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

Exercise 11

Use the data in CEMENT.RAW for this exercise.

(i) A static (inverse) supply function for the monthly growth in cement price (gprc) as a function of growth in quantity (gcem) is gprct = ?1gcemt + ?0 + ?1gprcpet + ?2febt + ... + ?12dect + ust, where gprcpe (growth in the price of petroleum) is assumed to be exogenous and feb, ., dec are monthly dummy variables. What signs do you expect for ?1 and ?1? Estimate the equation by OLS. Does the supply function slope upward?

(ii) The variable gdefs is the monthly growth in real defense spending in the United States. What do you need to assume about gdefs for it to be a good IV for gcem? Test whether gcem is partially correlated with gdefs. (Do not worry about possible serial correlation in the reduced form.) Can you use gdefs as an IV in estimating the supply function?

(iii) Shea (1993) argues that the growth in output of residential (gres) and nonresi-dential (gnon) construction are valid instruments for gcem. The idea is that these are demand shifters that should be roughly uncorrelated with the supply error ust. Test whether gcem is partially correlated with gres and gnon; again, do not worry about serial correlation in the reduced form.

(iv) Estimate the supply function, using gres and gnon as IVs for gcem. What do you onclude about the static supply function for cement? [The dynamic supply function is, apparently, upward sloping; see Shea (1993).]

Step 1 of 6

(i)

The static supply function for the monthly growth in cement price as a function of growth in quantity as given by:

The sign of the coefficient is expected to be positive as there is a direct positive relationship between and

The sign of the coefficient is expected to be positive as with the increase in, there will be a increase in as the petroleum is an input in the production of cement. With the increase in the price of petroleum, the input price increases which would be marked-up on the price of the cement

On estimating the supply function by OLS given by:

The result is:

It shall be noted that the coefficient is -0.044254 which is negative in sign as against expectation indicating that the supply function that relates the price of the cement with the supply of cement is downward sloping curve instead of an upward sloping curve.