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2A.3 Test5

The document describes demand and supply equations for corn. It asks questions about interpreting the coefficients, identifying the system of equations, deriving reduced-form equations, and using instrumental variables to estimate demand elasticity and identify both equations.

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Uti Lities
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4 views2 pages

2A.3 Test5

The document describes demand and supply equations for corn. It asks questions about interpreting the coefficients, identifying the system of equations, deriving reduced-form equations, and using instrumental variables to estimate demand elasticity and identify both equations.

Uploaded by

Uti Lities
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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PART IIA, PAPER 3, PRACTICE TEST 5

OLEG I. KITOV, UNIVERSITY OF CAMBRIDGE

The demand for corn is described by the function:

qt = β0 + β1 pt + ut , t = 1, . . . , T, (1)

and the supply of corn is described by the function:

qt = γ0 + γ1 pt + vt t = 1, . . . , T, (2)

where qt = ln Qt and pt = ln Pt are the natural logs of quantity Qt and price Pt ,


respectively,
  t = 1 . .. , T , ut and vt are iid mean-zero homoskedastic error terms with
E u2t = σu2 and E vt2 = σv2 . Some data points for price and quantity of corn are
observed over several time periods, (pt , qt ), where t = 1, . . . , T are plotted below. Note
that even though the observations are indexed in time with the variable t, instead of
the usual subscript i, this should not confuse you - this question is not about time
series, you can use t in the same way we always use i.
qt

pt

T5.1 [5] Explain the rational behind specification in equations (1) and (2). Provide eco-
nomic interpretation for the coefficients β1 and γ1 . What values of β1 and γ1 would
the economic theory predict? Interpret the error terms ut , vt , and explicitly state any
additional assumptions about them.

T5.2 [5] Explain what it means for this system of equations to be identified and illustrate
this concept graphically using the above data plot for (pt , qt ).

T5.3 [15] Derive the reduced-form equations (i.e. solve for the equilibrium price and quan-
tity in terms of ut and vt ). Would you be able to identify the original parameters of
interest in equations (1) and (2) from the knowledge of the reduced-form coefficients?

T5.4 [10] What does your result in T5.3 tell you about the relationship between pt and ut ?
Is that a problem for estimating equation (1) with OLS?

1
Part IIA, Paper 3 Practice Test 5

T5.5 [25] If the coefficients of the demand function are estimated by OLS, would you expect
the estimate of the demand elasticity to over- or under-estimate the true value of β1 ?
[Hint: Write down the OLS estimator for β1 and substitute in your reduced-form
equation from T5.3. Show that the OLS estimator is inconsistent for β1 and find the
sign of this inconsistency.]

T5.6 [15] It is proposed to estimate the demand elasticity by IV using one of the following
as an instrument: (a) disposable income per capita; (b) a measure of average rainfall.
Comment on the appropriateness of each of these variables as an instrument. Which
variable would you pick? Re-write the original system of equations (1) and (2) with
the relevant instrument included as an exogenous variable.

T5.7 [25] Find the reduced-form equations for your new system in T5.6. Show explicitly
that the structural parameters in the demand equation can be uniquely expressed in
terms of your reduced-form coefficients (i.e. they are identified). Are the structural
parameters in the supply function identified?
?
T5.8 Using the instrument you chose in T5.6, describe a procedure for testing the hypoth-
esis that pt is endogenous in the demand equation.
?
T5.9 Suppose we are now interested in identification of both the demand and the supply
equations, and that we can still use the IV from parts T5.6 and T5.7 to identify
the demand equation. Suggest a valid instrument for the supply equation. Write
down the new system of structural equations taking into account the corresponding
exclusion restrictions for both demand and supply functions. Derive the corresponding
reduced-form equations and show explicitly that both structural equations are now
identified.

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