The Calibration and Performance of a Non-homothetic CDE Demand System for CGE Models

Abstract

In computable general equilibrium modeling, whether the simulation results are consistent with a set of valid own-price and income demand elasticities that are observed empirically remains a key challenge in many modeling exercises, since functional forms that are not fully flexible can only allow a limited subset of elasticities. While not fully flexible, the Constant Difference of Elasticities (CDE) demand system has enough free parameters to match own-price and income elasticities in some cases, leading to its adoption by some models since the 1990s. However, perhaps due to complexities of the system, the applications of CDE demand in other models are less common. Furthermore, how well the system can represent the given elasticities is rarely discussed or examined in the existing literature. This study aims to fill this gap by revisiting calibration strategies for the CDE demand system and exploring conditions where the calibrated elasticities of the system can better match a set of valid target elasticities. Results show that the calibrated elasticities can be matched to the target ones more precisely if the sectoral expenditure shares are lower, the target own-price demand elasticities are lower, and target income demand elasticities are relatively higher. The study also incorporates a CDE demand into the GTAPinGAMS model and verifies that for the revised model with a CDE demand system, the model can successfully replicate the calibrated elasticities under various price and income shocks.