Two-Stage Least Squares (2SLS) and Structural Equation Models (SEM)

by Eddie Oczkowski
http://csusap.csu.edu.au/~eoczkows/home.htm
May 2003
These notes describe the 2SLS estimator for latent variable models developed by
Bollen (1996). The technique separately estimates the measurement model and
structural model of SEM. One can therefore use it either as a stand alone procedure
for a full SEM or combine it with factor analysis, for example, establish the
measurement model using factor analysis and then employ 2SLS for the structural
model only.
The advantages of using 2SLS over the more conventional maximum likelihood (ML)
method for SEM include:
It does not require any distributional assumptions for RHS independent variables,
they can be non-normal, binary, etc.
In the context of a multi-equation non-recursive SEM it isolates specification
errors to single equations, see Bollen (2001).
It is computationally simple and does not require the use of numerical
optimisation algorithms.
It easily caters for non-linear and interactions effects, see Bollen and Paxton
(1998).
It permits the routine use of often ignored diagnostic testing procedures for
problems such as heteroscedasticity and specification error, see Pesaran and
Taylor (1999).
Simulation evidence from econometrics suggests that 2SLS may perform better in
small samples than ML, see Bollen (1996, pp120-121).
There are however some disadvantages in using 2SLS compared to ML, these
include:
The ML estimator is more efficient than 2SLS given its simultaneous estimation
of all relationships, hence ML will dominate 2SLS always in sufficiently large
samples if all assumptions are valid and the model specification is correct.
Effectively ML is more efficient (if the model is valid) as it uses much more
information than 2SLS.
Unlike the ML method, the 2SLS estimator depends upon the choice of reference
variable. The implication being that different 2SLS estimates result given
different scaling variables.
Programs with diagram facilities such as EQS do not exist for 2SLS. One needs
to logically work through the structure of the model to specify individual
equations for all the relationships for the 2SLS estimator.
Substantive applications of the 2SLS estimator for latent variable models include: Li
and Harmer (1998), Oczkowski and Farrell (1998), Farrell (2000) and Oczkowski
(2001), Farrell and Oczkowski (2002), and Smith, Oczkowski, Noble and Macklin
(2002, 2003).

2SLS Estimation Basics

Consider a simple regression model:
y = + x + u
where
y is the dependent variable
x is the independent variable
and are estimable parameters
u is the error term

(1)

If x and u are correlated then this violates an assumption of the regression framework.
Applying standard ordinary least squares (OLS) to eqn (1) under these circumstances
results in inconsistent estimates, that is, even as the sample size approaches infinity
the estimates of the parameters on average will not equal the population estimates. To
remedy this problem one can apply 2SLS, also called the instrumental variables (IV)
procedure. To implement 2SLS we need to identify one or more instruments for x.
These instruments (call them z) must satisfy two conditions:
1.
2.

z must be uncorrelated with u.

z must be correlated with x.

In any software package which supports 2SLS/IV simply specify x as the independent
(explanatory) variable and z as the instrumental variables. This method will produce
consistent parameter estimates even given the correlation between x and u. The only
condition for identification is that the number of instruments is greater than or equal
to the number of independent variables.
There are two ways to get 2SLS/IV estimates. The first is through a direct 2SLS/IV
option available in packages such as SPSS and SHAZAM. These are based on a
single IV expression which involves matrix algebra. This approach will produce
consistent estimates and accurate standard errors.
The second method (as the 2SLS name suggests) to get the parameter estimates is to
run two OLS regressions:
1. OLS regression x on z and get predictions for x, say x
2. OLS regression y on x .
By forming predictions for x in the 2nd stage through the instruments z we correct for
the correlation between the error term and the independent variable. This will
produce 2SLS parameter estimates, the same as the estimates produced by the direct
2SLS/IV option. However the standard errors from the two-step procedure will be
incorrect. Effectively, employing x in the second stage rather than x, inaccurately
measures the standard error estimates. It is recommended therefore that the direct
2SLS/IV option be employed to get parameter and standard error estimates.
In choosing the number of instruments to employ in 2SLS asymptotically (as n
approaches infinity) the larger the no of instruments the better in terms of efficiency.
However, the small sample bias of the estimator may get worse as the number of

instruments increases. Further as more instruments are employed degrees of freedom

are lost and this will weaken the power of statistical tests.
To present the mechanics of the 2SLS estimator for latent variable models we will
work through a series of simple examples. These are examples only and generalise to
more complex models.
Structural Equation Estimation: The Single Equation Case
Consider the following latent variable model:

