651 Empirical Economics Assignment 4

Suggested solutions
Svante Midander
October 19, 2016
The assignment gives a maximum of 3 points. Answers should be provided in
English. The key to a good score is to be clear, precise and concise in your
answers. Refer to the course web page for further instructions regarding how
the solutions are to be structured.

Instrumental Variables

Use the data set The_Tax_Burden_on_Tobacco_Volume_49__1970-2014.csv,

again for studying the price elasticity of cigarette demand. Remember from the
previous assignment, that the coefficient in a linear equation relating log(salesit )
with log(priceit ) has the interpretation of the elasticity of cigarette sales with
respect to the price. This suggests we should estimate the linear demand function,
log(salesit ) = 0 + 1 log(priceit ) + uit .

(1)

where uit represents other factors that affect demand, such as income and
consumer preferences. Hence, for this model to identify the price elasticity of
demand, it is crucial that price changes are not demand-driven, otherwise we
cannot interpret 1 as the response in demand due to a change in the price. In the
data however, we usually cannot distinguish between demand and supply-driven
price fluctuations, as quantities and prices are simultaneously determined in the
market by the equilibrium of demand and supply.
Contact:

svante.midander@hhs.se.

Figure 1: Equilibrium price and quantity. Source: Stock and Watson - Introduction to Econometrics.
Therefore it is likely that log(priceit ) will be correlated with the error term uit ,
since some price changes origins from shifts in the demand curve, such as an
increase in consumers health awareness or increasing household income. This
means that prices are endogenous, and our estimate of 1 biased. Therefore, we
might want to use an instrumental variable approach for estimating the elasticity.
(a) A potential instrument for prices is to use the federal and state cigarette
excise tax. Explain how the cigarette excise tax could be a suitable instrument
for supply-driven price changes. Would you say it is exogenous?

Pd

Supply

Ps
Demand
Q

Figure 2: Impact of an excise tax on equilibrium price and quantity.

From microeconomic theory we know that a tax will raise the market price
by introducing a wedge between the price of the consumer Pd , and the price
of the producer Ps , see Figure 2. With the tax, less quantity is supplied and
demanded. The change in quantity sold is determined by the slope of the
demand and supply curves, the elasticities. By using variation in the price
that is due to changes in the excise tax, we would hence be able to estimate
the elasticity of demand, i.e. the slope of the demand curve.
The cigarette excise tax is an exogenous instrument if tax changes are not
induced by changes in consumers demand. The exogeneity assumption
would be violated if a change in taxes is due to for example the government
responding to lower tax income (which in turn was due to lower demand).
While the exogeneity assumption is quite reasonable in this context, we can
(as always) not be completely sure that it holds.
(b) Look at the reduced form of the first stage,
log(priceit ) = 0 + 1 log(taxit ) + it .

(2)

Run a simple linear regression for the year 1995 only, and report the coefficient of log(taxit ).1 Does the sign of 1 make sense? Now, run (2) for the
whole period 1970 to 2000. What happens now with the coefficient 1 ? Does
anything change if we include year fixed effect and state fixed effects? Is the
IV assumption of relevance fulfilled?
The results from the first stage for year 1995 is shown in column (1) in the
table below.
1 For

the sake of simplicity, use the default standard errors throughout the assignment.

Table 1: Reduced form the first stage.

VARIABLES
ltax
Constant

(1)
Year 1995

(2)
Full sample

(3)
Full sample

(4)
Full sample

0.383***
(0.023)
0.824***
(0.016)

1.116***
(0.014)
1.284***
(0.018)

0.352***
(0.004)
-0.360***
(0.010)

0.344***
(0.006)
-0.252***
(0.012)

Yes

Yes
Yes

Year FE
State FE
Observations
F-stat
R-squared

51
1,581
1,581
288.1
6555
13216
0.855
0.806
0.995
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

1,581
3619
0.998

In the cross section for the year 1995, the first stage yields a coefficient on
log(taxit ) of 0.383. The estimates are significant on the 1% level. Hence,
a 1 percent tax increase implies a 0.383 percent increase in the price. We
see that taxes and prices are positively correlated, which is what we would
expect.
The estimate becomes much larger when we use the full samplethe estimate
increases to 1.116as seen in column (2) of Table 1. The reason why the
estimate increase is that the relationship between prices and taxes gets
stronger when we add the time-dimension. A large part of the variation in
prices and taxes is over time, and prices and taxes show a strong common
trend across states, which is seen in Figure 3 below.
From the perspective of instrument exogeneity, using the general time trend
in taxes is problematic as there could also be a general trend toward lower
consumption (if people become more aware of the negative health effects
of smoking) or increased consumption (if incomes increases over time and
smoking is a normal good). Including year fixed effects implies we only use
the variation in taxes across states in the cross section and the differential
trends in taxes over time to instrument prices.

