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Competitive Analysis Using a Flexible Demand Specification

30 June 2005
By Dr. Gregory K. Leonard and MIT Professor of Economics Dr. Jerry A. Hausman

Econometric methods can be helpful when one is trying to understand the nature of competition between products in differentiated products industries, an issue that arises in many competition policy contexts. However, misspecification of the consumer demand system can result in biased econometric results and misleading conclusions.

This report by NERA Senior Vice President Dr. Gregory Leonard and MIT Professor of Economics Dr. Jerry Hausman discusses the key considerations involved with choosing a demand system specification. The authors suggest using a 'flexible functional form,' which avoids placing restrictions on the demand elasticities, and identify and analyze other issues that arise in the estimation of demand systems. The authors also present an empirical example -- the Almost Ideal Demand System (AIDS) -- concerning the calculation of lost profits damages in a patent infringement case, and discuss the strengths and weaknesses of AIDS in comparison with other demand system specifications.