Simultaneous-Equation

Estimation

Summary Chapter 12: Simultaneous-Equation Estimation, Econometric Models and

Economic Forecasts, 4th edition by Robert S. Pindyck and Daniel L. Rubinfeld (1998)

Simultaneous-equation models are models consisting of several equations, where each
model includes several endogenous variables which are simultaneously related by an
interrelated series of equations. These models require additional model-building and
estimation tools because they often render ordinary-least squares (OLS) estimators
inconsistent and/or biased.
12.1 Introduction to Simultaneous-Equation Models
A simultaneous-equation model is represented by a series of simultaneous interdependent
equations. The OLS estimation of individual equations in a simultaneous-equation model
can lead to biased and inconsistent parameter relations, as shall be proven in what follows.
To illustrate the constituents and terminology used in a simultaneous-equation model,
consider the following supply-demand model:
!! = ! + ! ! + ! !!! + !
!! = ! + ! ! + ! ! + !
!! = !!
Rather than considering dependent and independent variables, there is different
terminology for simultaneous-equation models, as explained in the below table:
Endogenous variables

Predetermined variables

Variables determined within the

system of equations
Variables determined within the
system, but by past values of the
endogenous variables
Variables determined completely
outside the model system

!! , !! , !
Lagged endogenous variables
!!!
Exogenous variables
!

Because ! and ! are endogenous, applying OLS to the estimation of the supply/demand
equation will generate biased and inconsistent estimators. Below is an adjusted version of
the supply-demand model which we will use to illustrate the bias of the OLS estimator:
Supply:

! = ! + ! ! + !

Demand:

! = ! + ! ! + ! ! + !

(1)

(2)

Model in deviations form (structural model*):

Supply:

! = ! ! + !

Demand:

! = ! ! + ! ! + !

Simultaneous-Equation Estimation

* A structural model contains endogenous variables on the left-hand side and (if
simultaneous) contains endogenous and predetermined variables on the right-hand side.
Solving for the endogenous variables as a function solely of the predetermined variables in
the structural model, we get the reduced-form solution:
! !

Equilibrium quantity:

! = ! !!!! ! +

Equilibrium price:

! = !

!! !! ! !! !!
!! !!!

!!
! !!!

= !" ! + !!

! !!

! + ! ! !!! = !! ! + !!
!

(3)

We use the deviations form to eliminate the constant term in each of the reduced-form
equations.
Estimating ! using OLS, the parameter is estimated to be
! =

! !

!!

(4)

! (! ! + ! )
= ! +
!!

! !

!!

(5)

Substituting for ! in equation (2), we find that:

! =

The OLS estimator, ! , would only be unbiased if

!! !!
!!!

= 0. Likewise, if the sum approached

0 as the sample size became large, we would know that OLS estimation was consistent.
Unfortunately, in simultaneous-equation models, neither of these conditions is true in
general.
In the case of supply-demand model it is not always possible to predict the direction of bias
and inconsistency resulting for the use of OLS estimation. However, in cases where only
one structural equation contains an error term, the direction of bias is clear.
12.2 The Identification Problem
The identification problem is the problem of determining the structural equations with the
reduced form being known. When a structural model is identified, it is vital to check if it is
possible to determine the structural parameters, once the reduced form is estimated.
Equations can be categorized, as follows;
1. An equation is unidentified, if there is no way of estimating all the structural
parameters from the reduced form
2. An equation is identified, if it is possible to obtain values of the parameters from
the reduced form
3. An equation is exactly identified, if a unique parameter value exists

Simultaneous-Equation Estimation

4. An equation is over-identified, if more than one value is obtainable for some

parameters

It is important to note, however, that within a given structural model some equations may
be identified as opposed to others. Furthermore, within a single equation, some parameters
may be identified while others may remain unidentified.

