A Simple Method of Incorporating Income Effects into Logit and Nested - Logit Models : Theory and Application

Substantive income effects are incorporated in a logit or nested-logit model by assuming that utility is a piece-wise linear spline function of residual income. Specific income data are not required, only income by category. Expected compensating variation is easily and accurately approximated by the difference between expected maximum utility in the proposed and initial state, multiplied by the inverse of the individual’s initial marginal utility of money. This approximation is almost exact because although any policy can, in theory, cause an individual to jump income categories, for most policies this probability will be very small.