Chapter Three

An Introduction to Simultaneous Equation Models

3.1. Nature of Simultaneous Equation models

In all the previous chapters discussed so far, we have been focusing exclusively with the
problems and estimations of a single equation regression models. In such models, a dependent
variable is expressed as a linear function of one or more explanatory variables. The cause-and-
effect relationship in such models between the dependent and independent variable is
unidirectional. That is, the explanatory variables are the cause and the independent variable is
the effect. But there are situations where such one-way or unidirectional causation in the function
is not meaningful. This occurs if, for instance, Y (dependent variable) is not only function of X’s
(explanatory variables) but also all or some of the X’s are, in turn, determined by Y. There is,
therefore, a two-way flow of influence between Y and (some of) the X’s which in turn makes the
distinction between dependent and independent variables a little doubtful. Under such
circumstances, we need to consider more than one regression equations; one for each
interdependent variable(s) to understand the multi-flow of influence among the variables. This is
precisely what is done in simultaneous equation models.

3.2. Simultaneous Bias

A system describing the joint dependence of variables is called a system of simultaneous
equation or simultaneous equations model. The number of equations in such models is equal to
the number of jointly dependent or endogenous variables involved in the phenomenon under
analysis. Unlike the single equation models, in simultaneous equation models it is not usually
possible (possible only under specific assumptions) to estimate a single equation of the model
without taking into account the information provided by other equation of the system. If one
applies OLS to estimate the parameters of each equation disregarding other equations of the
model, the estimates so obtained are not only biased but also inconsistent; i.e. even if the sample
size increases indefinitely, the estimators do not converge to their true values.

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The bias arising from application of such procedure of estimation which treats each equation of
the simultaneous equations model as though it were a single model is known as simultaneity bias
or simultaneous equation bias.
What happens to the parameters of the relationship if we estimate by applying OLS to each
equation without taking into account the information provided by the other equations in the
system? The application of OLS to estimate the parameters of economic relationships
presupposes the classical assumptions discussed in Econometrics I. One of the crucial
assumptions of the OLS is that the explanatory variables and the disturbance term is independent
i.e. the disturbance term is truly exogenous. Symbolically:𝐸(𝑋𝑖 𝑈𝑖 ) = 0. As a result, the linear
model could be interpreted as describing the conditional expectation of the dependent variable
(Y) given a set of explanatory variables. In the simultaneous equation models, such
independence of explanatory variables and disturbance term is violated i.e. 𝐸(𝑋𝑖 𝑈𝑖 ) ≠ 0. If this
assumption is violated, the OLS estimator is biased and inconsistent and hence we can treat
simultaneous bias as violation of assumption of independence of explanatory variables and
the disturbance term.

Simultaneity bias of OLS estimators: The two-way causation in a relationship leads to

violation of the important assumption of linear regression model, i.e. one variable can be
dependent variable in one of the equation but becomes also explanatory variable in the other
equations of the simultaneous-equation model. In this case 𝐸(𝑋𝑖 𝑈𝑖 ) may be different from zero.
To show simultaneity bias, let’s consider the following simple simultaneous equation model.
Y   0  1 X  U 
 -------------------------------------------------- (3.1)
X   0  1Y   2 Z  V 

Suppose that the following assumptions hold (recall assumptions of classical regression model).
(U )  0 , (V )  0
(U )   ,
2 2
u (V 2 )   u2
(U iU j )  0 , (ViV j )  0, also (UiVi )  0;

Where, X and Y are endogenous variables and Z is an exogenous variable.

The reduced form of X of the above model is obtained by substituting Y in the equation of X.
X   0  1 ( 0   1 X  U )   2 Z  V

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  0   0 1  2    U V 
X    Z   1                       (3.2)
1   1 1  1   1 1   1   1 1 
Applying OLS to the first equation of the above structural model will result in biased estimator
because cov( X iU i )  ( X iU j )  0 . Now, let’s proof whether this is the case or not.

cov( XU )  X  ( X )U  (U )

 X  ( X )U                           (3.3)