1 = o + 11 + u1

where

(2)
1 is the latent dependent variable with 3 indicators ( y1 , y 2, y 3 )

1 is the latent independent variable with 3 indicators ( x1 , x 2, x3 )

0 and 1 are estimable parameters

u1 is the disturbance error term.
Assume that the measurement models for 1 and 1 are:

where

y1 = y11 + 1

x1 = x11 + 1

y 2 = y 21 + 2

x 2 = x 21 + 2

y 3 = y 31 + 3

x3 = x 31 + 3

(3)

are factor loadings

and are measurement errors

Bollen (1996) suggests the following procedure. Choose a scaling (or reference)
variable for each latent variable, say y1 for 1 and x1 for 1 , this implies the
corresponding loadings are set to unity. These scaling variables should be those that
best reflect the constructs theoretically or empirically (the highest standardised factor
loading). This allows us to write:
y1 = 1 + 1

x1 = 1 + 1

(4)

Combining eqns (2) and (4) allows us to write (2) in observable variable terms only:

y1 = o + 1 x1 + u
where u = u1 + 1 1 1

(5)

u is a new composite error term. Clearly x1 is correlated with u since both x1 and u
depend upon 1 . This mimics eqn (1) and therefore OLS cannot be applied to (5) and
so instead a 2SLS procedure is needed. To identify suitable instruments for (5) we
need to find variables which are not correlated with u, but are highly correlated with
x1 . The non-scaling items for 1 ( x 2, x3 ) are suitable as they are expected to be highly
correlated with x1 given that they are all indicators of the same construct and they are
not correlated with u (as we assume that measurement errors are uncorrelated.). Note,
y 2, y 3 are not suitable instruments as they are correlated with u, since u, y 2, y 3 all
depend upon u1 . In sum to estimate eqn (2) perform a 2SLS regression of y1 on x1 ,
with instruments x 2, x3 .
So the general principle is that non-scaling item indicators of the independent variable
can be used as instruments, but not non-scaling items of the dependent variable as
they correlate with the composite error term. Effectively, any variable that has either
a direct or indirect effect on the dependent variable is not a candidate as an
instrumental variable as it will be correlated with the composite error term. That is, if
a causal chain exists between the composite error term and a variable then that
variable is not a valid instrument.
In some situations it is difficult to determine whether an instrument is valid. To
ascertain the validity of an instrument you need to explicitly determine if the
covariance between the instrument and composite error is zero. To illustrate this we
evaluate, from first principles, some examples. The following rules are useful:
cov( X , Y ) = E ( XY ) E ( X ) E (Y )
cov(aX + bY , cZ ) = cov(aX , cZ ) + cov(bY , cZ )

(5a)
(5b)

Consider eqn (5) and first the validity of x 2 as an instrument (i.e., cov( x 2 ,u) = 0) and
then the invalidity of y 2 as an instrument, (i.e., cov( y 2 ,u) 0).
cov( x 2 , u ) = cov( x 21 + 2 , u1 + 1 1 1 )

(use (3), (5))

= cov( x 21 , u1 ) + cov( x 21 , 1 ) cov( x 21 , 1 1 ) +

cov( 2 , u1 ) + cov( 2 , 1 ) cov( 2 , 1 1 )

(use (5b))

= E ( x 21u1 ) E ( x 21 ) E (u1 ) +
E ( x 21 1 ) E ( x 21 ) E ( 1 )
E ( x 21 1 1 ) + E ( x 2 1 ) E ( 1 1 ) +
E ( 2 u1 ) E ( 2 ) E (u1 ) +
E ( 2 1 ) E ( 2 ) E ( 1 )
E ( 2 1 1 ) + E ( 2 ) E ( 1 1 )

(use (5a))

Because of the assumptions of zero mean errors and independence between

u1 , 1 and 1 , and that 1 is independent of all error terms, all the expected value
expressions are zero and so cov( x 2 ,u) = 0.
cov( y 2 , u ) = cov( y 21 + 2 , u1 + 1 1 1 )

(use (3), (5))

= cov( y 21 , u1 ) + cov( y 21 , 1 ) cov( y 21 , 1 1 ) +

cov( 2 , u1 ) + cov( 2 , 1 ) cov( 2 , 1 1 )

