Structural Econometric Modeling in

Industrial Organization
Handout 1
Professor Matthijs Wildenbeest

16 May 2011

Reading

Peter C. Reiss and Frank A. Wolak A.

Structural Econometric Modeling: Rationales and Examples
from Industrial Organization.
Handbook of Econometrics 6A, Chapter 64, Sections 1-4,
2007.

Background on Empirical IO

Structural versus nonstructural econometrics

Constructing structural models
Framework for structural econometrics models in IO

Structural versus Nonstructural Econometrics

Example: auctions
Suppose we observe winning bids, y = {y1 , . . . , yT }, in a large
number of T similar auctions, as well as the number of bidders in
each market, x = {x1 , . . . , xT }.
Goal exercise: understand equilibrium relationship between winning
bids and the number of firms.
Nonstructural approach:
regress winning bids on the number of bidders.
use nonparametric smoothing techniques to estimate the

conditional density of winning bids given the observed number

of bidders, i.e., f (y |x).
Does the regression coefficient tell us what happens when we add
another bidder?
Not without further knowledge about the auction under study. For
instance, information paradigm matters.
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Structural versus Nonstructural Econometrics

Structural versus Nonstructural Econometrics

Structural versus Nonstructural Econometrics

Structural approach:
Use the structure of an auction model to say something about

winning bids and the number of firms.

For example, Paarsch (1992, j econometrics) shows that for
first-price sealed-bid auctions with Pareto-distributed private value
bidders, the conditional density of winning bids given the number
of firms f (y |x) is
f (y |x, ) =

2 x
y 2 x+1

1 2 (x 1)
2 (x 1) 1

2 x
,

so that the expected value of the winning bid given the number of
bidder is


2 x
1 2 (x 1)
.
E (y |x, ) =
2 (x 1) 1 2 x 1
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Structural versus Nonstructural Econometrics

Why use economic theory in this example?
Helps us to clarify how institutional and economic conditions affect
the relationship between x and y . Think of type of auction
(sealed-bid versus open-outcry or first-price versus second-price),
bidder behavior (risk neutral versus risk averse), and information
paradigm (common versus private values).
Three general reasons for specifying and estimating a structural
econometric model:
1

Estimate unobserved parameters that could not otherwise be

inferred from the data (costs, elasticities, valuations).

Perform counterfactuals or policy experiments.

Compare the predictive performance of two competing

theories.
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Structural versus Nonstructural Econometrics

Although using structural econometrics has many advantages, this
does not always mean structural models should be favored over
nonstructural models. Think of a situation where there little or no
useful economic theory to guide the empirical work.
Levitt (1997, am econ rev): using electoral cycles in police hiring
to estimate the effect of police on crime.
Studies the effect of police on reducing crime. Previous studies
found little evidence, likely due to simultaneity problems.
Levitt proposes a new instrument: timing of elections. Effects the
size of the police force, but does not belong directly to the crime
production function.

Constructing Structural Models

Sources of structure
1

economics

statistics

Since economic models are often deterministic we have to add

statistical structure to rationalize why economic theory does not
perfectly explain the data.

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Constructing Structural Models

Example
Cross-section data on output, Qi , labor inputs, Li , and capital
inputs Ki . Estimate the regression
ln Qi = 0 + 1 ln Li + 2 ln Ki + i ,
by ordinary least squares (OLS). Error term i necessary because
right hand side variables do not perfectly explain log output.
Interpretation?
Best Linear Predictor (BLP) of ln Qi given a constant, ln Li

and ln Ki : only statistical structure needed (sample second

moments converge to their population counterparts).
Estimation of Cobb-Douglas production function: structure

needed from both economics and statistics.