    0 1   2    U V   0   0 1   2  
   0    Z   1      Z U
 1   1 1  1   1 1   1   1 1  1   
1 1  1   
1 1   

 U 
   ( 1U  V )
1   1 1 

 1 
  ( 1U 2  UV )
 1   
1 1 

 1  2
  (U 2 )  1 u  0 , since 𝐸(𝑈𝑉) = 0
 1   1 1  1   1 1

That is, covariance between X and U is not zero. As a consequence, if OLS is applied to each
equation of the model separately the coefficients will turn out to be biased. Now, let’s examine
how the non-zero co-variance of the error term and the explanatory variable will lead to biasness
in OLS estimates of the parameters. If we apply OLS to the first equation of the above structural
equation (10) Y   0   1 X  U , we obtain

xy x(Y  Y ) xY Y x

ˆ 1    ; (since is zero)
x 2 x 2 x 2
x 2
x( 0   1 X  U )  0 x xU xU
   1 
x 2 x 2
x 2 x 2
xX
But, we know that x  0 and  1 , hence
x 2
xU
ˆ   1                       (3.4)
x 2
Taking the expected values on both sides;
 xU 
(ˆ )  1   2 
 x 

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Since, we have already proved that (XU )  0 ; which is the same as ( XU )  0 .

Consequently, when ( XU )  0 ; (ˆ )   , that is ̂ 1 will be biased by the amount equivalent

 xu
to .
x 2
3.3. Definitions of Some Concepts
I) Endogenous and exogenous variables
In simultaneous equation models’ variables are classified as endogenous and predetermined.
The endogenous variables are variables whose values are determined by the economic model
(within the system or model) and predetermined are those variables whose values are determined
outside the model. Predetermined variables can be divided into two categories. These are:
exogenous as well as current and lagged exogenous variables. For instance; X t and X t 1 depict

the current and lagged exogenous variables and Yt 1 depicts lagged endogenous variable. This is

on the assumption that X’s symbolize the exogenous variables and Y’s symbolize the
endogenous variables. Thus, X t , X t 1 and Yt 1 are regarded as predetermined variables.

Consider the demand and supply functions.

Q d   0  1 P   2Y  U1                  (3.5)

Q s   0  1 P   2 R  U 2                    3.6)

Where, Q=quantity, Y=income, P=price, R=Rainfalls, U1 &U 2 are error terms.

Here P and Q are endogenous variables and Y and R are exogenous variables.

II) Structural models

A structural model describes the complete structure of the relationships among the economic
variables. Structural equations of the model may be expressed in terms of endogenous variables,
exogenous variables and disturbances (random variables). The parameters of structural model
express the direct effect of each explanatory variable on the dependent variable. Variables not
appearing in any function explicitly may have an indirect effect and is taken into account by the
simultaneous solution of the system. For instance, a change in consumption affects the
investment indirectly and is not considered in the consumption function. The effect of
consumption on investment cannot be measured directly by any structural parameter, but is
measured indirectly by considering the system as a whole.

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Example: The following simple Keynesian model of income determination can be considered as
a structural model.
C     Y  U ----------------------------------------------- (3.7)
Y  C  Z ---------------------------------------------------- (3.8)
for  >0 and 0<<1
where: C=consumption expenditure
Z=non-consumption expenditure
Y=national income
C and Y are endogenous variables while Z is exogenous variable.

III) Reduced form of the model

The reduced form of a structural model is the model in which the endogenous variables are
expressed a function of the predetermined variables and the error term only.
Illustration: Find the reduced form of the above structural model.
Since C and Y are endogenous variables and only Z is the exogenous variables, we have to
express C and Y in terms of Z. To do this substitute Y = C + Z into equation (3.7).
C     (C  Z ) + U
C    C  Z  U
C  C    Z  U
C (1   )     Z  U

    U
C   Z  ---------------------------------- (3.9)
1  1   1 

Substituting again (9) into (8) we get;

  1  U
Y   Z  -------------------------------- (3.10)
1  1   1 

Equation (9) and (10) are called the reduced form of the structural model of the above. We can
write this more formally as:
Structural form equations Reduced form equations

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 C    Y  U     U
C   Z 
1  1   1 
Y CZ   1  U
Y   Z 
1  1   1 

Parameters of the reduced form measure the total effect (direct and indirect) of a change in
exogenous variables on the endogenous variable. For instance, in the above reduced form
  
equation (3.9),   measures the total effect of a unit change in the non-consumption
1  
 1 
expenditure on consumption. This total effect is  , the direct effect, times   ,the indirect
1  
effect.
The reduced form equations can be obtained in two ways:
1) To express the endogenous variables directly as a function of the predetermined
variables.
2) To solve the structural system of endogenous variables in terms of the predetermined
variables, the structural parameters, and the disturbance terms.

