Estimation of income elasticities and their use in a CGE model in 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, elastic demand and for gross substitution. To calibrate the parameters outside information on income elasticities and on the expenditure elasticity of the marginal utility of expenditure (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. 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. A comparison with the results obtained by the LES-model with the same income elasticities makes it possible to further clarify the importance of using a IAS to represent consumption behaviors.