Department of Economics W3412

Columbia University Fall 2013

Problem Set 8
Introduction to Econometrics
Seyhan Erden Arkonac, PhD
for both sections

1. Do you think attendance to lectures affects performance on final exam? A model to explain the
standardized outcome on a final exam (stndfnl) in terms of percentage of classes attended, prior
college grade point average, and ACT score is

stndfnl =
0
+
1
atndrte +
2
priGPA +
3
ACT + u

where variables are given in the following table:
Variable Definition
stndfnl Standardized final exam score
atndrte Percentage of classes attended
priGPA Prior college grade point average
ACT Achievement Test score
priGPAxatndrte Prior GPA times attendance rate

(a) Let dist be the distance from the students living quarters to the lecture hall. Do you think
dist is uncorrelated with u?
(b) Assuming that dist and u are uncorrelated, what other assumption must dist satisfy in order
to be a valid IV for atndrte?
(c) Suppose we add the interaction term priGPAxatndrte:

stndfnl =
0
+
1
atndrte +
2
priGPA +
3
ACT +
4
priGPAxatndrte + u

If atndrte is correlated with u, in general, so is priGPAxatndrte. What might be a good IV for
priGPAxatndrte? [Hint: if E(upriGPA,ACT,dist)=0, as happens when priGPA, ACT and dist
are all exogenous, then any function of priGPA and dist is correlated with u]

2. The purpose of this question is to compare the estimates and standard errors obtained by correctly
using 2SLS with those obtained using inappropriate procedures. Use the data file WAGE2.dta,
variables are:
Variable Definition
wage Monthly earnings
educ Years of education
exper Years of working experience
tenure Years with current employment
black =1 if the person is African-American, 0
otherwise
sibs Number of siblings

(a) Use a 2SLS routine to estimate the equation

Log(wage) =
0
+
1
educ +
2
exper +
3
tenure +
4
black + u

using sibs as the IV for educ. Report your results
(b) Now, manually, carry out 2SLS. That is, first regress educ on sibs, exper, tenure and
black, obtain the fitted values educ_hat, then run the 2
nd
stage regression log(wage) on
educ_hat, exper, tenure and black. Verify that estimated sample coefficients are identical
to those obtained form part (a) but that the standard errors are somewhat different. The
standard errors obtained from the second stage regression when manually carrying out
2SLS are generally inappropriate.
(c) Now, use the following two-step procedure, which generally yields inconsistent
parameter estimates of
j
and not just inconsistent standard errors. In step one, regress
educ on sibs only and obtain the fitted values, say educ_tilde (Note that this is an
incorrect first stage regression). Then, in the second step, run the regression of log(wage)
on educ_tilde, exper, tenure and black. How does the estimate from this incorrect, two-
step procedure compare with the correct 2SLS estimate of the return to education?

3. Suppose you are investigating how wage inflation affects price inflation. You hypothesize that
wage costs force prices up. You model this by the following linear relationship,
p =
0
+
1
w + u
p


where p = annual rate of growth of prices, w = annual rate of growth in wages, and u
p
is an error
term. You are then interested in estimating the parameter
1
. However, you suspect that, at the
same time, workers protect their wages by demanding higher wages as prices rise, but their ability
to do so becomes weaker, the higher the rate of unemployment.
You try to model this through the following second equation,

w =
0
+
1
p +
2
U + u
w

Here, U is the unemployment rate which we assume is an exogenous variable, Cov(U, u
p
) =0 and
Cov(U, u
w
) = 0.

(a) From the above economic arguments, what do you expect the signs of the slope
parameters in the two equations to be?
(b) Solve the two equations w.r.t. the endogenous variables, p and w. That is, express these
variables as functions of U, u
p
and u
w
only.
(c) Show that Cov(w, u
p
) 0 and use this to argue that the OLS estimator of
1
will be biased
and inconsistent.
(d) Under what additional assumption on U will 2SLS estimation of
1
with U as an
instrument be consistent? How can you test this assumption?



4. Consider the following regression model:

Y =
0
+
1
X + u

where Cov(X, u) 0. You want to use the variables Z
1
and Z
2
as instruments for X. You check
for instrument exogeneity using the overidentifying restrictions test and the value of the
heteroskedasticity-robust J-statistic you obtain is J = 15.7. Assume that the instruments are not
weak and that your sample is large.

(a) What does the value of the J-statistic mean? Do we reject the null hypothesis
of instrument exogeneity?

(b) Does the value of the J-statistic suggests that Cov(u,Z
1
) 0, or Cov(u,Z
2
) 0
or both? Explain.

5. By studying the probability limit (plim) of the IV estimator we can see that when Z and u
are possibly correlated, we can write

(1)

where
u
and
x
are the standard deviation of u and X in the population, respectively. The
interesting part of this equation involves the correlation terms. It shows that, even if
Corr(Z,u) is small, the inconsistency in the IV estimator can be very large if Corr(Z,X) is
also small. Thus, even if we focus only on consistency, it is not necessarily better to use
IV than OLS if the correlation between Z and u are smaller than that between X and u.
Using the fact that

along with the fact that plim

+ Cov(X,u)/Var(X) = when , we can write the plim of OLS estimator

call it

- as

(2)

Assume that
u
=
x
, so that the population variance in the error term is the same as it is
in X. Suppose the instrumental variable, Z, is slightly correlated with u: .
Suppose also that Z and X have somewhat stronger correlation:
(i) What is the bias in the asymptotic IV estimator?
(ii) How much correlation would have to exist between X and u before OLS has more
asymptotic bias than TSLS?