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Constructing Structural Models

Only structure from economics not enough to estimate
(logarithmic transformation) of Cobb-Douglas production function
Qi = ALi Ki : we have to add an error term as well:
Qi = ALi Ki exp i .
Where does the error term come from?
If i is measurement error distributed independently of the right
hand side variables the estimated OLS parameters can be
interpreted as the coefficient of the Cobb-Douglas production
function.
Moreover, firms should produce on their production function.
Note that if the error includes unobserved differences in
productivity, OLS fails to deliver consistent
estimates of the production function parameters.
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Constructing Structural Models

Linear regression model y = + x + . From a statistical

perspective we can always regress y on x (or the other way
around): the coefficients have statistical interpretations (Best
Linear Predictor).
However, we need economic arguments to make a case about
causation.
Moreover, without an economic model the OLS regression only
gives (under certain conditions) consistent estimates of a best
linear predictor function.

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Constructing Structural Models

Usually not possible to test a deterministic economic model by

running a regression.
Many descriptive studies treat the linear regression coefficient
estimates as as if they were estimates of the derivative of E (y |x)
with respect to x, although = BLP(y |x)/x is usually not
equal to E (y |x)/x.

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Constructing Structural Models

Nonexperimental data raises significant modeling issues.
Estimating the demand curve
qtd = 0 + 1 pt + 2 x1t + 1t
by OLS only gives consistent estimates of the demand curve
parameters if price pt and a demand shifter like income x1t are
uncorrelated with the error 1t . If we perform experiments where
we randomly select prices and observe the quantity demanded this
will work.
Same for the supply curve
qts = 0 + 1 pt + 2 x2t + 2t ,
where x2t is now a supply shifter like input prices.
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Constructing Structural Models

In the experiments the quantity supplied will in general not be
equal to the quantity demanded. However, no problem since we
observe the quantity demand and supplied directly for each
randomly generated price.
Prices around us are nonexperimental. OLS no longer possible
because of correlations between explanatory variables and error
term. But if we use economics and impose the market-clearing
equation
qts = qtd ,
we could apply instrumental variable techniques to get consistent
estimates of the simultaneous equation model.

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Constructing Structural Models

Simultaneous equations models

When dealing with endogeneity it is important to think about a

complete simultaneous equations model.

Example
Researcher estimates:
pi = POPi 1 + COMPi 2 + i ,
where pi is the price in market i, POPi is population size, and
COMPi is a dummy for whether the firm faces competition.
Has this equation a structural meaning? Could be: 2 measures
effect of competition on prices.

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Constructing Structural Models

Simultaneous equations models

Problem: COMPi is likely to depend on pi :

COMPi = POPi 1 + pi 2 + i .
Therefore COMPi will be correlated with i , so OLS will give
inconsistent estimates of 2 .
Possible solution: use average income Yi as instrument for
COMPi , since one can argue Yi is correlated with COMPi but not
with i . Statistical rationale.

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Constructing Structural Models

Simultaneous equations models

To be completely convincing two things need to be done:

1

explain why Yi is not part of pi .

make the case that Yi is part of COMPi .

Therefore, specify the complete system:

pi
COMPi

= POPi 1 + COMPi 2 + i ;
= POPi 1 + pi 2 + Yi 3 + i .

This requires the researcher to think carefully about the economic

model underlying the simultaneous system of equations.

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Framework for Structural Econometrics Models in IO

A structural model has two main components:
1

economic model;

stochastic model.

The economic model should have the following components:

description of economic environment (market, actors,

information available);
list of primitives (technologies, preferences, endowments);
exogenous variables (variables outside the model);
decision variables and objective functions (utility/profit

maximization);
equilibrium concept (nash equilibrium)

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Framework for Structural Econometrics Models in IO

The stochastic model transforms the (usually) deterministic
economic model into an econometric model. Main difference
between the two is inclusion of unobservables.
Major stochastic specifications:
unobserved heterogeneity
agent uncertainty
optimization errors
measurement error

Different forms can have dramatically different implications for

identification and estimation!

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Framework for Structural Econometrics Models in IO

Unobserved heterogeneity
Situation where agents decisions depend on something the
economist does not observe.