Figure 3: Average of US log cigarette price and excise tax.

When we include year dummies, we control for the common trend, and the
coefficient on log(taxit ) decreases to 0.352, as seen in column (3) of Table 1.
Including state fixed effect further decrease the estimate to 0.344 in column
(4). Given the F -statistic of 3619, which is well above the rule-of-thumb of
10, the instrument is clearly relevant.
(c) The reduced form for the outcome, including year and state dummies,2 is
log(salesit ) = 0 + 1 log(taxit ) + Tt 2 + Ii 3 + eit .

(3)

Run this regression and interpret the coefficient 1 of log(taxit ). Explain

why the tax elasticity might be meaningful.
The results from the reduced form of the outcome are shown in the table
below.
2 The year and state dummies are written in vector notation. So T is a row vector containing
t
the year dummies, and 2 is a column vector with the corresponding year dummy coefficients.
The state dummies Ii , and their coefficients 3 are structured in the same way.

Table 2: Reduced form the outcome.

(1)
lsales

VARIABLES
ltax

-0.472***
(0.014)
3.968***
(0.031)

Constant

Year FE
State FE

Yes
Yes

Observations
1,581
R-squared
0.920
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

The coefficient of log(tax) is significant and equals 0.472, and since this in
log-log form, it can be interpreted as a elasticity. Hence, a 1 percent increase
in the cigarette excise tax reduces demand by 0.472 percent.
The reduced form of the outcome can be meaningful in itself, especially in
this case when the instrument is a policy instrument. For a policy maker,
the tax elasticity is interesting since it is important to know how much
consumers will react to a tax increase or decrease.
(d) Run the regression of the two reduced form equations, including year and
state fixed effects, and store the coefficient of 1 and 1 . Calculate the IV
estimate of 1 . Show your derivations and interpret the coefficient.
The IV estimate of 1 is equal to the ratio of the reduced form estimate of
1 and the first stage estimate of 1 . If we use our estimates 1 and
1 , we
get
1
0.472
1 =
= 1.370
=

1
0.344
The IV estimate of the price elasticity of demand is 1.370, so a 1 percent
increase in the cigarette price decreases demand by 1.37 percent. In comparison with the OLS and RE/FE estimates we got in the previous assignment
(1.2 and 1.0), demand for cigarettes is more elastic.
A potential reason why the IV estimate is larger than the RE/FE is that
some the variation in prices comes from changes in the demand. If the
demand curve shifts outward, both prices and sales go up. Hence, if part of
the variation in prices is due to shifts in the demand curve, the estimates
from FE/RE/POLS will be biased toward zero. A likely reason for why the
IV-estimate is larger is that our instrumental variable strategy corrects for
this bias by only making use of variation in prices which are due to changes
in taxes.
(e) Now, estimate 1 , with year and state fixed effects, with 2SLS by predicting
\ it ) from the first stage, and then running the rethe fitted values log(price
6

\ it ). Compare the 2SLS estimate of 1

gression of log(salesit ) on log(price
with the IV estimate from (d).
\ from
The 2SLS estimates computed by regressing log(sales) on log(price)
the first stage are shown in column (1) of Table 3.
Table 3: 2SLS.
VARIABLES
lprice
Constant

Year FE
State FE

(1)
2SLS by hand

(2)
2SLS

-1.370***
(0.041)
3.623***
(0.040)

-1.370***
(0.044)
3.623***
(0.043)

Yes
Yes

Yes
Yes

Observations
1,581
1,581
F-stat
3619
3619
R-squared
0.920
0.902
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

As we can see, the 2SLS estimate is significant and coincide with the IV
estimate in question (d), 1.370.
(f) Estimate 1 again, with year and state fixed effects, with 2SLS, but now use
STATAs command ivregress. What happens to the standard errors compared
to those in question (e)? Why do they change?
The 2SLS estimates that we get by using STATAs command ivregress is
shown column (2) of Table 3. The coefficients correspond with the results in
(e), but the standard errors are larger. This is because the standard errors
that we yield using ivregress are adjusted for the first stage regression, while
the standard errors in (e) are just the OLS standard errors from the second
stage regression, which hence do not take into account that the estimation
is run in two separate steps.