Estimating Models of Supply and Demand: Instruments and Covariance Restrictions

Abstract

We consider the identification of empirical models of supply and demand with imperfect competition. We show that a covariance restriction on unobserved demand and cost shocks resolves endogeneity and identifies the price parameter. We demonstrate how to employ this approach in estimation, and we provide a comparison to instrumental variables approaches. Our formal results also indicate how weaker assumptions about the covariance term can be used to construct bounds on the price parameter. We illustrate the covariance restriction approach with applications to ready-to-eat cereal, cement, and airlines.

Keywords: Identification, Demand Estimation, Covariance Restrictions, Instrumental Variables

JEL Classification: C13, C36, D12, D22, D40, L10