Dougherty5e C09G06 2016 05 18

Type author name/s here
Dougherty
Introduction to Econometrics,
5th edition
Chapter heading
Chapter 9: Simultaneous
Equations Estimation
© Christopher Dougherty, 2016. All rights reserved.

THE ORDER CONDITION FOR IDENTIFICATION
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY
Three other equations with W , X , and Z as dependent variables

Endogenous variables: W , X , Y , Z
Exogenous variables: P , Q , R
We will discuss the order condition for identification in two stages. First, we will look at an
example. Then, we will generalize.
1
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY

Suppose that you have a four-equation simultaneous equations model that features four
endogenous variables W, X, Y, and Z, and three exogenous variables P, Q, and R.
2
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY

We will focus on the equation for Y. In principle, Y might be directly influenced by every
other endogenous variable and also by all of the exogenous variables, as shown above.
3
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY

Obviously, this equation would not be identified. It has three endogenous variables on the
right side. There are three exogenous variables in the model, but all of them appear in their
own right on the right side and so none is available.
4
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY

To make any progress with the identification of this equation, we have to be able to impose
exclusion restrictions on it. An exclusion restriction is an assumption that a variable does
not appear on the right side. In other words, its coefficient is assumed to be zero.
5
Y   1   2W   3 X   4 Z  uY

Variation 1: P , Q , R excluded
If we are in a position to assert that P, Q, and R do not have direct effects on Y, we can
impose exclusion restrictions on them and write the model as shown.
6
Y   1   2W   3 X   4 Z  uY

The equation would now be exactly identified, because we have three variables needing
instruments, and we have three instruments available, P, Q, and R.
7
Y   1   2W   3 X   5 P  uY

Variation 2: Z , Q , R excluded
Next, consider Variation 2, shown above. Is the equation for Y identified?
8
Y   1   2W   3 X   5 P  uY

Yes, it is. We now have only two exogenous variables excluded, but we need only two,
because one of the endogenous variables has also been excluded. Note that we still have
three exclusions in total: one endogenous and two exogenous variables.
9
Y   1   2W   5 P   6Q  uY

Variation 3: X , Z , R excluded
Finally, consider Variation 3. Here, two endogenous variables are excluded. Therefore we
need only one instrument, which means that we need exclude only one explanatory variable
from the right side. The total number of exclusions remains three.
10
Y   1   2W   5 P   6Q  uY

In each of the three variations, three variables were absent from the right side. This caused
the equation to be exactly identified. It did not matter whether the missing variables were
endogenous or exogenous.
11
Y   1   2W   5 P   6Q  uY

If more than three variables had been absent, the number of available exogenous variables
would have been greater than the number needed for identification, and the equation would
have been overidentified.
12
Y   1   2W   5 P   6Q  uY

Again, it would not matter whether the absent variables were endogenous or exogenous.
13
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY

We will now generalize. In the example, we saw that identification of the equation required
three exclusion restrictions, and it did not matter which three. This finding generalizes to
what is known as the order condition for identification.
14
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY

In a fully specified model, there will be as many equations as there are endogenous
variables. Let us suppose that there are G of each.
15
Y   1   2W   3 X   4 Z   5 P   6Q   7 R  uY

The maximum number of endogenous variables that can appear on the right side of an
equation is G ‒ 1 (the other is the dependent variable of that equation).
16
Y   1   2W   3 X   4 Z  uY

In such a case, identification requires that at least G ‒ 1 exogenous variables should be

excluded from the equation, as in Variation 1.
17
Y   1   2W   3 X   4 Z  uY

This is a worst-case scenario because all the other endogenous variables are on the right
side of the equation for Y.
18
Y   1   2W   3 X   4 Z  uY

Suppose, however, that j endogenous variables are absent from the equation. We would then
need only G ‒ 1 ‒ j instruments, so only G ‒ 1 ‒ j exogenous variables would have to be
excluded from the equation.
9
Y   1   2W   3 X   4 Z  uY

The total number of variables excluded remains the same: j endogenous variables and
exogenous variables make a total of G ‒ 1.
20
Y   1   2W   3 X   5 P  uY

Z excluded  j  1
This is illustrated by Variations 2 and 3. G is equal to 4. In Variation 2, Z has been excluded

and j = 1. G ‒ 1 ‒ j = 2, so we need only two exclusion restrictions on the exogenous
variables in order to have enough instruments. Q and R are excluded, so the equation is
identified. 21
Y   1   2W   5 P   6Q  uY

X and Z excluded  j  2
In Variation 3, X and Z have been excluded and j = 2. G ‒ 1 ‒ j = 1, so we need only one

exclusion restriction on the exogenous variables in order to have enough instruments. R is
excluded, so the equation is identified.
22
Y   1   2W   5 P   6Q  uY

Thus we come to the general conclusion that an equation in a simultaneous equations model
is likely to be identified if G ‒ 1 or more variables are missing from it.
23
Y   1   2W   5 P   6Q  uY

If exactly G ‒ 1 are missing, it is likely to be exactly identified, and if more than are missing,
it is likely to be overidentified, calling for the use of TSLS.
24
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
The order condition is only a necessary condition for identification. In practice, it is usually a
sufficient one, but exceptions are possible.
25
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
In general, when one has a simultaneous equations model, the reduced form equation for
each endogenous variable will have all of the exogenous variables in the model on its right
side.
26
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
The interconnectedness of the model ensures that every exogenous variable affects every
endogenous variable, either directly or indirectly, as has been the case in all of the examples
so far. Those exogenous variables with indirect effects are available as instruments.
27
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
However, it is possible for the structure of the model to be such that it is not fully
interconnected. It is then possible that one or more of the exogenous variables may be
absent from a reduced form equation. Then they are not available as instruments, after all.
28
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
We will consider an example. In the model shown, X, Y, and Z are endogenous variables,
and Q is exogenous.
29
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
At first sight, the equations for X and Y both appear to be identified. Each has an
endogenous variable on the right side, but each excludes Q, so in principle Q could be used
as an instrument.
30
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
However, looking at the structural equations for X and Y, neither of those variables depends
on Z, and as a consequence, the reduced form equations for X and Y do not include Q. So Q
is not available as an instrument.
31
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
The rank condition is a mathematical way of determining whether the structure of the model
is sufficiently interconnected that all of the exogenous variables are available as
instruments.
32
X   1   2Y  u
Y  1   2 X  v
Z   1   2Y   3 X   4Q  w
It involves the use of linear algebra and will not be pursued here. Fortunately, failure of the
rank condition is unusual in practice.
33
Copyright Christopher Dougherty 2016.
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refer to the author.
The content of this slideshow comes from Section 9.2 of C. Dougherty,

Introduction to Econometrics, fifth edition 2016, Oxford University Press.
Additional (free) resources for both students and instructors may be
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Individuals studying econometrics on their own who feel that they might benefit
from participation in a formal course should consider the London School of
Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
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2016.05.18

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Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Next, consider Variation 2, shown above. Is the equation for Y identified?

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

In such a case, identification requires that at least G ‒ 1 exogenous variables should be

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

This is illustrated by Variations 2 and 3. G is equal to 4. In Variation 2, Z has been excluded

Three other equations with W , X , and Z as dependent variables

In Variation 3, X and Z have been excluded and j = 2. G ‒ 1 ‒ j = 1, so we need only one

Three other equations with W , X , and Z as dependent variables

Three other equations with W , X , and Z as dependent variables

These slideshows may be downloaded by anyone, anywhere for personal use.

The content of this slideshow comes from Section 9.2 of C. Dougherty,

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