Econ 140 - Fall 2013 October 31, 2013

Problem Set 4
Instructions: Solve the following questions and show how you arrived at your answers. When
asked to solve a question using Stata, attach the relevant portion of a Stata .do le and/or
.log le. Include all intermediate steps and indicate the nal solution clearly (i.e. with a
dierent color, box, etc):
1. Suppose you observe rms i = 1, . . . , n, each of which produces Y
i
units of output
using K
i
units of capital and L
i
units of labor (Y
i
, K
i
and L
i
may dier from rm to
rm). The rms all share the same technology, which is captured by the Cobb-Douglas
production function Y
i
= e

0
K

K
i
L

L
i
.
(a) Show that the relationship between Y
i
, K
i
and L
i
captured by the Cobb-Douglas
production function can be expressed as: log(Y
i
) =
0
+
K
log(K
i
) +
L
log(L
i
).
Justify your derivation line by line.
(b) If you were to regress log(Y
i
) on log(K
i
) and log(L
i
) and a constant term, and
the OLS assumptions were to hold, what would be the interpretation of
K
? How
about
L
?
(c) You run the regression and obtain the following estimates (standard errors in
parentheses):

log(Y
i
) = 1.50 + 0.55 log(K
i
) + 0.63 log(L
i
),
(0.20) (0.10) (0.20)
Recalling that the exponent on capital and labor in a Cobb-Douglas production
function equal the shares that are earned by the factors
1
test and report whether
the prot share of capital is 0.5.
1
The prot of a competitive (i.e. price-taking) rm is given by = pQrKwL, where Q = e
0
K

K
L

L
.
At a prot maximum, two marginal conditions hold in which the value of the marginal product of each factor
is equal to its factor price: p
K
e
0
K

K
1
L

L
= r and p
L
e
0
K

K
L

L
1
= w (the conditions arise from
dierentiating the prot with respect to K and L). Multiplying each equation by its respective factor
level gives:
K
pQ = rK and
L
pQ = wL. Rearranging we have the exponents equal to the factor shares:

K
= rK/pQ and
L
= wL/pQ. When
K
+
L
= 1 production exhibits constant returns to scale since
scaling up all factors will scale up output in the same proportion. Note that in that case the combined
payment to the two factors exactly equals the revenue of the rm.
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Econ 140 - Fall 2013 October 31, 2013
(d) Explain a method for testing whether there are constant returns to scale. State
the null hypothesis and describe which type of test you would use.
2. Antitrust authorities are interested to know whether airline companies use their market
power to charge higher fares in the U.S. A dataset called airlinefares2000.dta is provided
with this problem set and consists of average fares and other characteristics of the most
popular U.S. origin-destination pairs (e.g. Boston-Chicago) for the year 2000: lfare
is the log of the average fare on the given route (log of dollars), dist is the distance
of the route (in thousand miles), passen is the average number of passengers per day
(in thousands), concen stands for concentration and is the market share of the biggest
airline carrier on the given route, measured in terms of passengers carried (ranging
from 0.1 to 1).
(a) Regress lfare on dist, passen and concen, and report your results in the regular
way with heteroskedasticity-robust standard errors.
(b) What is the interpretation of the coecient on passen?
(c) Based on your OLS estimates, and assuming the OLS assumptions hold, what
is the partial eect of the market share of the largest carrier on prices? Is your
answer consistent with the hypothesis that rms use their market power to charge
higher prices?
(d) What reason could there be for fares to rst increase with market power but,
beyond a threshold, to decrease with them? Write down a specication - i.e. a
new regression - in which you are able to test this, and carry out the test. In
particular, which new variable would you create and include in your model?
(e) How would you test whether market power aects fares similarly on more popular
and less popular routes? Write down a model and an appropriate hypothesis, and
carry out the estimation and the test.
(f) Do you think that the external validity of your results concerning the eect of
market power on fares extend to the European airline industry? And to the year
2013? Why?
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Econ 140 - Fall 2013 October 31, 2013
3. Using the Stata dataset SFworkers.dta, regress wages on years of schooling:
(a) What is the interpretation of each of the coecients?
(b) Regress log wages on years of schooling [Hint: you may need to generate a new
variable]. What is the interpretation of each of the coecients now? How does
the interpretation relate to your answer in (a)?
(c) What is the expected log wage of a worker who has only a high school degree? A
college degree? In percent terms, what is the return to going to college?
(d) Regress log wages on years of schooling and experience. What is the interpretation
of each of the coecients? How does the interpretation relate to your answers in
(a) and (b)?
(e) Regress log wages on years of schooling, years of experience and the indicator
variable for black. What is the interpretation of each of the coecients?
(f) What is the expected log wage of a worker who is black, has a college degree and
7 years of work experience? What is the expected log wage of a worker who is
white, has a college degree and 7 years of work experience?
(g) What is the minimum number of years of work experience observed in the sample?
Can use your regression model to estimate the expected log wage of a worker
who is black, has a college degree and 0 years of work experience? How is this
possible? What are you implicitly assuming when you extrapolate out-of-sample
in this way?
4. Measurement Error:
Suppose you are interested in regressing Y
i
=
0
+
1
X
i
+ u
i
and you know that
E[u
i
|X
i
] = 0 (and therefore that cov(X
i
, u
i
) = 0), but you cannot observe X
i
directly.
Instead, you observe a variable