To illustrate the identification problem, consider the following supply-demand time-series
model, in which there are no predetermined variables:

Supply:
! = ! + ! ! + !
Demand: ! = ! + ! ! + !
(6)
Assuming the market is in equilibrium in each time period, we know that at each period of
time there is one value of P and one value of Q sold. Principally, the only data available are
the market values of P and Q. Errors suggest that values of P and Q will not be identical, but
all values will lie in close proximity to the equilibrium values.
Estimating separate supply and demand equations using market data generates
meaningless results, as it is impossible to determine true supply and demand slopes given
only equilibrium data. Any pair of supply and demand intersecting at the equilibrium could
be the true supply and demand curves i.e. there are an infinite # of structural models
consistent with the same reduced form. In this model, both supply and demand are
unidentified, because we cant obtain the values of the structural parameters (slope m;
intercept c for both supply and demand) from the reduced form for the deviation form,
which looks like this:
! =
! =

! !

! !

! ! ! !

! !
(7)

Evidently, the identification of equations in a model necessitates further information. We

consider the following supply-demand system:
Supply:

! = ! + ! ! + !

Demand: ! = ! + ! ! + ! ! + !

(8)

In this sense, identification is made possible by the existence of prior information about the
exogenous variable Y. The supply equation is identified, because Y was excluded from the

Simultaneous-Equation Estimation

supply equation, whereas the demand equation is unidentified because prior knowledge is
not available, allowing for the unique determination of the demand relationship. A model,
in which the supply relationship is determined by the temperature T, the excluded
exogenous variable (temperature) in the demand equation, would allow us to identify the
demand curve.
Conclusively, the order condition elucidates conditions, under which an equation is
identified. If an equation is to be identified, the number of predetermined variables excluded
from the equation must be greater than or equal to the number of included endogenous
variables minus 1. Nonetheless, the aforementioned satisfactory condition can occasionally
be insufficient for determining identification.
12.3 Consistent Parameter Estimation
Going back to consider equation (2), we need to consistently estimate the supply
parameters (! ). One approach to the estimation problem is the use of instrumentalvariables estimation; predetermined variables in the model serve as excellent
instrumental variables. They are correlated with the endogenous variables by virtue of
their inclusion in the model, and assumed to be uncorrelated with the error term because
they are predetermined. For the model in equation (2), ! is a suitable instrument, yielding
the following consistent estimator:
! =

! !

! !

(9)

While the use of instrumental variables is appropriate, we are often faced with the problem
of choosing among several available instruments. We, therefore, consider some alternative
single-equation estimation techniques. For example, in our reduced-form solutions,
!" /!! is identically equal to ! . So, we can estimate ! consistently be estimating the
reduced-form equations using OLS and then solving for ! = !" /!! . This procedure is
known as indirect least-squares estimation and it produces consistent estimates.
Note that when indirect least-squares estimation is possible and a unique estimate of the
parameter is available, the indirect least-squares estimation is identical to the instrumental
variable estimation. This can be proven in the previous example by substituting for !" /
!! :
! =

!"
=
!!

! ! /
! ! /

!!
=
!!

! !
= !
! !

However, this example cannot be generalised; in some cases, indirect least-squares is not
possible, and in other cases it leads to several distinct slope estimates. For example, if we
attempted to estimate the slope parameter of the demand equation in (2) using the
reduced form, this would be impossible. On the other hand, consider the following modified
supply-demand system:
Structural model:
4

Supply:

! = ! ! + !

Demand:

! = ! ! + ! ! + ! ! + !

Simultaneous-Equation Estimation

(10)

Reduced form model:

! !

! !

Equilibrium quantity:

! = ! !!!! ! + ! !!!! ! +

Equilibrium price:

! = !

!!
! !!!

! + !

!!
! !!!

!! !! ! !! !!
!! !!!

= !" ! + !" ! + !!

! !!

! + ! ! !!! = !! ! + !" ! + !! (11)

!