(use (5b))

= E ( y 21u1 ) E ( y 21 ) E (u1 ) +
E ( y 21 1 ) E ( y 21 ) E ( 1 )
E ( y 21 1 1 ) + E ( y 21 ) E ( 1 1 ) +
E ( 2 u1 ) E ( 2 ) E (u1 ) +
E ( 2 1 ) E ( 2 ) E ( 1 )
E ( 2 1 1 ) + E ( 2 ) E ( 1 1 )

(use (5a ))

Because of the assumptions of zero mean errors and independence between

u1 , 1 , 2 and 1 many of these expressions are zero, however not all. In these terms
for 1 we need to substitute the RHS of eqn (2), which among other terms inserts u1
wherever 1 appears. This makes (at least) the first term non-zero:
E ( y 21u1 ) = E ( y 2 ( 0 + 11 + u1 )u1 )
= E ( y 2 0 ) + E ( y 2 11 ) + E ( y 2 u1u1 )

The last term is non-zero here (it depends on the variance of u1 ) and so cov( y 2 ,u)
0, which means that y 2 is not a valid instrument.
To assess how good the instruments are, the R 2 s from the equations used to generate
x from the 1st stage of 2SLS should be examined. If these are lower than 0.10 then
the instruments are most likely to be inappropriate, that is they are insufficiently
correlated with x. In fact, if the instruments are very weakly correlated with the
regressors, then tests of hypotheses become very inaccurate, even in large samples.
Another useful check of the relevance of instruments is to ensure that the F statistics
from the first stage regressions exceed 10, see Stock and Watson (2003, ch 10). If the
measurement scales for x have good reliability measurement properties then these 1st
stage R 2 s and F statistics will usually be acceptably high.
Other Variables
If eqn (2) has more independent latent variables then set a scaling variable for each
independent variable, they enter as additional RHS variables and the non-scaling
variables enter as additional instruments. If observed variables (not latent) enter
directly as independent variables, then these appear as both RHS variables and as
instruments, that is, they serve as their own instruments.

Dependent Variable Treatment

Note, in this single equation case consistent 2SLS estimates can be gained even if
summated or factor based composite variables are used for 1 . Instruments are only
needed for the RHS variables. Measurement error in the dependent variable does not
affect the consistency of the regression estimator, only measurement error in the
independent variables causes estimation problems.
Structural Equation Estimation: Simultaneous Equations The Recursive (No
Feedback) Case

Consider the following latent variable model without feedback but involving two
dependent variables and hence two equations:

1
2

Note there is no feedback of 1 back into 2 , all arrows move left to right. In
equation form we have:
1 = o + 1 2 + 21 + u1
(6)
2 = o + 1 2 + u 2
(7)
where
1 is a latent variable with 3 indicators ( y1 , y 2, y 3 )

2 is a latent variable with 3 indicators ( z1 , z 2, z 3 )

1 is a latent variable with 3 indicators ( x1 , x 2, x3 )
2 is a latent variable with 3 indicators ( w1 , w2, w3 )
and are estimable parameters
u1 and u 2 are the disturbance error terms.

Note, here 2 serves as a dependent variable in (7) but as an independent variable in

(6). The procedure as described for the single equation case can also be applied here.
Consider eqns (6) and (7), assume the following scaling variables ( y1 , z1 , x1 , w1 ) , this
allows us to re-write (6) and (7) in observed variables as:
y1 = o + 1 z1 + 2 x1 + u *1

(8)

z1 = o + 1 w1 + u

(9)

here u1* and u 2* define new composite error terms.

For eqn (8) the non-scaling zs, xs, and ws can be employed as instruments, but not
*
the non-scaling ys as they depend upon u1 . Note, the non-scaling items for 2 (zs)
are valid for eqn (8) since 2 does not depend upon 1 , as there is no feedback.
For eqn (9) the non-scaling xs and ws are valid instruments, but not the non-scaling
*
zs as they depend upon u 2 . Note, the non-scaling items for 1 (ys) are not valid
for eqn (9) since 1 does depend upon 2 , and hence is related to u * 2 (the chain is
u * 2 zy).
So generally the same principle as in the single equation case applies here, the nonscaling RHS variables can be used as instruments. This principle applies even if one
the RHS variables is a dependent variable. This is permitted given the recursive
nature of the equations. In this case however, other variables may also serve as
instruments depending upon the causal chain from the composite error term.
Structural Equation Estimation: Simultaneous Equations The Non-Recursive
(Feedback) Case

