BSc IV-Econometrics II

Assignment 4- Simultaneous Equations

Name: ___________________________ Section: _______

Question 1: Write a two-equation system in “supply and demand form”, that is, with the same
variable Yi (typically, “quantity”) appearing on the left-hand side:
𝑌1 = 𝛼1 𝑌2 + 𝛽1 𝑍1 + 𝜇1
𝑌1 = 𝛼2 𝑌2 + 𝛽2 𝑍2 + 𝜇2
a. If 𝛼1 = 0 or 𝛼2 = 0, explain why a reduced form exists for 𝑌1 .

(i) If 1 = 0, then y1 = 1z1 + u1, and so the right-hand-side depends only on the exogenous variable z1 and
the error term u1. Then this is the reduced form for y1. If 2 = 0, the reduced form for y1 is y1 = 2z2 + u2.
(Note that having both 1 and 2 equal zero is not interesting as it implies the bizarre condition u2 – u1 =
1z1  2z2.)

b. If 𝛼1 ≠ 0 or 𝛼2 = 0, find the reduced form for 𝑌2 .

If 1  0 and 2 = 0, we can plug y1 =  2z2 + u2 into the first equation and solve for y2:

2z2 + u2 = 1y2 + 1z1 + u1

or

1y2 = 1z1  2z2 + u1 – u2.

Dividing by 1 (because 1  0) gives

y2 = ( 1/1)z1 – ( 2/1)z2 + (u1 – u2)/1

 21z1 + 22z2 + v2,

where 21 =  1/1, 22 = 2/1, and v2 = (u1 – u2)/1. Note that the reduced form for y2 generally
depends on z1 and z2 (as well as on u1 and u2).
Question 2: A model to estimate the effects of smoking on annual income (perhaps through lost
work days due to illness, or productivity effects is:
log(𝑖𝑛𝑐𝑜𝑚𝑒) = 𝛽0 + 𝛽1 𝑐𝑖𝑔𝑠 + 𝛽2 𝑒𝑑𝑢 + 𝛽3 𝑎𝑔𝑒 + 𝛽4 𝑎𝑔𝑒 2 + 𝜇1
Where cigs is number of cigarettes smoked per day, on average.

a. Interpret the slope parameter 𝛽1.

Assuming the structural equation represents a causal relationship, 1001 is the approximate percentage
change in income if a person smokes one more cigarette per day.

b. To reflect the fact that cigarette consumption might be jointly determined with income, a
demand for cigarettes equation is:

cigs = 𝛾0 + 𝛾1 log(𝑖𝑛𝑐𝑜𝑚𝑒) + 𝛾2 𝑒𝑑𝑢 + 𝛾3 𝑎𝑔𝑒 + 𝛾4 𝑎𝑔𝑒 2 + 𝛾5 log(𝑐𝑖𝑔𝑝𝑟𝑖𝑐) + 𝛾6 restaurn

+ 𝜇2
where cigpric is the price of a pack of cigarettes (in cents), and restaurn is a binary variable equal
to a unity if the person lives in a state with restaurant smoking restrictions. Assuming these are
exogenous to the individual, what signs would you expect for 𝛾5 and 𝛾6?

Since consumption and price are, ceteris paribus, negatively related, we expect 5  0 (allowing for 5 =
0). Similarly, everything else equal, restaurant smoking restrictions should reduce cigarette smoking, so
6  0.

c. Do you think that cigarette prices and restaurant smoking restrictions are exogenous in
the income equation?
Assuming that state level cigarette prices and restaurant smoking restrictions are exogenous in
the income equation is problematical. Incomes are known to vary by region as do restaurant
smoking restrictions. It could be that in states where income is lower (after controlling for
education and age), restaurant smoking restrictions are less likely to be in place.