A hoary econometrics principle is that an ordinary least squares (OLS) estimation of a demand equation in which price is treated as an exogenous independent variable contains a specification error that is likely to produce a biased estimate of the coefficient on price. Price is an endogenous variable that a profit-maximizing supplier chooses on the basis of the cost function and the shape of the demand relationship. In a single-equation OLS model the coefficient on price measures its combined effects on demand (negative) and supply (positive). Only if the exogenous shocks to the equilibrium price and quantity operate to shift the supply curve but not the demand curve will an OLS estimate of the demand equation produce an unbiased estimate of the coefficient on price. If the unexplained shocks affect primarily the demand equation, the coefficient on price will measure primarily the positive response of supply to an increase in price, thereby causing the estimated equation to trace the supply curve rather than the demand curve.
Institutional Login
Log in with Open Athens, Shibboleth, or your institutional credentials
Personal login
Log in with your Elgar Online account