3.4. The Identification Problem

Note that since the reduced form coefficients can be estimated by the OLS method and these
coefficients are combinations of the structural coefficients, the possibility exist that the structural
coefficients can be “retrieved” from the reduced-form coefficients, and it is in the estimation of
the structural parameters that we may be ultimately interested. Unfortunately, retrieving the
structural coefficients from the reduced form coefficients is not always possible; this problem is
one way of viewing the identification problem.

By the identification problem we mean whether numerical estimates of the parameters of a

structural equation can be obtained from the estimated reduced-form coefficients. If this can be
done, we say that the particular equation is identified. If this cannot be done, then we say that the
equation under consideration is unidentified, or under identified. Note that the identification

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problem is a mathematical (as opposed to statistical) problem associated with simultaneous
equation systems. It is concerned with the equation of the possibility or impossibility of
obtaining meaningful estimates of the structural parameters.

An identified equation may be either exactly (or fully or just) identified or over identified. It is
said to be over identified if more than one numerical value can be obtained for some of the
parameters of the structural equations. The circumstances under which each of these cases occurs
will be shown in the following discussion.

a) Under Identification

Example: Consider the following linear demand and supply models.

Demand function 𝑄𝑡𝑑 = 0 + 1Pt + U1t ……………………………... (3.11)
Supply function 𝑄𝑡𝑠 = 0 + 1Pt + U2t………………………………… (3.12)
Equilibrium Condition 𝑄𝑡𝑑 = 𝑄𝑡𝑠 ……………….…………………….. (3.13)
Where 𝑄𝑡𝑑 = Quantity demanded, 𝑄𝑡𝑠 = Quantity supplied, P = price and t = time
By the equilibrium condition (i.e., 𝑄𝑡𝑑 = 𝑄𝑡𝑠 ) we obtain,
0 + 1Pt + U1t = 0 + 1Pt + U2t …………………………… (3.14)
Solving (3.14) using the substitution technique, we obtain the equilibrium price
Pt = 0 + Vt …………………………………………..(3.15)
𝛽0 +𝛼0 𝑈2𝑡 −𝑈1𝑡
where 𝜋0 = V1 =
𝛽1 −𝛼1 𝛼1 −𝛽1

Then, we obtain the following equilibrium quantity:

𝑄𝑡 = 𝜋1 + 𝑊𝑡 …………………………….. (3.16)
𝛼1 𝛽0 −𝛼0 𝛽1 𝛼1 𝑈2𝑡 −𝛽1 𝑈1𝑡
where 𝜋1 = Wt =
𝛼1 −𝛽1 𝛼1 −𝛽1

Note that 𝜋0 and 𝜋1 , (the reduced-form-coefficients) contain all four structural parameters; 0,
1, 0 and 1. But, there is no way in which the four structural unknowns can be estimated from
only two reduced form coefficients. Recall from Algebra for Economists that to estimate four
unknowns we must have four (independent) equations, and in general, to estimate k unknowns
we must have R (independent) equations. What all this means is that, given time series data on
p(price) and Q(quantity) and no other information, there is no way the researcher guarantees

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whether he/she is estimating the demand function or the supply function. That is, a given 𝑃𝑡 and
𝑄𝑡 represent simply the point of intersection of the appropriate demand and supply curves
because of the equilibrium condition that demand is equal to supply.

b) Just or Exact Identification

The reason we could not identify the preceding demand function or the supply function was that
the same variables P and Q are present in both functions and there is no additional information.
But suppose we consider the following demand and supply model.
Demand function 𝑄𝑡𝑑 = 0 + 1Pt +2It + U1t , 1 < 0, 2 > 0 ……………... (3.17)
Supply function 𝑄𝑡𝑠 = 0 + 1Pt + 2Pt-1 +U2t , 1 > 0, 2 > 0 …………..…… (3.18)
where I = income of the consumer, an exogenous variable
Pt-1 = Price lagged one period, usually incorporated in the model to explain the supply of
many agricultural commodities. Note that Pt-1 is a predetermined variable because its value is
known at time t. By the market-clearing mechanism we have
0 + 1Pt +2 It + U1t = 0 + 1Pt + 2Pt-1 +U2t …………...............……… (3.19)
Solving this equation, we obtain the following equilibrium price
Pt = 0 + 1It + 2Pt-1 + Vt ………………..................................………..… (3.20)
𝛽0 −𝛼0 𝛼2 𝛽2 𝑈2𝑡 −𝑈1𝑡
Where 𝜋0 = 𝜋1 =- 𝜋2 = 𝑉1 =
𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1

