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Tarun Singh

Economics 1123, Problem Set 7

1.
a) The estimated demand elasticity is -.6620, and the standard error is .0754.

b) This estimator of the elasticity is biased due to simultaneous causality


biased in the regression on price and quantity because price and quantity are
both determined by the interaction of demand and supply.

2.
a) Cartel can only be a valid instrument if it is both relevant and exogenous.
In order to relevant it means that it must have a casual effect on the
instrumented variable. It is reasonable to think that the presence of a cartel
will have an effect on prices, since the purpose of a cartel is to create a
monopoly to create price discrimination leading to higher prices, so cartel is
relevant. In order for Cartel to be exogenous it must be uncorrelated with the
error term. Cartel will only have an effect on quantity through the price
mechanism, so therefore cartel is exogenous. Given that these two conditions
are met, we can say that cartel is a valid instrument.

b) Ice can only be a valid instrument if it is both relevant and exogenous. In


order to relevant it means that it must have a casual effect on the
instrumented variable. It is reasonable to think that the presence of ice on
the great lakes will have an effect on prices because ice on the great lakes
makes transportation of grain harder therefore increasing prices. In order for
Ice to be exogenous it must be uncorrelated with the error term. Ice is
correlated with the error term since the presence of ice means a colder winter
which could decrease the quality of grain and therefore cause consumers to
substitute away from grain and to a substitute good, this effect on the
quantity of grain is not due to the effect on the change in price, so therefore
Ice is not exogenous. Since Ice is not exogenous we can say that Ice is not a
valid instrument.

3.
Table 1
Estimates of the own-price elasticity of the demand
for rail shipments of grain, 1880 – 1886
(1) (2) (3) (4) (5) (6)
Dependent ln(P) ln(Q) ln(Q) ln(Q) ln(Q) ln(Q)
variable:
Regressors:
cartel .3558 – – – – –
(.0260)
ln(P) – -.6620 -.9382 -4.7467 -.9210 –
(.0754) (.1357) (2.7110) (.1355)
Ice – – – – – -.1090
(.0705)
F-statistic 5.22 8.79 9.98 0.77 9.93 2.42
testing (<0.0001) (<0.0001) (<0.0001) (.6855) (<0.0001) (0.0051)
coefficients on
monthly
indicators (p-
value)
Estimation OLS OLS TSLS TSLS TSLS OLS
method
Instrumental n/a n/a cartel Ice ice, cartel n/a
variables
First stage F- n/a n/a 186.42 2.39 92.85 n/a
statistic (<0.0001) (.1231) (<0.0001)
J-test of n/a n/a n/a n/a 11.96
overidentifying (.9994)
restrictions
Notes: ln(P) is the logarithm of the price of transporting one ton of grain by
rail and ln(Q) is the logarithm of the quantity (weekly tonnage) of grain
shipped. The entries in the rows labeled cartel and ln(P) are the
corresponding regression coefficient and, in parentheses, its
heteroskedasticity-robust standard error, estimated using the regression
method in the relevant column. All regressions contain a full set of monthly
indicators, and the row labeled “F-statistic testing coefficients on monthly
indicators (p-value)” gives the F-statistic (and its p-value in parentheses)
testing the hypothesis that the coefficients on these monthly indicators are
all zero. The penultimate row presents the first-stage F-statistic testing the
hypothesis that the coefficients on the instruments are zero in the first-stage
regression, when TSLS is used, and the final row presents the J-test of
overidentifying restrictions. All regressions contain an intercept, the value of
which is not reported in the table. The data are weekly, 1880-1886, for a
total of n = 328 observations. Note that there are 13 “months” in a year in
this dataset (see the variable definitions).

4.
Regression (1) is a simple OLS regression that tells us that the presence of a
Cartel does have a statistically significant effect on prices. However,
Regression (1) does not estimate the demand elasticity. Regression (6) is a
simple OLS regression that shows that Ice doesn’t have a statistically
significant effect on prices. Regression (6) also doesn’t estimate the demand
elasticity. The fact that Ice doesn’t have a statistically significant effect on
prices supports our analysis from question 2 part b where we said that Ice is
not a valid instrument. We can say that Regression (2) is invalid due to the
fact that it doesn’t account for the simultaneous causality bias. Regression
(3), Regression (4), and Regression (5) are TSLS regressions that account for
the biases present in OLS regressions, such as simultaneous causality bias.

Regression (3) is likely the most valid regression because it is a TSLS


regression that uses the regressor Cartel. This means Regression (3) not only
accounts for the simultaneous causality bias and other biases present in OLS
regression and also accounts for the effect of Cartel on price since Cartel is
the regressor. The coefficient on ln(P), is -.9382, which is really close to -1,
and close enough to determine a relationship. It probably wouldn’t be best to
use Regression (4) because the F-statistic is significantly less than 10, so
therefore we are led to believe that Ice is not a valid instrument. In
Regression (5), the J-test rejects the null hypothesis that both the instruments
are exogenous at the one percent significance level. Therefore we know that
at least one of the instruments is not exogenous.

Regression (3) leads us to believe that Cartel pricing did exist. Regression (1)
indicates that Cartels increase prices at a statistically significant level. To
determine whether the Cartel was able to raise prices to a point at which
demand becomes elastic, the regression coefficient on ln(P) (elasticity)
should be less than or equal to -1. Our estimate from Regression (3) is -.9382,
which is not -1 but is fairly close, this suggests that the cartel existed, but it
was weak (due to disagreements between members perhaps). Furthermore,
the 95% confidence interval for the elasticity is [-1.204, -.6722], so we cannot
reject the null hypothesis that the elasticity is less than or equal to -1. This
confidence interval shows us that the elasticity is close to that at which cartel
may be present. This conclusion also fits with the evidence provided by the
introduction which stated that although a cartel was present it was sometime
undermined by mistrust and cheating, thus making the elasticity close to that
of a cartel but not quite, thus -.9382 makes sense.

Threats to internal validity can be overcome by using IV-regressions (TSLS),


and it seems as though Regression (3) accounts for any threats to internal
validity. Regressions (4) and (5), both use invalid instruments because they
use Ice, so therefore there are internal validity issues present in both. The
fact the GDP was presented in real terms may be a major threat to our model.
We can make a Ice a valid instrument by adding the variable temperature.
This would control for the effect of weather on demand for grain and
therefore make Ice a valid instrument.