Functional form bias in goodness-of-fit optimizing models

Abstract

Following the weak axiom of revealed preference (WARP), developed by Varian, a money-metric expenditure function is derived for a CES utility function in this paper. Using the US aggregate data on consumption used by Varian, the money-metric expenditure function is estimated to calculate an efficiency index measuring the magnitude of departure from the optimum expenditures. The results are then compared to those reported by Varian for a Cobb-Douglas utility function. The findings point to a sizeable bias in the calculated efficiency index in the near-optimization analysis as determined by the choice of the functional form.