Substituting the equilibrium price (3.20) into the demand or supply equation of (3.17) or (3.18)
we obtain the corresponding equilibrium quantity:
Qt = 3 + 4It + sPt-1 + Wt …..............................................…….. (3.21)
where the reduced-form coefficients are
𝛼1 𝛽0 −𝛼0 𝛽1 𝛼2 𝛽1 𝛼1 𝛽2 𝛼1 𝑈2𝑡 −𝛽1 𝑈1𝑡
𝜋3 = 𝜋4 = 𝜋5 = 𝑊𝑡 =
𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1

the demand-and-supply model given in equations (3.17) and (3.18) contain six structural
coefficients 0, 1, 2, 0, 1, and 2 – and there are six reduced form coefficients - 0, 1, 2, 3,
4 and 5 – to estimate them. Thus, we have six equations in six unknowns, and normally we
should be able to obtain unique estimates. Therefore, the parameters of both the demand and
supply equations can be identified and the system as a whole can be identified.

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c) Over identification
Note that for certain goods and services, wealth of the consumer is another important
determinant of demand. Therefore, the demand function (3.17) can be modified as follows,
keeping the supply function as before:
Demand function 𝑄𝑡𝑑 = 0 + 1Pt +2It +3Rt + U1t …………….... (3.22)
Supply function 𝑄𝑡𝑠 = 0 + 1Pt + 2Pt-1 +U2t ………………………… (3.23)
Where R represents wealth
Equating demand to supply, we obtain the following equilibrium price and quantity
Pt = 0 + 1It + 2Rt + 3Pt-1 + Vt ……………………………..….. (3.24)
Qt = 4 + 5It + 6Rt + 7Pt-1 + Wt ……………………………….... (3.25)
𝛽0 −𝛼0 𝛼2 𝛼3 𝑈2𝑡 −𝑈1𝑡
Where 𝜋0 = 𝜋1 = 𝜋2 = 𝑉1 =
𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1
𝛽2 𝛼1 𝛽0 −𝛼0 𝛽1 𝛼2 𝛽1 𝛼1 𝛽2
𝜋3 = 𝜋4 = 𝜋5 = 𝜋5 =
𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1
𝛼3 𝛽1 𝛼1 𝛽2 𝛼1 𝑈2𝑡 −𝛽1 𝑈1𝑡 𝑈2𝑡 −𝑈1𝑡
𝜋6 = 𝜋7 = 𝑊𝑡 = 𝑉𝑡 =
𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1 𝛼1 −𝛽1

The demand and supply model in (3.22) and (3.23) contains seven structural coefficients, but
there are eight equations to estimate them – the eight reduced form coefficients given above (i.e.,
0 … 7). Notice that the number of equations is greater than the number of unknowns. As a
result, unique estimation of all the parameters of our model is not possible. For example, one can
solve for 1 in the following two ways
𝜋6 𝜋5
𝛽1 = or 𝛽1 =
𝜋2 𝜋1

That is, there are two estimates of the price coefficient in the supply function, and there is no
guarantee that these two values or solutions will be identical. Moreover, since 1 will be
transmitted to other estimates. Note that the supply function is identified in the system (3.17) and
(3.18) but not in the system (3.22) and (3.23), although in both cases the supply function remains
the same. This is because we have “too much” or an over sufficiency of information to identify
the supply curve. The over sufficiency of the information results from the fact that in the model
(3.22) and (3.23) the exclusion of the income variable form the supply function was enough to
identify it, but in the model (3.22) and (3.23) the supply function excludes not only the income

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variable but also the wealth variable. However, this situation does not imply that over
identification is necessarily bad since the problem of too much information can be handled.

Notice that the situation is the opposite of the case of under identification where there is too little
information. The only way in which the structural parameters of unidentified (or under
identified) equations can be identified (and thus be capable of being estimated) is through
imposition of further restrictions, or use of more extraneous information. Such restrictions, of
course, must be imposed only if their validity can be defended.

In a simple example such as the forgoing, it is easy to check for identification; in more
complicated systems, however, it is not so easy. This time consuming procedure can be avoided
by resorting to either the orders condition or the rank condition of identification. Although the
order condition is easy to apply, it provides only a necessary condition for identification. On the
other hand, the rank condition is both a necessary and sufficient condition for identification.
Hence, in the next section we discuss orders condition or the rank condition of identification.

