A Flexible Demand Model for Complements Using Household Production Theory

Abstract

We utilize household production theory to address the problem of micro-level demand estimation across complementary goods. According to this theory, consumers buy inputs and combine them to produce final goods from which they derive utility. We use this idea to build a structural model of demand for complements that can be estimated on purchase data in the presence of corner solutions and indivisible packages. We find that, even when reusing the same functional form as some previous models of demand for substitutes, our model can accommodate very different patterns of consumer preferences over complements and lead to a flexible demand system from perfect complementarity to no complementarity. We estimate the model on purchase data from a panel of consumers and show how it can be used to increase the profitability of couponing strategies by taking into account the spillover effect of coupons on demand for complementary categories. We also show how our model can be used by manufacturers to make decisions regarding the size of packages by taking into account cross-category consumption.

Keywords: Utility Theory, Multicategory Demand Models, Bayesian Estimation