Introductory Econometrics: A Modern Approach 6th Edition by Jeffrey M Wooldridge

Exercise 1

Use SMOKE.RAW for this exercise.

(i) A model to estimate the effects of smoking on annual income (perhaps through lost work days due to illness, or productivity effects) is

log(income) = ?0 + ?lcigs + ?2educ + ?3age + ?4age2 + u1,

where cigs is number of cigarettes smoked per day, on average. How do you interpret ?1?

(ii) To reflect the fact that cigarette consumption might be jointly determined with income, a demand for cigarettes equation is

cigs = ?0 + ?1log(income) + ?2educ + ?3age + ?4age2 + ?5log(cigpric) + ?6restaurn + u2,

where cigpric is the price of a pack of cigarettes (in cents), and restaurn is a binary variable equal to unity if the person lives in a state with restaurant smoking restrictions. Assuming these are exogenous to the individual, what signs would you expect for ?5 and ?6?

(iii) Under what assumption is the income equation from part (i) identified?

(iv) Estimate the income equation by OLS and discuss the estimate of ?1

(v) Estimate the reduced form for cigs. (Recall that this entails regressing cigs on all exogenous variables.) Are log(cigpric) and restaurn significant in the reduced form?

(vi) Now, estimate the income equation by 2SLS. Discuss how the estimate of ?l compares with the OLS estimate.

(vii) Do you think that cigarette prices and restaurant smoking restrictions are exogenous in the income equation?

Step 1 of 8

(i)

In the model that estimates the effects of smoking on annual income given by:

The coefficient of is interpreted as an increase in number of cigarettes smoked per day by one cigarette would bring a change in income by