3.5.1. Establishing Identification from the Structural Form of the Model

There are two conditions which must be fulfilled for an equation to be identified.

1. The Order Condition for Identification

This condition is based on a counting rule of the variables included and excluded from the
particular equation. It is a necessary but not sufficient condition for the identification of an
equation. The order condition may be stated as follows.
For an equation to be identified the total number of variables (endogenous and exogenous)
excluded from it must be equal to or greater than the number of endogenous variables in the
model less one. Given that in a complete model the number of endogenous variables is equal to
the number of equations of the model, the order condition for identification is sometimes stated
in the following equivalent form. For an equation to be identified the total number of variables
excluded from it but included in other equations must be at least as great as the number of
equations of the system less one.

10 | P a g e
Let: G = total number of equations (= total number of endogenous variables)
K= number of total variables in the model (endogenous and predetermined)
M= number of variables, endogenous and exogenous, included in a particular equation.
Then the order condition for identification may be symbolically expressed as:
(K  M )  (G  1)
excluded
 var iable   total number of equatioins 1
 
For example, if a system contains 10 equations with 15 variables, ten endogenous and five
exogenous, an equation containing 11 variables is not identified, while another containing 5
variables is identified.
a. For the first equation we have
G  10 K  15 M  11
Order condition:
( K  M )  (G  1)
;that is, the order condition is not satisfied.
(15  11)  (10  1)
b. For the second equation we have
G  10 K  15 M 5
order condition:
( K  M )  (G  1)
; that is, the order condition is satisfied.
(15  5)  (10  1)
The order condition for identification is necessary for a relation to be identified, but it is not
sufficient, that is, it may be fulfilled in any particular equation and yet the relation may not be
identified.

2. The Rank Condition for Identification

The rank condition states that: in a system of G equations any particular equation is identified if
and only if it is possible to construct at least one non-zero determinant of order (G-1) from the
coefficients of the variables excluded from that particular equation but contained in the other
equations of the model. The practical steps for tracing the identifiability of an equation of a
structural model may be outlined as follows.

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Firstly. Write the parameters of all the equations of the model in a separate table, noting that the
parameter of a variable excluded from an equation is equal to zero.
Example 1: For example, let a structural model be:
y1  3 y2  2 x1  x2  u1
y 2  y 3  x3  u 2

y3  y1  y 2  2 x3  u 3

where the y’s are the endogenous variables and the x’s are the predetermined variables. This
model may be rewritten in the form
 y1  3 y 2  0 y3  2 x1  x 2  0 x3  u1  0

0 y1  y 2  y3  0 x1  0 x2  x3  u 2  0

y1  y 2  y3  0 x1  0 x2  2 x3  u 3  0

Ignoring the random disturbance, the table of the parameters of the model is as follows:
Variables
Equations Y1 Y2 Y3 X1 X2 X3
st
1 equation -1 3 0 -2 1 0
2nd equation 0 -1 1 0 0 1
3rd equation 1 -1 -1 0 0 -2

Secondly. Strike out the row of coefficients of the equation which is being examined for
identification. For example, if we want to examine the identifiability of the second equation of
the model we strike out the second row of the table of coefficients.
Thirdly. Strike out the columns in which a non-zero coefficient of the equation being examined
appears. By deleting the relevant row and columns we are left with the coefficients of variables
not included in the particular equation, but contained in the other equations of the model. For
example, if we are examining for identification the second equation of the system, we will strike
out the second, third and the sixth columns of the above table, thus obtaining the following
tables.

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Table of structural parameters Table of parameters of excluded variables
Y1 Y2 Y3 X1 X2 X3 Y3 X1 X2
  
st
1 -1 3 0 -2 1 0 -1 -2 1
2 nd 0 -1 1 0 0 1
3rd 1 -1 -1 0 0 -2 1 0 0

Fourthly. Form the determinant(s) of order (G-1) and examine their value. If at least one of
these determinants is non-zero, the equation is identified. If all the determinants of order (G-1)
are zero, the equation is under-identified. In the above example of exploration of the
identifiability of the second structural equation, we have three determinants of order
(G-1)=3-1=2. They are:
1  2 2 1 1 1
1  0 2  0 3  0
1 0 0 0 1 0
(the symbol  stands for ‘determinant’) We see that we can form two non-zero determinants of
order G-1=3-1=2; hence the second equation of our system is identified.
Fifthly. To see whether the equation is exactly identified or overidentified we use the order
condition ( K  M )  (G  1). With this criterion, if the equality sign is satisfied, that is if
( K  M )  (G  1) , the equation is exactly identified. If the inequality sign holds, that is, if
( K  M )  (G  1) , the equation is overidentified.
In the case of the second equation we have:
G=3 K=6 M=3
And the counting rule ( K  M )  (G  1) gives
(6-3)>(3-1)
Therefore, the second equation of the model is overidentified.

