Simultaneous Equations Model

Prepared by Rizka Isnaini Husna, S.E.

Econometrics Tutorial for Regular 65 Class

Outline
1. Simultaneity
2. Simultaneous Equation Model (SEM)
Review: Endogeneity Problem
There are three sources of endogeneity
1. Omitted variables
2. Measurement error
3. Simultaneity
 Simultaneity
• When one or more of the explanatory variables is jointly determined with
the dependent variable, typically through an equilibrium mechanism.

x y
Simultaneous Equation Model
• The classic example of an SEM is a supply and demand equation
• Example: labor supply function

• To analyze this model, we cannot separate it with the labor demand

equation because the observed wage and hours are determined by the
intersection of supply and demand.
• Thus, labor supply and demand constitute a simultaneous equations
model (SEM)
Simultaneous Equation Model
Example
Cities often want to determine how much additional law enforcement will
decrease their murder rates. A simple cross-sectional model to address this
question is

Murdpc : murders per capita

Polpc : number of police officers per capita
Incpc : income per capita (exogenous)

If a city increases its police force, will that lower the murder rate? If no, why?
Simultaneous Equation Model
• Each equation in the SEM should have a ceteris paribus interpretation
in isolation from the other equation.
• Two endogenous variables cannot be chosen by the same economic
agent.
Simultaneous Equation Model
Example 2
Suppose that, for a random household in the population, we assume that
annual housing expenditures and saving are jointly determined by

Is this an appropriate SEM?

Simultaneous Equation Model
• Housing and saving are chosen by the same household
• If family income increases, a household will generally change the optimal
mix of housing expenditures and saving
• Therefore, just because two variables are determined simultaneously does
not mean that a SEM is suitable.
Identifying SEM
Identification Rules in Two–Equation System
1. Order Condition
At least one exogenous variable is excluded from the first equation.
2. Rank Condition
At least one of the exogenous variables excluded from the first equation
must have a nonzero coefficient in the second equation.
If both conditions are fulfilled, we can say that the first equation is
identified.
Thus, we can estimate it by using 2SLS with excluded variables as IVs.
Estimating SEM
Example
Romer (1993) proposes theoretical models of inflation that imply that more
“open” countries should have lower inflation rates. His measure of openness is
the average share of imports in GDP. He has in mind a two-equation system

The first equation is the one of interest, with the hypothesis that ∝1 < 0
The second equation reflects that the degree of openness might depend on the
average inflation rate, as well as other factors.
 Estimating SEM
1. Use OPENNESS.dta
2. Identify the first equation, does this equation satisfies both conditions?
3. Estimate the first equation using 2SLS!
4. What can you conclude?
Simultaneous Equations Models with Panel Data
The basic approach to estimating SEMs with panel data involves two steps:
1. Eliminate the unobserved effects from the equations of interest using the
FE/FD
2. Find instrumental variables for the endogenous variables in the
transformed equation.
Simultaneous Equations Models with Panel Data
Example:
In order to estimate the causal effect of prison population increases on crime
rates at the state level, Levitt (1996) used instances of prison overcrowding
litigation as instruments for the growth in prison population. We can write
an underlying fixed effects model as

The vector z contains:

log of police per capita, log of income per capita, the unemployment rate,
proportions of black and those living in metropolitan areas, and age
distribution proportions.
Simultaneous Equations Models with Panel Data
1. Use PRISON.dta.
2. Run first-differencing estimation on the equation to solve the
unobserved heterogeneity.
3. Estimate the FD equation using 2SLS.
Source
Wooldridge, J. M. (2016). Introductory Econometrics, 6e. Boston: Cengage
Learning.