# Structural Econometric Modeling in

Industrial Organization
Handout 1
Professor Matthijs Wildenbeest

16 May 2011

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Peter C. Reiss and Frank A. Wolak A.
Structural Econometric Modeling: Rationales and Examples
from Industrial Organization.
Handbook of Econometrics 6A, Chapter 64, Sections 1-4,
2007.

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Background on Empirical IO

• Structural versus nonstructural econometrics
• Constructing structural models
• Framework for structural econometrics models in IO

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.Structural versus Nonstructural Econometrics Example: auctions Suppose we observe winning bids. Does the regression coefficient tell us what happens when we add another bidder? Not without further knowledge about the auction under study. Nonstructural approach: • regress winning bids on the number of bidders. i. yT }. xT }. For instance. . . .e. . f (y |x).. • use nonparametric smoothing techniques to estimate the conditional density of winning bids given the observed number of bidders. in a large number of T similar auctions. y = {y1 . . 4 . x = {x1 . Goal exercise: understand equilibrium relationship between winning bids and the number of firms. . information paradigm matters. . as well as the number of bidders in each market.

Structural versus Nonstructural Econometrics 5 .

Structural versus Nonstructural Econometrics 6 .

so that the expected value of the winning bid given the number of bidder is   θ2 x θ1 θ2 (x − 1) . θ) = θ2 (x − 1) − 1 θ2 x − 1 7 . For example. the conditional density of winning bids given the number of firms f (y |x) is f (y |x. E (y |x. θ) = θ2 x y θ2 x+1  θ1 θ2 (x − 1) θ2 (x − 1) − 1 θ2 x . j econometrics) shows that for first-price sealed-bid auctions with Pareto-distributed private value bidders. Paarsch (1992.Structural versus Nonstructural Econometrics Structural approach: • Use the structure of an auction model to say something about winning bids and the number of firms.

Three general reasons for specifying and estimating a structural econometric model: 1 Estimate unobserved parameters that could not otherwise be inferred from the data (costs. 2 Perform counterfactuals or policy experiments. valuations). and information paradigm (common versus private values). elasticities. 8 . 3 Compare the predictive performance of two competing theories. Think of type of auction (sealed-bid versus open-outcry or first-price versus second-price).Structural versus Nonstructural Econometrics Why use economic theory in this example? Helps us to clarify how institutional and economic conditions affect the relationship between x and y . bidder behavior (risk neutral versus risk averse).

Effects the size of the police force. but does not belong directly to the crime “production function. Think of a situation where there little or no useful economic theory to guide the empirical work. Previous studies found little evidence. Studies the effect of police on reducing crime.” 9 . am econ rev): using electoral cycles in police hiring to estimate the effect of police on crime. this does not always mean structural models should be favored over nonstructural models. Levitt proposes a new instrument: timing of elections.Structural versus Nonstructural Econometrics Although using structural econometrics has many advantages. likely due to simultaneity problems. Levitt (1997.

Constructing Structural Models Sources of structure 1 economics 2 statistics Since economic models are often deterministic we have to add statistical structure to rationalize why economic theory does not perfectly explain the data. 10 .

and capital inputs Ki . ln Li and ln Ki : only statistical structure needed (sample second moments converge to their population counterparts).Constructing Structural Models Example Cross-section data on output. Estimate the regression ln Qi = θ0 + θ1 ln Li + θ2 ln Ki + i . Qi . Error term i necessary because right hand side variables do not perfectly explain log output. Li . Interpretation? • Best Linear Predictor (BLP) of ln Qi given a constant. 11 . • Estimation of Cobb-Douglas production function: structure needed from both economics and statistics. by ordinary least squares (OLS). labor inputs.

firms should produce on their production function.Constructing Structural Models Only structure from economics not enough to estimate (logarithmic transformation) of Cobb-Douglas production function Qi = ALαi Kiβ : we have to add an error term as well: Qi = ALαi Kiβ exp i . OLS fails to deliver consistent estimates of the production function parameters. Note that if the error includes unobserved differences in productivity. Where does the error term come from? If i is measurement error distributed independently of the right hand side variables the estimated OLS parameters can be interpreted as the coefficient of the Cobb-Douglas production function. 12 . Moreover.

