Estimation of Cross Equation Residuals Correlation for the Fulfillment of

Assumption 5:
In order to fulfill assumption 5 related to application of 3SLS we will estimate cross equation
residual correlation. If there exist correlation then 3SLS is appropriate. Moreover we can
estimate variance-covariance matrix of residuals, if var-cov matrix of residuals is not
diagonal1 then 3SLS does not reduce to 2SLS.

1
A square matrix is said to be diagonal matrix if and only if there exists at least one element which is non zero
on main diagonal and all other elements are zero of the matrix. For example A = 10
04
2* 2