its price. p i ​ is the price of the ith good. γ i is the income elasticity of demand for the ith good. It measures how the quantity demanded of the good responds to changes in consumer income ( Y ). Y is the consumer's income. ϵ i ​ is the error term, representing unexplained variations in the quantity demanded. It captures factors other than price and income that affect demand for the ith good.

17. In the AIDS model, each equation represents the demand for a specific good, and the parameters (α, β, and γ) are estimated using econometric techniques with real-world data on prices, incomes, and quantities consumed. These estimated parameters provide insights into how consumers allocate their income among different goods and how sensitive their consumption is to changes in prices and income. It's important to note that the AIDS model allows for non-linear relationships between prices, income, and demand. This flexibility makes it a valuable tool for analyzing consumer behavior and market dynamics in a more realistic way compared to the simpler linear models like the Linear Expenditure System (LES).

18. Structure 1. Expenditure Share Equations : The expenditure share equations in the AIDS model represent the share of the total expenditure allocated to each individual good or commodity. These equations account for how consumers distribute their budget among various goods based on their preferences and budget constraints. The expenditure share equations are typically estimated as follows: For a given good i, the expenditure share equation can be expressed as:

19.   Where: s i represents the expenditure share of good i. e i ​ is the total expenditure on good i. E is the total expenditure on all goods. a i ​ is a parameter representing the intercept for good i. b ij ​ is a parameter representing the price elasticity of good i with respect to the price of good j. p j is the price of good j. ε i ​ represents the error term for good i. n is the total number of goods considered in the analysis.

20. 2. Price Elasticity Equations : The price elasticity equations in the AIDS model are used to estimate the responsiveness of the quantity demanded for each good to changes in its own price and the prices of other goods. These elasticity equations are crucial for understanding how consumers make substitution choices when prices change. The price elasticity equations are typically estimated as follows : For good i, the price elasticity equation can be expressed as : =  

21. Where : represents the price elasticity of demand for good i with respect to the price of good j . bij ​ is the parameter representing the price elasticity of good i with respect to the price of good j . xi ​ is the quantity demanded of good i. si ​ is the expenditure share for good i . The AIDS model's structure is designed to capture how consumers allocate their budget among different goods and how they respond to changes in prices, making it a valuable tool for analyzing consumer preferences and market dynamics for multiple goods.  

22. Advantages Incorporation of Both Price and Income Effects: AIDS simultaneously considers how changes in prices and incomes affect consumer behavior . Flexibility for Analyzing Multiple Goods: It is adaptable for analyzing consumer choices across various goods. Estimation of Price and Income Elasticities : AIDS calculates the responsiveness of demand to price and income changes. Captures Substitution Effects: It quantifies how consumers switch between goods when prices change. Realistic Representation of Consumer Behavior: It aligns with economic theory, offering a more realistic portrayal of consumer decision-making.

23. Limitations Data and Computation Demands: AIDS requires extensive data and computational resources, limiting its use in smaller-scale studies. Complex Mathematical Structure: The model's complexity can be a barrier to understanding and application. Assumption of Utility Maximization: It relies on the assumption of rational utility-maximizing consumers, which may not always hold in reality. Sensitivity to Model Specification: Results can vary based on specific assumptions and functional forms chosen, introducing subjectivity. Limited Causality: AIDS provides correlations but doesn't explain causation in consumer choices.

24. Diffrences in LES and AIDS Aspect Linear Expenditure System (LES) Almost Ideal Demand System (AIDS) Type of Model Simplified budget allocation model Comprehensive demand analysis model Budget Constraint Linear Non-linear and more flexible Price Elasticities Limited to one good Provides price elasticities for all goods Income Effects Ignores income effects Incorporates income effects Price Effects Considers only price effects Simultaneously accounts for price and income effects Substitution Effects Minimal representation of substitution effects Captures substitution patterns among goods Complexity Simpler and less data-intensive More complex and data-intensive Realism May not accurately represent consumer behavior Aligns with economic theory and provides a more realistic portrayal of consumer choices Applicability Suitable for basic demand analysis Applicable to analyzing complex consumer preferences and diverse goods Policy Analysis Limited in its ability to assess policy impacts Valuable for policy analysis, including tax and subsidy effects on consumer choices Data Requirements Requires less extensive data Demands more data for parameter estimation

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