Selecting correct functional form in consumption function: Analysis of energy demand at household level

Abstract

In the estimation of demand functions for energy resources, parametric econometric models of energy demand are commonly used to predict future energy needs. The functional forms commonly assumed in parametric energy demand models include linear functional forms, log-linear forms, trans-log models, and an almost ideal demand system. It is frequently debated which is the “best” functional form to employ in order to accurately represent the underlying relationships between the demand for various energy resources and explanatory variables such as energy prices, income, and other demographic factors. The study has focused on developing proper non-nested tests to compare the two demand systems, the double log model and the LA-AIDS model. C-test is used to test the validity of using the two parametric functional forms in models of residential energy demand. Cross-sectional household-level data of the Pakistan Social and Living Standards Measurement (PSLM) 2013–14 and Asian Development Bank (ADB) Asia and Pacific 2018 are used. Results indicate that the LA-AIDS model is better than the double log model. The estimated elasticity of own prices, cross-prices, and income in terms of spending, family size, and equipment are particularly important to producers and policymakers in making investment and incentive choices. A significant part of the budget for families is for electricity, natural gas, firewood, and other fuels; smaller budget shares are set down to other items such as kerosene oil, cylinder gas, and diesel. Household per capita demand for energy resources will rise over the next decade; therefore, the government needs to make progress on developing energy-saving strategies. If not addressed the issue properly, we may face energy shortages and high energy import bills.