Example 2: Assume that we have a model describing the market of an agricultural product.
From the theory of partial equilibrium, we know that the price in a market is determined by the
forces of demand and supply. The main determinants of the demand are the price of the
commodity, the prices of other commodities, incomes and tastes of consumers. Similarly, the
most important determinants supply are the price of the commodity, other prices, technology, the
prices of factors of production, and weather conditions. The equilibrium condition is that demand

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be equal to supply. The above theoretical information may be expressed in the form of the
following mathematical model.
D  a0  a1 P1  a 2 P2  a3Y  a 4 t  u

D  b0  b1 P1  b2 P2  b3C  b4 t  w

DS
Where: D= quantity demanded
S= quantity supplied
P1  price of the given commodity
P2  price of other commodities
Y= income
C= costs (index of prices of factors of production)
t= time trend. In the demand function it stands for ‘tastes’; in the supply function it
stands for ‘technology’.
The above model is mathematically complete in the sense that it contains three equations in three
endogenous variables, D,S and P1. The remaining variables, Y, P2, C, t are exogenous. Suppose
we want to identify the supply function. We apply the two criteria for identification:
1. Order condition: ( K  M )  (G  1)
In our example we have: K=7 M=5 G=3
Therefore, (K-M)=(G-1) or (7-5)=(3-1)=2
Consequently, the second equation satisfies the first condition for identification.
2. Rank condition
The table of the coefficients of the structural model is as follows.
Variables
Equations D P1 P2 Y t SC
1st equation -1 a1 a2 a3 a4 0
0
2nd equation 0 b1 b2 0 b4 -1
b3
3rd equation 1 0 1
0
0 0 0
Following the procedure explained earlier we strike out the second row an the second, third,
fifth, sixth and seventh columns. Thus, we are left with the table of the coefficients of excluded
variables:

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Complete table of Table of parameters of
Structural parameters variables excluded from
the second equation
-1 a1 a2 a3 a4 0 0 -1 a3
0 b1 b2 0 b4 1 b3
1 0 1 1 -1 0
0 0 0
From this table we can form only one non-zero determinant of order
(G-1) = (3-1) =2
1 a3
  (0)(1)  (1)(a3 )  a3
1 0

The value of the determinant is non-zero, provided that a 3  0 .

We see that both the order and rank conditions are satisfied. Hence the second equation of the
model is identified. Furthermore, we see that in the order condition the equality holds: (7-5) =
(3-1) = 2. Consequently, the second structural equation is exactly identified.

3.6. Approaches to Estimation

As we have discussed in section 3.2, the bias arising from application of OLS estimation
which treats each equation of the simultaneous equations model as though it were a single
model is known as simultaneity bias or simultaneous equation bias. To avoid this bias we
use other methods of estimation, such as, Indirect Least Square (ILS), Two Stage Least
Square (2SLS), three Stage Least Square(3SLS), Maximum Likelihood Methods and the
Method of Instrumental Variable (IV). However, in view of the introductory nature of this
course we shall consider very briefly the following techniques.

1. The Method of Indirect Least Squares (ILS)

For just or exactly identified structural equation, the method of obtaining the estimates of the
structural coefficients from the OLS estimators of the reduced form coefficients is known as the
method of indirect least squares (ILS). ILS involves the following three steps
• Step I: We first obtain the reduced form equations.
• Step II: Apply OLS to the reduced form equations individually.
• Step III: Obtain estimates of the original structural coefficients from the estimated
reduced form coefficients obtained in step II.

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Example: Consider the following model for demand and supply of beef:
𝑄𝑡 = 𝑎1 + 𝑏1 𝑃𝑡 + 𝑐1 𝑌𝑡 + 𝑈1𝑡 ……………….. Demand Function
𝑄𝑡 = 𝑎2 + 𝑏2 𝑃𝑡 + 𝑐2 𝑍𝑡 + 𝑈2𝑡 ………………. Supply Function
Where, Qt = Quantity of beef (in kg), Pt = real price of beef (in birr), Yt = disposable personal
income and Zt = selling cost of beef.

