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An exploration of Australian petrol demand: Unobservable habits, irreversibility, and some updated estimates

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This document estimates a demand equation for petrol in Australia. It explores a methodological improvement to the standard dynamic demand model – a more general model which allows for slowly evolving, unobservable habits. If this habit formation model with unobserved stocks is correct, then standard estimation techniques produce inconsistent estimates. This document finds a short-run price elasticity of -0.1 to -0.14 and a long-run price elasticity of -0.2 to -0.3. Importantly, we find that standard techniques are misleading about the precision of elasticity estimates and that the confidence interval around the long-run price elasticity is quite wide, with a 90% confidence interval of -0.02 to -0.38. Results are very sensitive to the inclusion of time trends, which appear to be appropriate. We test for price irreversibility and find, in contrast to the U.S., almost no evidence that petrol responds differently to price increases and decreases.