From a statistical perspective we can always regress y on x (or the other way around): the coefficients have statistical interpretations (Best Linear Predictor). 13 . However.Constructing Structural Models Linear regression model y = α + xβ + . we need economic arguments to make a case about causation. Moreover. without an economic model the OLS regression only gives (under certain conditions) consistent estimates of a best linear predictor function.

14 . Many descriptive studies treat the linear regression coefficient estimates as as if they were estimates of the derivative of E (y |x) with respect to x.Constructing Structural Models Usually not possible to “test” a deterministic economic model by running a regression. although β = ∂BLP(y |x)/∂x is usually not equal to ∂E (y |x)/∂x.

Estimating the demand curve qtd = γ0 + γ1 pt + γ2 x1t + 1t by OLS only gives consistent estimates of the demand curve parameters if price pt and a demand shifter like income x1t are uncorrelated with the error 1t . Same for the supply curve qts = β0 + β1 pt + β2 x2t + 2t . 15 . where x2t is now a supply shifter like input prices. If we perform experiments where we randomly select prices and observe the quantity demanded this will work.Constructing Structural Models Nonexperimental data raises significant modeling issues.

Prices around us are nonexperimental. But if we use economics and impose the market-clearing equation qts = qtd . OLS no longer possible because of correlations between explanatory variables and error term. no problem since we observe the quantity demand and supplied directly for each randomly generated price. However. 16 .Constructing Structural Models In the experiments the quantity supplied will in general not be equal to the quantity demanded. we could apply instrumental variable techniques to get consistent estimates of the simultaneous equation model.

where pi is the price in market i. POPi is population size. 17 . Has this equation a structural meaning? Could be: θ2 measures effect of competition on prices. and COMPi is a dummy for whether the firm faces competition. Example Researcher estimates: pi = POPi θ1 + COMPi θ2 + i .Constructing Structural Models Simultaneous equations models When dealing with endogeneity it is important to think about a “complete” simultaneous equations model.

so OLS will give inconsistent estimates of θ2 . Statistical rationale. 18 .Constructing Structural Models Simultaneous equations models Problem: COMPi is likely to depend on pi : COMPi = POPi γ1 + pi γ2 + ηi . Therefore COMPi will be correlated with i . since one can argue Yi is correlated with COMPi but not with i . Possible solution: use average income Yi as instrument for COMPi .

This requires the researcher to think carefully about the economic model underlying the simultaneous system of equations.Constructing Structural Models Simultaneous equations models To be completely convincing two things need to be done: 1 explain why Yi is not part of pi . = POPi γ1 + pi γ2 + Yi γ3 + ηi . 2 make the case that Yi is part of COMPi . 19 . specify the complete system: pi COMPi = POPi θ1 + COMPi θ2 + i . Therefore.

2 stochastic model. The economic model should have the following components: • description of economic environment (market. information available). • decision variables and objective functions (utility/profit maximization). preferences. • exogenous variables (variables outside the model). endowments). actors.Framework for Structural Econometrics Models in IO A structural model has two main components: 1 economic model. • list of primitives (technologies. • equilibrium concept (nash equilibrium) 20 .

Framework for Structural Econometrics Models in IO The stochastic model transforms the (usually) deterministic economic model into an econometric model. Main difference between the two is inclusion of unobservables. Major stochastic specifications: • unobserved heterogeneity • agent uncertainty • optimization errors • measurement error Different forms can have dramatically different implications for identification and estimation! 21 .

Still. they can have different implications.Framework for Structural Econometrics Models in IO Unobserved heterogeneity Situation where agents’ decisions depend on something the economist does not observe. Agent uncertainty Situation where agents’ decisions depend on something the agent does not (fully) observe. 22 . Note that in both cases the econometrician is ignorant.