X
i
which is the sum of X
i
and a measurement error
w
i
, i.e.

X
i
= X
i
+ w
i
.
(a) Write down the infeasible regression that you would run if you could observe X
i
directly.
(b) As you only observe

X
i
, you can only run the regression Y
i
=
0
+
1

X
i
+ v
i
.
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Econ 140 - Fall 2013 October 31, 2013
Express the error term v
i
in terms of X
i
, the measurement error w
i
and the error
term from the infeasible regression, u
i
.
(c) Suppose that w
i
is distributed with mean 0 and variance
2
w
, and that cov(w
i
, X
i
) =
0 and cov(w
i
, u
i
) = 0. Once you make these assumptions, our measurement error
model becomes the classical measurement error model (until now, it was just a
model with measurement error).
In order to determine if

1
is biased, we need to know whether cov(

X
i
, v
i
) = 0.
Lets derive the covariance:
i. Express cov(

X
i
, v
i
) in terms of cov(

X
i
, w
i
) and cov(

X
i
, u
i
).
ii. What does cov(

X
i
, u
i
) equal?
iii. What does cov(

X
i
, w
i
) equal?
iv. As a result, what does cov(

X
i
, v
i
) equal?
(d) In light of your result to part (c) is

1
biased? Is the bias up or down or do you
need more information to determine the direction of the bias? If so, precisely
what information do you need?
(e) Characterize the direction of the bias in a conditional way, i.e. if so-and-so then

1
is biased upwards, and if so-and-so then

1
is biased downwards.
(f) In order to decide how large a concern the bias is, we need to derive its magnitude:
i. Use the formula for omitted variable bias (equation (6.1) in the textbook) to
express the bias of

1
. [Hint: the correlation of between two random variables,
A and B, is corr(A, B)
AB


AB

cov(A,B)

var(A)

var(B)
.]
ii. What is the variance of

X
i
? [Hint: recall that cov(w
i
, X
i
) = 0.]
iii. Derive the bias formula for the classical measurement error model (equation
(9.2) in the textbook).
(g) Can the magnitude (absolute value) of

1
in the classical measurement error model
ever exceed the true value of
1
?
(h) The magnitude of the bias, i.e. the seriousness of the problem caused by measure-
ment error, depends on the relative magnitudes of the variances of X
i
and the
measurement error, or noise - w
i
. Explain this relationship clearly in your own
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Econ 140 - Fall 2013 October 31, 2013
words. Provide an example in which you believe the bias will be small (

X

X
+w
closer to 1) and a second example in which you believe the bias will be more
substantial (

X

X
+w
not as close to 1, or even close to 0).
(i) Lets return from the classical measurement error model to just a model with
measurement error, i.e. it no longer holds that w
i
is distributed with mean 0 or
variance
2
w
, or that cov(w
i
, X
i
) = 0 or cov(w
i
, u
i
) = 0.
Does the bias formula for the classical measurement error model still hold? If so,
prove it; if not, provide a counter-example.
(j) Suppose we observe X
i
directly, but that Y
i
now has measurement error, so that
instead of observing Y
i
we observe

Y
i
= Y
i
+ w
i
, where w
i
has mean zero and
variance
2
w
. Will

1
be biased? If so, in what direction?
(k) Will the measurement error in Y
i
aect the precision of

1
? Give an example in
which Y
i
suers from measurement error, and explain in intuitive terms (no math)
how the measurement error aects the precision of

1
.
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