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Lecture / Discussion Simultaneous Equations: Regression Analysis Tutorial

This document discusses simultaneous equation models and methods for addressing endogeneity, including two-stage least squares (2SLS) and instrumental variables (IV). It provides three examples of simultaneous equation models where one variable is endogenous. It then explains that 2SLS/IV involves: (1) regressing endogenous variables on exogenous variables to obtain predicted values, and (2) using the predicted values in place of the endogenous variables when estimating the structural equations. The document also discusses reduced form equations and how their parameters relate to the structural parameters.

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0% found this document useful (0 votes)
175 views20 pages

Lecture / Discussion Simultaneous Equations: Regression Analysis Tutorial

This document discusses simultaneous equation models and methods for addressing endogeneity, including two-stage least squares (2SLS) and instrumental variables (IV). It provides three examples of simultaneous equation models where one variable is endogenous. It then explains that 2SLS/IV involves: (1) regressing endogenous variables on exogenous variables to obtain predicted values, and (2) using the predicted values in place of the endogenous variables when estimating the structural equations. The document also discusses reduced form equations and how their parameters relate to the structural parameters.

Uploaded by

mazamniazi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Regression Analysis Tutorial 228

LECTURE / DISCUSSION

Simultaneous Equations

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 229

Simultaneous Equations

Example 1

Gas consumption = " + $(thermostat setting) + 2(sq. ft.) + g

Thermostat setting = 0 + N(income) + µ

g and µ are correlated.

Gas
consumption
OLS estimate

. .
. true
. . .
. .
. . .
. .
. .
. . .
Thermostat
. setting

Problem: Because µ is correlated with g , and µ affects


thermostat setting, thermostat setting is
correlated with g .

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 230

Example 2

Price elasticity of telecommunications demand:


MOU ' % (price) % (Nemply) % g
Price ' % (MOU) % (region dum.) % µ

g and µ are correlated.

MOU
OLS
.
.
.
.
.
.
. . .
.
. true
. Price

Demand

Problem: Because µ is correlated with g , and µ affects


price, price is correlated with g .

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 231

Example 3

Aggregate demand and supply:

Demand: Q = " + $P + g
Supply: P = 8 + 2Q + µ

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 232

Solution: Apply IV/2SLS


M ' % P % N % g
P ' % M % R % µ

Endogenous: M, P
Exogenous: R, N

Step 1: Regress endogenous variables against all the


exogenous variables.

M = a + bR + cN + e
P = d + fR + gN + u
Get M̂ , P̂

Step 2: Regress original equations, replacing endogenous


explanatory variables M and P with predicted
values M̂ and P̂ .

M ' % P̂ % N % g(

P ' % M̂ % R % µ (

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 233

Or apply IV directly.

Regress M = " + $P + 2N + g
with instruments N and R
and P = 8 + NM + 0R + µ
with instruments N and R .

TSP commands:

2sls(inst = (c,n,r)) m c,p,n ;


2sls(inst = (c,n,r)) p c,m,r ;
or
inst m c,p,n invr c,n,r ;
inst p c,m,r invr c,n,r ;

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 234

Reduced-Form Equation

Structural model: causal relationships

M = " + $P + 2N + g
P = 8 + NM + 0R + µ

Structural parameters: ", $, 2, 8, N, 0 .

Reduced-form
equations: endogenous variables expressed as a
function of exogenous variables.

M ' % ( % M % R % µ) % N % g
M ' % % M % R % N % µ % g

(1 & )M ' % % R % N % µ % g

% µ % g
M ' % R % N %
1& 1& 1& 1&
| | | |
| | | |
M= a + bR + cN + e

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 235

Similarly,

% g % µ
P ' % R % N %
1& 1& 1& 1&
| | | |
| | | |
P= d + fR + gN + u

Reduced form parameters: a, b, c, d, f, g .

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 236

1. Reduced-form equations are estimated in first step of


2SLS. Structural equations are estimated in second
step of 2SLS.

2. Reduced-form equations can be estimated by OLS


because exogenous variables are uncorrelated with
errors.

3. There is a relation between the reduced-form


parameters and the structural parameters.

For example:

c '
1&

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 237

Reduced form parameters give the full effect of a change in


an exogenous variable.