Consider the following latent variable model with feedback but involving two
dependent variables and hence two equations:

1
2

Note there is feedback between 1 and 2 . In equation form we have:

1 = o + 1 2 + 21 + u1
(10)
2 = o + 11 + 2 2 + u 2
(11)
where
1 is a latent variable with 3 indicators ( y1 , y 2, y 3 )

2 is a latent variable with 3 indicators ( z1 , z 2, z 3 )

1 is a latent variable with 3 indicators ( x1 , x 2, x3 )
2 is a latent variable with 3 indicators ( w1 , w2, w3 )
and are estimable parameters
u1 and u 2 are the disturbance error terms.

Note, here 1 serves as a dependent variable in (10) but as an independent variable in

(11), while 2 serves as a dependent variable in (11) but as an independent variable in
(10). Assume the following scaling variables ( y1 , z1 , x1 , w1 ) , this allows us to re-write
(10) and (11) in observed variables as:

*
1

y1 = o + 1 z1 + 2 x1 + u *1

(12)

z1 = o + 1 y1 + 2 w1 + u

(13)

*
2

here u and u define new composite error terms.

Consider eqn (12) the non-scaling xs and ws can be employed but not the nonscaling zs and ys. As before the ys are directly correlated with u1* . The logic for
the unsuitability of the zs is more involved but the casual link exists as: u1* yz.
Consider eqn (13) the non-scaling xs and ws can be employed but not the nonscaling zs and ys. As before the zs are directly correlated with u 2* . The logic for
the unsuitability of the ys is more involved but the casual link exists as: u 2* zy.
So for the non-recursive case the general the principle that all non-scaling RHS
variables can be used as instruments is not longer valid. Only the non-scaling items
of the RHS variables which are not dependent variables in other equations can be
employed as instruments. In this case however, other variables may also serve as
instruments depending upon the causal chain from the composite error term.
Modelling Interaction Effects

Bollen and Paxton (1998) discuss modelling interaction or moderator effects in great
detail. Effectively most of the concepts apply above except for a few minor
modifications. Consider the following model:

where

1 = o + 11 + 2 2 + 31 2 + u1
(14)
1 is the latent dependent variable with 3 indicators ( y1 , y 2, y 3 )
1 is a latent independent variable with 3 indicators ( x1 , x 2, x3 )
2 is a latent independent variable with 3 indicators ( w1 , w2, w3 )
1 2 is the moderator or interaction term
0 , 1 and 2 are estimable parameters
u1 is disturbance error term.

Assume the following scaling variables ( y1 , x1 , w1 ) , this allows us to re-write (14) in

observed variables as:
y1 = o + 1 x1 + 2 w1 + 3 x1 w1 + u *1

(15)

Note here the interaction latent variable is replaced by the interaction between the
corresponding scaling variables. The valid instruments are the non-scaling xs and
ws, but also all the products of the non-scaling xs and ws ( x 2 w2 , x 2 w3 , x3 w2 , x3 w3 ),
these are instruments for x1 w1 . As before the non-scaling ys are not valid as they
directly depend upon the composite error term.
In general the number of instruments resulting from the new interaction term equals
the no. of non-scaling items for 1 times the number of non-scaling items for 2 , for
our example it is 2 x 2 = 4. Clearly, for scales with a large number of items this
number will increase quickly and may consume a large no. of degrees of freedom. A
resolution to this dilemma is to parcel the non-scaling items into groups (sum them)
before multiplying to get the interaction instruments.
A similar strategy to modelling interaction effects can be used for a non-linear model
which includes a squared latent independent variable. Here the chosen scaling
variable is squared to act as the independent variable and the squares of the
corresponding non-scaling variables act as instruments. Note however, in this
quadratic case a modification is needed to the intercept parameter to get consistent
estimates, see Bollen (1995, pp 240-241).
Intrinsically Non-Linear Models

