The Biases in Applying Static Demand Models Under Dynamic Demand

Abstract

This article investigates the mechanisms that underlie the biases in price elasticities of demand in applying static demand models under dynamic demand, which have been pointed out by previous empirical studies. It studies three sources of biases: disregard of state variables (affecting short-run elasticity); inconsistent utility parameter estimates; and changing expectations of consumers (affecting long-run elasticity). Disregard of state variables, such as durable product holdings, which is not negligible but not paid much attention to in the literature, leads to an overestimate of short-run own elasticities. Inconsistent utility parameter estimates arises due to the failure to account for consumers’ future expectations and unobserved state variables. Changing expectations of consumers are not explicitly specified in the static model, and this also leads to biased results when applying static models. Regarding the magnitude of the biases, the first and the third sources of biases might induce large biases in price elasticities, especially when the focus is on the large conditional choice probability products. Possible remedies for the use of static demand models are also discussed.