Subject: Statistics

Paper: Econometrics
Module: Simultaneous Equations Model : The
Identification problem

Simultaneous Equations Model 1 /20

Development Team

Principal Dr. Bhaswati Ganguli,

investigator: Professor, Department of Statistics, University of Calcutta

Paper Dr. Sugata SenRoy,

co-ordinator: Professor, Department of Statistics, University of Calcutta

Content writer: Mr. Santu Ghosh,

Lecturer, Department of Environmental Health Engineering,
Sri Ramachandra University, Chennai

Content reviewer: Dr. Malay Naskar,

Principal Scientist, Central Inland Fisheries Research
Institute, Barrackpore

Simultaneous Equations Model 2 /20

Objectives

To introduce the problem of identification in simultaneous equations

models.

To illustrate the problem through various examples.

To show the problems non-identifiability causes in the estimation of

the parameters.

Simultaneous Equations Model 3 /20

The study of simultaneous
equations models

Broadly the study of simultaneous equations models can be divided

into two aspects :
I The Identification Problem
I The Methods of Estimation

The estimation problem only comes in after the equations are

identified.
And the parameters of only the identified equations need to be
estimated.

Simultaneous Equations Model 4 /20

The Identification Problem

What is identification ?
Given a set of equations, it is necessary to know if the parameters of
a particular equation can be meaningfully estimated. The equation is
then said to be identified.
Another way of looking at the identification problem is to see if an
equation in a system is unique in the sense that no other equation or
combination of equations in the system resemble it.
i.e. an estimated equation should not lead to the confusion as to
what it represents.

Simultaneous Equations Model 5 /20

An Illustration

Consider the demand-supply model :

1 Demand function : qt = α0 + α1 pt + u1
2 Supply function : qt = β0 + β1 pt + u2
Take a convex combination of the two equations by adding λ times
the first to (1 − λ) times the second, for any 0 < λ < 1. Gives
qt = [λα0 + (1 − λ)β0 ] + [λα1 + (1 − λ)β1 ]pt + [λu1 + (1 − λ)u2 ]
This for γ0 = λα0 + (1 − λ)β0 , γ1 = λα1 + (1 − λ)β1 and
u3 = λu1 + (1 − λ)u2 gives the
Convex combination of the two : qt = γ0 + γ1 pt + u3
How to estimate the parameters (α0 , α1 ), (β0 , β1 ) or (γ0 , γ1 ) ?

Simultaneous Equations Model 6 /20

Illustration (contd.)
Given the data (pt , qt ) for a number of time-points t = 1, . . . , n,
estimates of the intercept and the slope of a linear model can be
obtained as
n
X
(pt − p̄)(qt − q̄)
t=1
α̂1 = β̂1 = γ̂1 = n = slope
X
(pt − p̄)2
t=1

α̂0 = β̂0 = γ̂0 = q̄ − slope × p̄ = intercept

Question : So what does the slope represent - α1 , β1 or γ1 ?

and the intercept - α0 , β0 or γ0 ?
Since their parameters cannot be meaningfully estimated,neither of
the equations is identified.
Simultaneous Equations Model 7 /20
Illustration (contd.)

Next let us a add a new variable taste/habit (ht ) in the demand function.
Demand function : qt = α0 + α1 pt + α2 ht + u1
Supply function : qt = β0 + β1 pt + u2
Convex combination : qt = γ0 + γ1 pt + γ2 ht + u3
Here we can run the regression of qt on pt and ht .
Notice that if the coefficient of ht is insignificant (i.e. it’s coefficient
can be taken to be zero) then it must be the supply function. But
otherwise, it can either be the demand function or the convex
combination - we don’t know which.
So the supply function is identified, but not the demand function.

Simultaneous Equations Model 8 /20

Illustration (contd.)

Now let us a add a new variable rainfall (rt ) to the supply function.
Demand function : qt = α0 + α1 pt + α2 ht + u1
Supply function : qt = β0 + β1 pt + β2 rt + u2
Convex combination : qt = γ0 + γ1 pt + γ2 ht + γ3 rt + u3
Here we can run the regression of qt on pt , ht and rt .
What will be the conclusion ?
The supply function is identified if coefficient of ht is insignificant.
The demand function is identified if coefficient of rt is insignificant.

Simultaneous Equations Model 9 /20

What is happening ?

The illustration shows that an equation is identified if it has missing

variables.
Put in another way, an equation is identified if it has some zero
coefficients (means the corresponding variable doesn’t enter the
equation).
Of course if a variable is missing from all the equations it does not
help in the identification.
But apart from the mix-up, what other problems does
non-identification create ? We will see.

