Using the Domestic Production Framework To Explain the Endogeneity Bias on Cross-Section Income Elasticities

Abstract

Estimating unbiased demand elasticities is a challenging task on cross-sectional data due to unobserved heterogeneity. Indeed, the estimation of demand functions on cross-section surveys produces an endogeneity bias on income elasticities caused by the correlation between households' relative income position in the survey and the non-monetary costs of consumption, such as the cost of time allocated to consumption. We generalize the standard household production model, which posits that individuals combine goods with their time to produce commodities such as a lunch or leisure, in order to estimate, at the individual level, the shadow price of time and the full prices of commodities. Our findings show that using full prices instead of market prices can explain more than 70% of the endogeneity bias on cross-section income elasticities. We also find that changes in the shadow price of time affect the demand for commodities almost as much as changes in the prices of market goods.