M = " + $P + 2N + g
P = 8 + NM + 0R + µ

N rises by 1 unit:

M increases by 2
P increases by N2
M increases by $[N2]
P increases by N[$N2] = $N22
M increases by $[$N22] = $2N22
P increases by N[$2N22] = $2N32
M increases by $[$2N32] = $3N32
.
.
.

Total effect on M

4
% % ( ) 2
% ( ) 3
% ... ' j ( )t
t'0

'
1&

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 238

Total effect on P

% 2
% 2 3
' % ( ) % ( )2
4
' j( )t '
t'0 1&

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 239

Indirect Least Squares

Sometimes, structural parameters can be calculated from


reduced-form parameters.

% %
a ' d '
1& 1&

b ' f '
1& 1&

c ' g '
1& 1&

Six equations, six unknowns.

b g
' ' etc.
f c

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 240

Example:

if â ' 4 d̂ ' 8
b̂ ' 3 f̂ ' 2
ĉ ' 7 ĝ ' 3.5

then ˆ ' & 8. ˆ ' 6


ˆ ' 1.5 ˆ ' 0.50
ˆ ' 1.75 ˆ ' 0.50

Note: ILS gives same estimates as 2SLS.

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 241

Cannot Always Apply ILS

I. Add an exogenous variable:


M ' % P % N % I % g
P ' % M % R % µ
7 structural parameters

Reduced-form equations:

M = a + bN + cI + dR + e

P = f + gN + hI + RR + u

8 reduced-form parameters

Eight equations for seven unknowns. No solution.

Can still apply 2SLS.

2SLS finds structural parameters that best fit the


reduced form parameters.

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 242

II. Omit an exogenous variable:

M ' % P % g
P ' % M % R % µ
5 structural parameters

Reduced-form equations

M = a + bR + e

P = c + dR + u

4 reduced-form parameters

Four equations, five unknowns. Infinite number of


solutions.

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 243

Also: Cannot apply 2SLS in Case II

Step 1: M̂ ' â % b̂R


P̂ ' ĉ % d̂R

Step 2: M ' % P̂ % g

P ' % M̂ % R % µ
' % â % b̂R % R % µ
' ( % â) % ( b̂ % )R % µ

Cannot estimate N and 0 separately.

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 244

Identification

Name Estimation method


Just identified NRFP = NSP 2SLS = ILS
Over identified NRFP > NSP 2SLS
Under identified NRFP < NSP Cannot estimate

NRFP: Number of reduced form parameters.


NSP: Number of structural parameters.

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 245

Efficiency

2SLS gives unbiased estimate.

But 2SLS ignores information contained in correlation


between errors. So, 2SLS is not efficient.

M ' % P % N % g
P ' % M % R % µ
g, µ correlated

If we knew µ was high, we would know that g is


probably also high and hence M is higher than predicted
from P and N only.

Similarly for g and P .

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 246

3SLS: An Efficient Estimator

Step 1: Estimate reduced form equations. Get M̂ , P̂ .

Step 2: Estimate structural equations with M̂ and P̂ .

Save residuals from these regressions, labeled ĝ


and µ̂ .

Step 3: Re-estimate structural equations with ĝ and µ̂


included as explanatory variables.

M ' % P̂ % N % µ̂ % g((

P ' % M̂ % R % ĝ % µ ((

Because g and µ are correlated, µ̂ provides


information for explaining M and ĝ provides
information for explaining P . Including this
information makes the estimates better.

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998


Regression Analysis Tutorial 247

Special Case:
Seemingly Unrelated Equations
Yn ' % X n % gn

Wn ' % Sn % µ n

No endogenous explanatory variables.


But: gn and µn are correlated.

Example: Yn = temperature in San Francisco.


Wn = temperature in Monterey.

3SLS can be done in two steps, because reduced-form


equations are the same as the structural equations.

Step 1: Estimate equations by OLS.


Get residuals ĝ n and µ̂ n .

Step 2: Re-estimate equations including residuals as


explanatory variables:
(
Yn ' % Xn % µ̂ n % gn
(
Wn ' % S n % ĝ n % µ n

Econometrics Laboratory C University of California at Berkeley C 23-27 March 1998

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