7- Empirical IO, Demand estimation

Question 1

What are the 2 main reasons we are interested in demand analysis?

Answer 1

-Market definition
-Determinants of innovation

Question 2

How does Market definition work in demand analysis?

Answer 2

Cross price elasticities inform us which products belong to a market

Question 3

What do Determinants of innovation show in demand analysis?

Answer 3

One can predict mark-ups for new goods and therefore understand the drivers of innovation

Question 4

What is the structural/behavioural Demand equation?

Answer 4

Qᵢ = α₀ + α₁Pᵢ + α₂Yᵢ + εᵢ

Question 5

What is the structural/behavioural Supply equation?

Answer 5

Pᵢ = β₀ + β₁Qᵢ + β₂Wᵢ + ϵᵢ

Question 6

What do α & β represent in the behavioural Supply & Demand equations?

Answer 6

Structural parameters for each variable

Question 7

What are reduced form regressions?

Answer 7

Supply and demand expressed in terms of exogenous variables

Question 8

What do reduced form regressions show?

Answer 8

Estimate changes in market equilibrium as a result of exogenous shifts in demand and supply determinants

Question 9

What would regressing demand (Qᵢ) on an exogenous variable tell you?

Answer 9

How the equilibrium 𝑄𝑖 would change as a result of a change in the variable

Question 10

What would regressing demand (Qᵢ) on an exogenous variable not tell you?

Answer 10

The mechanism through which the variable alters equilibrium: does it work mainly through supply, demand or both?

Question 11

When is the explanatory variable endogenous?

Answer 11

If the residual variable (ϵᵢ) is correlated with any of the explanatory variables

Question 12

What are the 2 main causes of endogeneity?

Answer 12

-Simultaneity bias
-Omitted variable bias

Question 13

What does an endogenous explanatory variable mean?

Answer 13

The estimator will be biased

Question 14

What is Simultaneity bias?

Answer 14

When the error term is correlated with the explanatory variable

Question 15

What is Omitted variable bias?

Answer 15

When residuals of supply and demand are correlated

Question 16

What is a main practical limitation of controlling variables in real life?

Answer 16

If you want to control for education, for example, there are ethical implications of forcing someone to do a certain degree

Question 17

How can we identify the demand curve?

Answer 17

Need a variable (instrument) that shifts supply but not demand

Question 18

What are the 2 conditions of Instrumental Variable (IV) estimation?

Answer 18

-Exogeneity/validity
-Relevance

Question 19

What is IV exogeneity?

Answer 19

IV cannot effect demand, it must be uncorrelated with the error term

Question 20

What is IV relevance?

Answer 20

IV must affect supply

Question 21

What are the 2 stages of IV estimation?

Answer 21

1.Break down demand into exogenous and endogenous components Pᵢ = p̂ᵢ + ŵᵢ
2.Regress demand on fitted supply p̂ᵢ

Question 22

What are 3 common IVs for exogenous supply shifting?

Answer 22

-Marginal cost variables, input prices
-Exogenous changes in competitive conditions (e.g. change in market size)
-“Hausman instruments”: prices of the same product by the same (or other) firm in other markets