Suppose a regulator chooses a price pir and that firms have different Ai . and input prices pK and pL . the latter being observed by the firm and regulator but not by the econometrician. Assume inelastic demand. Goal is to estimate α and β in Qi = Ai Lαi Kiβ . Firm chooses inputs to maximize π(Ki . 23 . total costs TC . Li ) = pir Ai Lαi Kiβ − pKi Ki − pLi Li .Framework for Structural Econometrics Models in IO Example Cross-section data on firms consisting of output Q.

i and solving for Li gives 1 α+β Li = Qi −1 α+β Ai  pLi pKi  −β   −β α+β β α+β α 24 . β−1 α MPK β Li pKi Ai βLi Ki This means Ki = pLi β Li . so Ai αLα−1 Kiβ α Ki pLi MPL i = = = . pKi α Substituting this into the production function gives  Qi = Ai pLi β Li pKi α β Lαi  = Ai pLi β pKi α β Lα+β .Framework for Structural Econometrics Models in IO Firms produce in a cost minimizing way.

Similarly. and CL = (α/β)γ . the total capital cost pKi Ki is given by γ 1−γ δ −δ pKi Ki = CK pKi pLi Qi Ai . where δ = 1/(α + β). where C0 = CL + CK . where CK = (α/β)γ−1 . The total cost function is therefore γ 1−γ δ −δ TCi = C0 pKi pLi Qi Ai . 25 . γ = β/(α + β).Framework for Structural Econometrics Models in IO The total labor cost pLi Li is then given by γ 1−γ δ −δ pLi Li = CL pKi pLi Qi Ai .

positive random variables. where ln C1 = ln C0 + E [ln Ai ] and ln ui = ln Ai − E [ln Ai ]. which holds exactly. 26 .d. The efficiency differences are assumed to be i. so subtracting E [ln Ai ] from the error term and adding it to the constant gives ln TCi = ln C1 + γ ln pKi + (1 − γ) ln pLi + δ ln Qi − δ ln ui . This equation can finally be taken to the data using OLS.i.Framework for Structural Econometrics Models in IO Transforming this equation using natural logarithms gives ln TCi = ln C0 + γ ln pKi + (1 − γ) ln pLi + δ ln Qi − δ ln Ai .

Li )] = pir E [Ai Lαi Kiβ ] − pKi Ki − pLi Li . β α and do not depend on Ai . Firms now choose inputs to maximize E [π(Ki . Li = β pLi Observed total costs are TCi = α+β α+β pKi Ki = pLi Li .Framework for Structural Econometrics Models in IO Now suppose the firms (and the regulator) do not know the efficiency parameters Ai either. First-order condition for expected profit maximization imply   α pKi Ki . 27 .

Researcher does not observe Ai .Framework for Structural Econometrics Models in IO This means Li = α β+α TCi /pLi and Ki = β β+α TCi /pKi .Taking natural logarithms gives ln Qia = ln D0 + (α + β) ln TCi − β ln pKi − α ln pLi + ln Ai . 28 . so −β −α Qia = D0 TCiα+β pKi pLi Ai . so treat as random and move unconditional expectation again to the constant: ln Qia = D1 + (α + β) ln TCi − β ln pKi − α ln pLi + ηi . Final output produced Qia does depend on Ai . where ηi = ln Ai − E [ln Ai ] and D1 = ln D0 + E [ln Ai ]. which holds exactly.

29 . Measurement errors Occurs when the variable the research observes are different from those the agents observe.Framework for Structural Econometrics Models in IO Optimization errors Failure of agents’ decisions to satisfy exactly first-order necessary conditions for optimal decisions. Straightforward way of converting a deterministic model into a statistical model.

Framework for Structural Econometrics Models in IO Steps left 1 selection of functional forms. 30 . and 4 selection of specification test. 3 selection of an estimation technique. 2 selection of distributional assumptions.