Agent uncertainty
Situation where agents decisions depend on something the agent
does not (fully) observe.
Note that in both cases the econometrician is ignorant. Still, they
can have different implications.

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Framework for Structural Econometrics Models in IO

Example
Cross-section data on firms consisting of output Q, total costs TC ,
and input prices pK and pL . Goal is to estimate and in
Qi = Ai Li Ki .
Suppose a regulator chooses a price pir and that firms have
different Ai , the latter being observed by the firm and regulator
but not by the econometrician. Assume inelastic demand.
Firm chooses inputs to maximize
(Ki , Li ) = pir Ai Li Ki pKi Ki pLi Li .

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Framework for Structural Econometrics Models in IO

Firms produce in a cost minimizing way, so
Ai L1
Ki
Ki
pLi
MPL
i
=
=
=
.
1

MPK
Li
pKi
Ai Li Ki
This means
Ki =

pLi
Li .
pKi

Substituting this into the production function gives


Qi = Ai

pLi
Li
pKi

Li


= Ai

pLi
pKi

L+
,
i

and solving for Li gives

1
+

Li = Qi

1
+

Ai

pLi
pKi

  
+
+

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Framework for Structural Econometrics Models in IO

The total labor cost pLi Li is then given by
1
pLi Li = CL pKi
pLi Qi Ai ,

where = 1/( + ), = /( + ), and CL = (/) .

Similarly, the total capital cost pKi Ki is given by
1
pKi Ki = CK pKi
pLi Qi Ai ,

where CK = (/)1 .
The total cost function is therefore
1
TCi = C0 pKi
pLi Qi Ai ,

where C0 = CL + CK .
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Framework for Structural Econometrics Models in IO

Transforming this equation using natural logarithms gives
ln TCi = ln C0 + ln pKi + (1 ) ln pLi + ln Qi ln Ai ,
which holds exactly. The efficiency differences are assumed to be
i.i.d. positive random variables, so subtracting E [ln Ai ] from the
error term and adding it to the constant gives
ln TCi = ln C1 + ln pKi + (1 ) ln pLi + ln Qi ln ui ,
where ln C1 = ln C0 + E [ln Ai ] and ln ui = ln Ai E [ln Ai ].
This equation can finally be taken to the data using OLS.

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Framework for Structural Econometrics Models in IO

Now suppose the firms (and the regulator) do not know the
efficiency parameters Ai either. Firms now choose inputs to
maximize
E [(Ki , Li )] = pir E [Ai Li Ki ] pKi Ki pLi Li .
First-order condition for expected profit maximization imply


pKi
Ki .
Li =
pLi
Observed total costs are
TCi =

+
+
pKi Ki =
pLi Li ,

and do not depend on Ai .

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Framework for Structural Econometrics Models in IO

This means Li =

+ TCi /pLi

and Ki =

+ TCi /pKi ,

so

Qia = D0 TCi+ pKi
pLi Ai .

Final output produced Qia does depend on Ai .Taking natural

logarithms gives
ln Qia = ln D0 + ( + ) ln TCi ln pKi ln pLi + ln Ai ,
which holds exactly. Researcher does not observe Ai , so treat as
random and move unconditional expectation again to the constant:
ln Qia = D1 + ( + ) ln TCi ln pKi ln pLi + i ,
where i = ln Ai E [ln Ai ] and D1 = ln D0 + E [ln Ai ].

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Framework for Structural Econometrics Models in IO

Optimization errors
Failure of agents decisions to satisfy exactly first-order necessary
conditions for optimal decisions.

Measurement errors
Occurs when the variable the research observes are different from
those the agents observe. Straightforward way of converting a
deterministic model into a statistical model.

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Framework for Structural Econometrics Models in IO

Steps left
1

selection of functional forms;

selection of distributional assumptions;

selection of an estimation technique; and

selection of specification test.

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