7- Empirical IO, Demand estimation Flashcards
What are the 2 main reasons we are interested in demand analysis?
-Market definition
-Determinants of innovation
How does Market definition work in demand analysis?
Cross price elasticities inform us which products belong to a market
What do Determinants of innovation show in demand analysis?
One can predict mark-ups for new goods and therefore understand the drivers of innovation
What is the structural/behavioural Demand equation?
Qᵢ = α₀ + α₁Pᵢ + α₂Yᵢ + εᵢ
What is the structural/behavioural Supply equation?
Pᵢ = β₀ + β₁Qᵢ + β₂Wᵢ + ϵᵢ
What do α & β represent in the behavioural Supply & Demand equations?
Structural parameters for each variable
What are reduced form regressions?
Supply and demand expressed in terms of exogenous variables
What do reduced form regressions show?
Estimate changes in market equilibrium as a result of exogenous shifts in demand and supply determinants
What would regressing demand (Qᵢ) on an exogenous variable tell you?
How the equilibrium 𝑄𝑖 would change as a result of a change in the variable
What would regressing demand (Qᵢ) on an exogenous variable not tell you?
The mechanism through which the variable alters equilibrium: does it work mainly through supply, demand or both?
When is the explanatory variable endogenous?
If the residual variable (ϵᵢ) is correlated with any of the explanatory variables
What are the 2 main causes of endogeneity?
-Simultaneity bias
-Omitted variable bias
What does an endogenous explanatory variable mean?
The estimator will be biased
What is Simultaneity bias?
When the error term is correlated with the explanatory variable
What is Omitted variable bias?
When residuals of supply and demand are correlated
What is a main practical limitation of controlling variables in real life?
If you want to control for education, for example, there are ethical implications of forcing someone to do a certain degree
How can we identify the demand curve?
Need a variable (instrument) that shifts supply but not demand
What are the 2 conditions of Instrumental Variable (IV) estimation?
-Exogeneity/validity
-Relevance
What is IV exogeneity?
IV cannot effect demand, it must be uncorrelated with the error term
What is IV relevance?
IV must affect supply
What are the 2 stages of IV estimation?
1.Break down demand into exogenous and endogenous components Pᵢ = p̂ᵢ + ŵᵢ
2.Regress demand on fitted supply p̂ᵢ
What are 3 common IVs for exogenous supply shifting?
-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
