Long-run water demand estimation: Habits, adjustment dynamics and structural breaks

Abstract

This paper examines a water demand equation for Milan for the second half of the twentieth century: 1950-2001. We focus mainly on the effects of price and habits, but also account for other factors in the demand for water such as climate, income and productive activity. Allowing for trend break stationarity or non-linear trend stationarity we find evidence against the unit root hypothesis for many time series. Based on this result, standard cointegration analysis would not be appropriate; therefore we adopt an alternative estimation and testing procedure. We focus in particular on the so called bounds testing approach which can be applied irrespective of the level of integration of the variables and which can be a useful modelling strategy given that dynamics are important when estimating a water demand equation. The main results are that long run price elasticity is higher than short run elasticity, and that consumption habits are relevant. We also find that both climate, sectoral and technological modifications affect water consumption, while income is not significant. Finally, the changes to pricing schemes in the mid seventies provoked reactions of different magnitudes among households and firms.