Simultaneous Equations Model 10 /20

Structural form equations

Structural Model : By + Γx = u
Structural parameters : (B, Γ)
The structural form equations are not suitable for estimation because
I even if identification is possible, the endogenous variables yj ’s are
correlated with the uj ’s leading to inconsistent estimators.

How to get over this problem ?

Simultaneous Equations Model 11 /20

Reduced form equations

By + Γx = u
Since B is a G × G nonsingular matrix,
∴ y = −B −1 Γx + B −1 u
Reduced form equations : y = Πx + v where v = B −1 u
Π : reduced form parameter
- a G × K matrix
 
π11 π12 ... π1K
π π22 ... π2K 
 21
Π=


. . . ... ... ... 
πG 1 πG 2 ... πGK

Relationship : Π = −B −1 Γ or BΠ + Γ = 0

Simultaneous Equations Model 12 /20

Reduced form equations:
implications

The reduced form expresses the y variables solely in terms of x,

which are uncorrelated to u and hence v .
Least squares on the reduced form will thus not lead to inconsistent
estimators.
The only problem is that whereas in the structural form we had
G 2 + GK parameters, the reduced form has GK parameters. We will
come to this later.

Simultaneous Equations Model 13 /20

Identification revisited

Although reduced form parameters can be consistently estimated,

econometricians will not be interested in them.
They will want estimates of the structural form parameters which
relates to their economic models.
So can we estimate (B, Γ) from Π ?
And how does the identification problem relate to this ?

Simultaneous Equations Model 14 /20

Example

Take G = 2 and K = 2.

y1 = α0 + α1 y2 + α2 x1 + α3 x2 + u1 (i)
y2 = β0 + β1 y1 + β2 x1 + β3 x2 + u2 (ii)

In reduced form the equations become

α0 + α1 β0 α2 + α1 β2 α3 + α1 β3
y1 = + x1 + x2 + v1 (iii)
1 − α1 β1 1 − α 1 β1 1 − α 1 β1
β0 + α0 β1 β2 + α2 β1 β3 + α3 β1
y2 = + x1 + x2 + v2 (iv)
1 − α 1 β1 1 − α1 β1 1 − α 1 β1

Simultaneous Equations Model 15 /20

Example(Contd.)

So if y1 is regressed on x1 and x2 , the estimates of the reduced

form parameters of equation (iii) are

α0 + α1 β0 α2 + α1 β2 α3 + α1 β3
π̂10 = , π̂11 = , π̂12 =
1 − α 1 β1 1 − α 1 β1 1 − α1 β1

Similarly the estimates of equation (iv ) are

β0 + α0 β1 β2 + α 2 β1 β3 + α3 β1
π̂20 = , π̂21 = , π̂22 =
1 − α 1 β1 1 − α 1 β1 1 − α1 β1

Unfortunately, neither (α0 , α1 , α2 , α3 ) nor (β0 , β1 , β2 , β3 ) can be

solved in terms of the π’s. Try.
Simultaneous Equations Model 16 /20
Example(Contd.)

But suppose α3 = 0.
We know then equation (i) is identified but not equation (ii).
The estimates become
α0 + α1 β0 α2 + α1 β2 α1 β3
π̂10 = , π̂11 = , π̂12 =
1 − α1 β1 1 − α1 β1 1 − α1 β1
and
β0 + α0 β1 β2 + α2 β1 β3
π̂20 = , π̂21 = , π̂22 =
1 − α1 β1 1 − α1 β1 1 − α1 β1
Then
π̂12
α̂1 = , α̂2 = π̂11 − α̂1 π̂21 , α̂0 = π̂10 − α̂1 π̂201
π̂22

However, (β0 , β1 , β2 , β3 ) cannot be solved for.

Simultaneous Equations Model 17 /20

Example(Contd.)

What if both α2 = 0 and α3 = 0.

The estimates become
α0 + α1 β0 α1 β2 α1 β3
π̂10 = , π̂11 = , π̂12 =
1 − α1 β1 1 − α1 β1 1 − α1 β1
and
β0 + α0 β1 β2 β3
π̂20 = , π̂21 = , π̂22 =
1 − α1 β1 1 − α1 β1 1 − α1 β1
Then
π̂11 π̂12
α̂1 = or α̂2 = ?
π̂21 π̂22

There are multiple solutions for the 1st equation parameters.

The equation is said to be overidentified.

Simultaneous Equations Model 18 /20

Example(Contd.)

Thus an equation is
underidentified if it does not have enough relationships to solve for its
parameters
exactly identified if it has enough equations to solve for its
parameters uniquely
overidentified if it has more equations than required so that its
parameters have multiple solutions

Simultaneous Equations Model 19 /20

 Thank You

Simultaneous Equations Model 20 /20