The interaction model is an example of a linear in parameters non-linear model. As

such 2SLS can be easily adapted to gain consistent estimates. In other cases models
may be non-linear in parameters and here the 2SLS method is no longer applicable.
For example when dealing with dichotomous dependent variables we need to use logit
or probit models. These models are intrinsically non-linear. To estimate a non-linear
model in the spirit of 2SLS we can employ the Generalised Methods of Moments
estimator (GMM). GMM is effectively a more general version of 2SLS which can
handle non-linear models. Conceptually we can use the Bollen (1996) methodology
with GMM. That is, choose scaling variables as independent variables and nonscaling variables as instruments and apply GMM. Programs such as SHAZAM and
LIMDEP support GMM, one needs to write some code to define the non-linear
function. For example, the LIMDEP code for the logit GMM estimator is provided by
Foster (1997). For an application of combining probit GMM with Bollens latent
variable approach see Smith, Oczkowski, Noble and Macklin (2002, 2003).
Measurement Model Estimation

Even though the 2SLS estimator has mainly been employed to estimate the structural
model it can also be used to estimate the measurement model.
Consider a single latent variable ( 1 ) with three observed indicators:
x1 = x11 + 1

(16)

x 2 = x 2 1 + 2

(17)

x3 = x 31 + 3

(18)

Choose a scaling (or reference) variable say x1 for 1 , this implies the corresponding
loading is set to unity. This allows us to write:
x1 = 1 + 1

(19)

Eqn (19) can be substituted into (17) to get:

(20)
x 2 = x 2 x1 + u
where u = 2 x 2 1
As before (20) can be estimated via 2SLS using x3 as an instrument, x 2 is not valid as
it directly depends upon u. The same logic applies for the equation of x3 , x1 is the
regressor and x 2 is the instrument.
To show why x3 is a valid instrument for eqn (20) consider the following:

cov( x3 , u ) = cov( x 31 + 3 , 2 x 2 1 )

(use (3), (20))

= cov( x 31 , 2 ) cov( x 31 , x 2 1 ) +
cov( 3 , 2 ) cov( 3 , x 2 1 )

(use (5b))

= E ( x 31 2 ) E ( x 31 ) E ( 2 )
E ( x 31 x 2 1 ) + E ( x 31 ) E ( x 2 1 ) +
E ( 3 2 ) E ( 3 ) E ( 2 )
E ( 3 x 2 1 ) + E ( 3 ) E ( x 2 1 )

(use (5a))

Because of the assumptions of zero mean errors and independence between

1 , 2 , and 3 , and because 1 is independent of all the s , then all these expressions
are zero, and so x3 is a valid instrument for eqn (20).
In general an equation has to be estimated for each non-scaling item, the specific nonscaling item is the dependent variable, the independent variable is the scaling item and
all other non-scaling items are the instruments. This approach permits the estimation
of the factor loadings. One can extend this approach to estimate higher order factor
models using 2SLS, see Bollen and Biesanz (2002).
Diagnostic Testing and Goodness of Fit in 2SLS Models

Most of this discussion is based on Pesaran and Smith (1994) and Pesaran and Taylor
(1999). Initially we need to make a distinction between various types of residuals and
forecasts when using 2SLS/IV methods. These distinctions relate to the two alternate
ways to produce 2SLS/IV estimates. Reconsider the basic representation:
y = + x + u
where z are valid instruments for x.

(21)

10

After estimating this model we get estimates for the parameters of and , using
these we can formulate two types of predictions. Most programs (including SPSS
and SHAZAM) allow you to save:
y = + x

(22)

these are termed 'fitted values or IV predictions. These fitted values are typically
used in the calculation of the goodness of fit R 2 . A problem with this is that this
value can be negative and therefore lacks its conventional interpretation.
The other type of prediction is termed forecast or 2SLS predictions, these are
formed as:
~
y = + x

(23)

here the predicted values for x from the 1st stage regression are used instead of x.
These forecasts ( ~
y ) are gained from the 2nd OLS regression in the 2SLS procedure
rather than the direct IV option. The R 2 based on this 2nd OLS regression of y on x
is termed GR 2 (the generalised R 2 ) this measure of goodness of fit does fall between
zero and unity. Pesaran and Smith (1994) show asymptotically, that GR 2 will be
greatest for the correctly specified model and is valid for both nested and non-nested
model comparisons.
A similar distinction is made between IV and 2SLS for residuals. The IV residuals
correspond to the fitted values and are defined as:
u = y x
(24)
These residuals are typically available as saved options in packages such as SPSS and
SHAZAM.

