Suppose you are estimating demand relationships, where you are attempting to identify the effect of price on quantity sold (i.e., Q_i = α₀ + α₁Price_i + U_i). It will often be the case that the use of an instrumental variable for price will likely yield a coefficient (for α₁) that relates to the use of multiple regression in what way? A) Is lower, because price and U_i are likely positively correlated. B) Is lower, because price and U_iare likely negatively correlated. C) Is higher, because price and U_i are likely negatively correlated. D) Is higher, because price and U_iare likely positively correlated.

Question

Quizplus · Accepted Answer

Using an instrumental variable helps to correct for the bias caused by the correlation between price and the error term (U_i). If price and U_i are positively correlated, the OLS estimate of α₁ would be biased upwards, so using an instrumental variable would yield a lower coefficient.

Suppose You Are Estimating Demand Relationships, Where You Are Attempting