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Original Title: Harvard Ec 1123 Econometrics Problem Set 7 - Tarun Preet Singh

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Harvard Ec 1123 Econometrics Problem Set 7 - Tarun Preet Singh

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

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1.

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

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.

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 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.

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.

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