With the indirect-least squares method, we would get two estimators for ! : !" /!!
and !" /!" . Both estimators will yield consistent estimates of the true parameter.
However, choosing one of the two estimators may involve a loss of important information
about the model being estimated.
Before describing an estimation procedure that avoids any information loss, note that there
is one special case in which OLS does yield consistent parameter estimates. That is when
the system of equations is recursive; if the endogenous variables can be determined
sequentially and the errors form each equation are independent of each other. Below is an
example of a recursive model:
Supply:

! = ! + ! !!! + !

Demand:

! = ! + ! ! + ! ! + !

(12)

Given values for !!! , we can solve directly for ! in the supply equation. Then knowing !
allows us to solve for ! in the demand equation. We also make the important assumption
that ! , ! = 0. In any recursive model of this sort, OLS is the appropriate estimation
procedure.
12.4 Two-Stage Least Squares
Two-Stage Least Squares (2SLS) is a very useful estimation procedure for obtaining the
values of structural parameters in over-identified equations. It uses the information
available from the specification of an equation system to obtain a unique estimate for each
structural parameter. 2SLS is divided into two stages, the first of which involves the
creation of an instrument, while the second stage involves a variant of instrumentalvariables estimation;
1. First stage: In this stage, the reduced form equation for ! is estimated by using
OLS, which is accomplished by regressing ! on all predetermined variables in the
equation. From this regression, the fitted values of the dependent variable ! , which
will be independent of the error terms ! and ! . The first-stage process allows for
the construction of a variable that is linearly related to the predetermined model
variables.

2. Second stage: In the second-stage regression, the supply equation of the structural
model is estimated by replacing the variable ! with the first-stage fitted
5

Simultaneous-Equation Estimation

variable ! . The use of OLS will generate a consistent estimator of the supply
parameter ! . If further predetermined variables appear in the supply equation,
2SLS would also estimate those parameters consistently.
When an equation is exactly identified, 2SLS estimation is identical to indirect least-squares
and instrumental-variables estimation. To see this, we re-examine the model depicted in
(2) and (3), where 2SLS would proceed as follows:
1. Using OLS to estimate the second part of (3), and calculating the fitted values:

! !
! = !! ! when !! = !! !!
!

(13)
2. Using OLS to estimate the equation:

! = ! ! + !
Then
!

! !
! !
=

! ! ( ! ! /
!! ( ! ! /

!! )
!! )

! !

= !
!
! !

! using indirect least squares

! using instrumental variables

(14)

If the equation is exactly identified, identical parameter estimates will be obtained, when
2SLS, indirect least squares and instrumental-variables estimation techniques are used.
However, the indirect least-squares is not valid in the over-identified case.
2SLS and instrumental variables are equivalent estimation procedures on the condition
that the first stage of two-stage least squares involves all predetermined variables in the
system and that the instrument used in the instrumental-variables procedure is the fitted
value of the first-stage regression.
12.5 Simultaneous-Equation Estimation with Serial Correlation and Lagged
Dependent Variables
OLS generates consistent but biased estimators when there are lagged dependent
variables, but neither OLS nor 2SLS is consistent when the equation to be estimated
contains a lagged dependent variable and the error term is serially correlated. To illustrate
this, consider the following model:
! = !!! + ! , where ! = !!! + !

(15)

Using OLS,
6

! !!!
=+
!
!!!

Simultaneous-Equation Estimation
!!! !
(!!! , ! )
=

+

!
(!!! )
!!!

!!! , ! = !!! ! = !!! + !!! (!!! + ! )

!
= !!! !!! + !!! ! + !!!
+ !!! !

since ! = 0
!
!!! ! = (!!! !!! + !!!
)

Note that !!! = !!! and !!! = ! , so

!!! ! = (!!! ! + !! )
!!! ! = !!! ! + (!! )
!!! ! =
!!! , ! =

(!! )

1
(! )

1

The ratio of this covariance to the variance of !!! will be nonzero even with no serial
correlation, so will always be biased.
To get consistent, unbiased estimators for models with serial correlation and lagged
dependent variables, we use Fairs estimation method. We illustrate the method using the
following model:
Supply:

! = ! ! + ! !!! + !