The 2SLS residuals correspond to forecasts and are defined as:

u~ = y x

(25)

Over-identifying Restrictions Test

Bollen (1996) proposes this as a test of whether the general model specification and
the instruments are valid. It is similar to the chi-square test in maximum likelihood
SEM. The test checks whether the extra variables which over-identify the model are
valid for the specification. To conduct the test proceed as follows:
1.
2.
3.
4.

Regress u (IV residuals) against all the instruments and get the R 2
Using the R 2 from step 1, form the test statistic: N * R 2 (N is the sample size)
The test statistic has a 2 (chi-square) distribution with degrees of freedom
equal to the no. of instruments less the no. of RHS variables in the equation.
If the statistic is significant then a problem exists.

11

The logic underlying this test is that the residuals should be independent of the
instruments as required by the estimation procedure. A high R 2 in step 1 would
indicate that this would not be the case leading to a rejection of the model
specification or instruments.
RESET (Specification Error Test)

Pesaran and Taylor (1999) propose the RESET ( FF2 in their paper) general
specification error test for appropriate functional form and/or omitted variables. The
test has good relative power (compared to other tests in their paper) and is robust to
heteroscedasticity. To conduct the test proceed as follows:
1.
2.
3.
4.

Square the 2SLS forecasts from the estimated model : ~

y2.
Run a 2SLS/IV regression of y against the original RHS variables and ~
y 2 , use
as instruments the original instruments and ~
y2.
The t-statistic on the ~
y 2 variable is the test statistic.
If the test statistic is significant then there is a specification error.

The logic underlying this test suggests, in a correctly specified model the predictions
from the model should not have any explanatory power in the original model.
Effectively, the predictions from the model should not be able to explain any variation
in the residuals in a correctly specified model.
Heteroscedasticity Test

Pesaran and Taylor (1999) propose a heteroscedasticity ( HET1 ) test. This test has
good size and power properties (compared to other tests in their paper) and is robust
to non-normality in cross section data sets. To conduct the test proceed as follows:
1.
2.
3.

Regress u 2 (the squared IV residuals) on ~

y 2 (the squared 2SLS forecasts)
The t-statistic on the ~
y 2 variable is the test statistic.
If the test statistic is significant then there is a heteroscedasticity problem.

Non-nested Testing

Oczkowski and Farrell (1998) and Oczkowski (2002) develop non-nested tests for
competing models for the 2SLS latent variable estimator. In a series of Monte Carlo
experiments it appears the augmented encompassing test has useful small sample
properties and can be recommended for testing alternative models.
Label the two competing models as H 0 the null and H 1 the alternative:
H0 :

y = 0 0 + u 0

H1 :

y = 11 + u1

where, y is an observed dependent variable (could be summated or factor-scores)

12

 0 is a latent independent variable with 3 indicators ( x1 , x 2, x3 )

1 is a latent independent variable with 3 indicators ( w1 , w2, w3 )
Assume the scaling variables are x1 and w1 , the competing models in observed
variables become:
H0 :
y = 0 x1 + e 0
H1 :
y = 1 w1 + e1
with new composite error terms. Encompassing is the notion that a preferred model
should be able to account for the salient features of rival models. In the context of
non-nested testing this implies that H 0 is validated if H 0 can account for the salient
features of H 1 . The augmented encompassing test requires the following two
regressions:
(i)
(ii)
(iii)

OLS regression: w1 on w2 , w3 and save predictions, call then p.

2SLS regression: y on x1 and p ( x 2 , x3 , p as instruments), and test for the
significance of the p variable.
If the p variable is significant then H 1 rejects H 0 .

If there is more than one different independent variable between competing models
then step (i) involves as many regressions as differing variables producing multiple
prediction variables. In step (ii) these prediction variables are then tested for their
joint significance using an F test.
The test described for the null H 0 against the alternative H 1 is only uni-directional
and there is persuasive argument that one should not make inferences about the
alternative model based on tests of the null model alone. As a consequence it is
common practice to perform paired tests where the null and alternative models
alternate. For example, consider the paired tests for competing models A and B:
employ the procedure using: (i) Model A as H 0 and Model B as H 1 and (ii) Model B
as H 0 and Model A as H 1 . One of four scenarios will result from the paired tests for
comparing models A and B: (i) accept both A and B; (ii) reject both A and B; (iii)
accept A and reject B, (iv) accept B and reject A.
All the extensions discussed previously for 2SLS carry over to this non-nested testing
procedure.

13

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