6. In the US, both Federal and state governments spent millions of dollars on anti-trust suits against
Microsoft. Proving monopolistic behavior is no easy task. Economists use econometric tools to
determine whether shifts in prices and quantities indicate that a company or group of companies
has market power (that is, that it is a price-setter rather than a price-taker). In this problem set,
you will use market data to attempt to decide whether a cartel was at work in a nineteenth century
market: the market for railroad transportation of grain.
Price-fixing was not illegal in the US until the Sherman Antitrust Act of 1890. This Act was a
response to the market power of the railroad robber barons, who included such names as
Vanderbilt and Forbes. Their cartel, the Joint Executive Committee (JEC), controlled the
railroads which, among other things, carried grain from the farmlands of the Midwest to coastal
ports. During this period, however, the price of shipping grain by rail still fluctuated. One reason
for the price fluctuations is that the JEC price-fixing agreement collapsed into a price war a dozen
times between 1880 and 1886. Economic historians attribute this to random fluctuations in each
railroads market share that caused them to suspect each other of price-cutting. Another reason
that prices fluctuated was that the Great Lakes periodically froze over, making shipping grain by
boat impossible and temporarily increasing the demand for rail shipping services.
Economic theory predicts two telltale signs of a cartel. First, a cartel increases prices! To see if
the JEC raised the price of shipping services above its competitive level, you will compare the
price charged for shipping grain by rail during periods when the cartel was active and inactive.
The second, more subtle, sign of market power is that price and output are at a point where
demand is elastic (that is, the price elasticity is 1). [Suppose demand is inelastic, for example,
the price elasticity is -.5. Then a 1% increase in price leads to less than a 1% decline in quantity
demanded, so the increase in price more than compensates for the reduction in units sold so total
revenue = pricequantity goes up. Thus firms operating in a region of inelastic demand would
want to raise prices at least to the point that demand becomes elastic, and if they form a
successful cartel, they should be able to do so.] To examine whether demand is elastic or
inelastic, you will estimate the own-price elasticity of demand for rail shipping of grain.
(a) Estimate the own-price elasticity of demand by using OLS to regress the log of the
quantity of grain shipped on the log of the price of shipping grain and the full set of
month binary indicators.

(b) What is the estimated demand elasticity and its standard error?

(c) Explain why the interaction of supply and demand plausibly makes this estimator of
the elasticity biased.

(d) Consider two possibilities for instrumental variables: whether the railroad cartel was
experiencing one of its periodic collapses (cartel), and whether the Great Lakes are
closed because of ice (ice).
a. Use economic reasoning to argue whether cartel plausibly satisfies the two
conditions for a valid instrument.
b. Use economic reasoning to argue whether ice plausibly satisfies the two
conditions for a valid instrument.

(e) Read Table 1, then compute and fill in the missing entries (an electronic copy of the
table is available on the course Web site). Note that an additional blank column and
blank row have been provided in case you have an additional specification and/or
estimator you wish to report; you are not expected to fill in entries in the blank row
when running regressions (1) (5). (Feel free to add more rows or columns as
desired by editing the electronic file directly.)
(f) Write a brief essay (400 words or less) in which you:
Indicate which (if any) of the regressions in Table 1 provide the more reliable
estimates of the demand elasticity, and why;
Draw a conclusion about whether or not there is evidence of cartel pricing;
Summarize what you consider to be the main threats, if any, to the internal validity of
this study.
Table 1
Estimates of the own-price elasticity of the demand for rail shipments of grain,
1880 1886

(1) (2) (3) (4) (5) (6)
Dependent variable: ln(P) ln(Q) ln(Q) ln(Q) ln(Q) ln(Q)
Regressors:
cartel


( )

ln(P)


( )

( )

( )

( )

( )
ice
( )
F-statistic testing coefficients
on monthly indicators (p-
value)

Estimation method OLS OLS TSLS TSLS TSLS TSLS
Instrumental variables n/a n/a cartel ice ice,
cartel
cartel
First stage F-statistic

n/a n/a
J-test of overidentifying
restrictions
n/a n/a n/a n/a
(< )
n/a
Notes: ln(P) is the logarithm of the price of transporting one ton of grain by rail and ln(Q) is the
logarithm of the quantity (weekly tonnage) of grain shipped. The entries in the rows labeled
cartel and ln(P) are the corresponding regression coefficient and, in parentheses, its
heteroskedasticity-robust standard error, estimated using the regression method in the relevant
column. All regressions contain a full set of monthly indicators, and the row labeled F-statistic
testing coefficients on monthly indicators (p-value) gives the F-statistic (and its p-value in
parentheses) testing the hypothesis that the coefficients on these monthly indicators are all zero.
The penultimate row presents the first-stage F-statistic testing the hypothesis that the coefficients
on the instruments are zero in the first-stage regression, when TSLS is used, and the final row
presents the J-test of overidentifying restrictions. All regressions contain an intercept, the value
of which is not reported in the table. The data are weekly, 1880-1886, for a total of n = 328
observations. Note that there are 13 months in a year in this dataset (see the variable
definitions).



The following questions will not be graded, they are for you to practice and will be discussed at
recitation:
1. SW Exercise 12.2
2. SW Exercise 12.5
3. SW Exercise 12.7
4. SW Exercise 12.8
5. SW Exercise 12.10
6. SW Empirical Exercise 12.1
7. SW Empirical Exercise 12.2