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Errors in Variables and Engel Curve Analysis

Nissan Liviatan

Abstract

The traditional method of estimating Engel curve parameters uses either (recorded) income or total expenditure as an independent variable in least squares analysis. Neither of these variables is, however, a satisfactory index of the true economic position of the family. This results in biased estimates of the income elasticities of the various consumption categories. The bias can, however, be eliminated in large samples by using both income and total expenditures in the estimation procedure. This can be accomplished by applying the method of "instrumental variables" to Engel curve analysis, with recorded income serving as the instrumental variable. Having formulated consistent estimation procedures, we use empirical data to investigate and analyze the direction and size of the biases in the traditional estimates of income elasticities of various commodity groups.