(16)

! = !!! + !

(17)

(18)

Demand:

! = ! ! + ! ! + !

Where ! and ! are uncorrelated

If we substitute (12) into (13) to eliminate ! from the equation, we get:
! ! ! + ! !!! = !!! ! !!! + ! !!! + !

! !!! = ! ! !!! + ! !!! !!! + !

For this equation, OLS estimation will generate an inconsistent estimate. A 2SLS procedure
that replaces ! with ! will be consistent when is known, since ! will be uncorrelated
with ! . However, when is unknown, we must account for the possibility that our
estimate of the serial correlation coefficient, r, will not equal . So, the equation becomes:
! !!! = ! ! !!! + ! !!! !!! + ! + ( )!!!
7

Simultaneous-Equation Estimation

(19)

Now a 2SLS procedure which replaces ! with ! will not be consistent because !!! still
appears in the equation and it is correlated with !!! ; this correlation is not removed when
we use the instrumental variable.
Alternately, the Fair method uses the following procedure:
1. Estimate the reduced form equation:
! = ! ! + ! !!! + ! !!! + ! !!! + !

(20)

2. Estimate the modified structural equation:

! !!! = ! ! !!! + ! !!! !!! + ! + !!! + ! !











(21)
Where ! = ! ! is the residual from the regression in the first step
The sum of squared residuals in equation (16) is minimised when = . It is important for
!!! , !!! and !!! to be used in the first-stage regression, otherwise the sum of squared
residuals would not be minimised as such.
In general, it is essential when applying the Fair method to include as first-stage
instruments the lagged dependent variable as well as lagged values of all included
exogenous and endogenous variables.
12.6 More Advanced Estimation Methods
Thus far, the focus of this chapter was on two-equation models that are simultaneous in
nature. In the first part of this section, we describe a model that can be estimated efficiently
when treated as a system of equations. In the second part, we concentrate on estimation
procedures that are both consistent and efficient whether or not the equation system is
truly simultaneous. In the following, we delve into more advanced estimation methods;
1. The Seemingly Unrelated Model
The seemingly unrelated regression (SUR) model is a recursive model, which occurs in
business and economic modelling, consisting of a series of endogenous variables that
are considered as a group. An example of a SUR model is;
!! = ! + ! !! + !!
!! = ! + ! !! + !!

(22)

The equations represent a set of two demand equations for related products. If the
disturbances of each equation are uncorrelated, there is no relationship between the
equations and OLS estimation is appropriate. However, if the errors are correlated, efficient
estimates can be obtained by using more a sophisticated estimation technique.

Simultaneous-Equation Estimation

2. Estimation of Equation Systems

2SLS and instrumental-variables estimators generate consistent parameter estimates when
equation systems are simultaneous. However, each estimation technique yields inefficient
estimates, because these techniques apply only to a single equation within the system of
equations. Hence, they do consider the fact that one or more predetermined variables are
excluded from the equation to be estimated, yet they do not account for the fact that there
may be predetermined variables omitted from other equations as well. Another source of
inefficiency occurs as a result of single-equation estimation not accounting for the crossequation correlation among errors.
Either ways, this lack/loss of efficiency can be addressed by using any of several methods
of estimating systems of equations in which parameters for all equations are determined in
a single procedure.
The previously mentioned SUR method involves generalized least-squares estimation and
achieves an improvement in efficiency by taking into explicit account the fact that crossequation error correlations may not be zero. Practically, SUR estimation is a two-stage
estimation procedure that is shown to be consistent and efficient. An extension of the SUR
estimation technique is the three-stage least squares (3SLS), which involves the application
of generalized least-squares estimation to a system of equations, each of which has first
been estimated using 2SLS. The first two stages are concurrent to those in the 2SLS
estimation method, and in the third stage of the estimation process, generalized leastsquares parameter estimates are obtained. The 3SLS is shown to produce more efficient
parameter estimates than 2SLS, because it takes cross-equation correlation into account.