Here, P and Q are endogenous variables while Y and Z are predetermined variables. It can easily
be shown that both equations are exactly identified. Thus, we can apply Indirect Least Square
(ILS) to estimate the parameters. We first express P and Q in terms of the predetermined
variables and disturbances as:

𝑏2 𝑎1 − 𝑏1 𝑎2 𝑐1 𝑏2 𝑏1 𝑐2 𝑏2 𝑈1𝑡 − 𝑏1 𝑈2𝑡
𝑄𝑡 = + 𝑌𝑡 + 𝑍𝑡 +
𝑏2 − 𝑏1 𝑏2 − 𝑏1 𝑏2 − 𝑏1 𝑏2 − 𝑏1
𝑎1 − 𝑎2 𝑐1 𝑐2 𝑈1𝑡 − 𝑈2𝑡
𝑃𝑡 = + + +
𝑏2 − 𝑏1 𝑏2 − 𝑏1 𝑏2 − 𝑏1 𝑏2 − 𝑏1
We ca rewrite the two reduced form equations as;
𝑄𝑡 = 𝜋1 + 𝜋2 𝑌𝑡 + 𝜋3 𝑍𝑡 + 𝜀1𝑡
𝑃𝑡 = 𝜋4 + 𝜋5 𝑌𝑡 + 𝜋6 𝑍𝑡 + 𝜀2𝑡
By applying OLS to the above reduced form equations, we get the reduced form equation
estimates 𝜋̂1 , 𝜋̂2 , 𝜋̂3 , 𝜋̂4 , 𝜋̂5 , 𝑎𝑛𝑑 𝜋̂6 .
𝑐1 𝑏2
𝜋2 𝑏2 − 𝑏1 𝜋
̂2
= 𝑐 = 𝑏2 =======> ̂2
=𝑏
𝜋5 1 𝜋
̂5
𝑏2 − 𝑏1
𝑐2 𝑏1
𝜋3 𝑏2 − 𝑏1 𝜋
̂3
= 𝑐 = 𝑏1 =======> = 𝑏̂1
𝜋6 2 𝜋
̂6
𝑏2 − 𝑏1
𝑐1
𝜋5 = ====> 𝑐1 = 𝜋5 (𝑏2 − 𝑏1 ) ====> 𝑐̂1 = 𝜋 ̂ ̂
̂(𝑏
5 2 − 𝑏1 )
𝑏2 − 𝑏1
𝑆𝑖𝑚𝑖𝑙𝑎𝑟𝑙𝑦, 𝑖𝑡 𝑐𝑎𝑛 𝑏𝑒 𝑠ℎ𝑜𝑤𝑛 𝑡ℎ𝑎𝑡, 𝑐̂2 = −𝜋 ̂2 − 𝑏̂1 ), 𝑎
̂6 (𝑏 ̂1 − 𝑏̂1 𝜋
̂1 = 𝜋 ̂4 𝑎𝑛𝑑 𝑎
̂2 = 𝜋 ̂2 𝜋
̂1 − 𝑏 ̂4

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 2. The Method of two stage least squares (2SLS)

This method is applied in estimating an over identified equation. Theoretically, the two stages
least squares may be considered as an extension of ILS method. The 2SLS method boils down to
the application of ordinary list squares in two stages. Note, however, that since 2SLS is
equivalent to ILS in the just-identified case, it is usually applied uniformly to all identified
equations in the system.

Steps:

• Step I: Estimate the reduced form equations by OLS and obtain the predicted 𝑦̂𝑖
• Step II: Replace the right-hand side endogenous variables in the structural equations by
the corresponding 𝑦̂𝑖 and estimate them by OLS.

Consider the above simultaneous equations model:

𝑦1 = 𝑎1 + 𝑏1 𝑦2 + 𝑐1 𝑧1 + 𝑐2 𝑧2 + 𝑈1
𝑦𝑡 = 𝑎2 + 𝑏2 𝑦1 + 𝑐3 𝑧3 + 𝑈2
where y1 and y2 are endogenous while z1, z2 and z3 are predetermined.

Since equation the first structural equation is exactly identified, the 2-SLS procedure is the same
as the IV method. The 2-SLS procedure of estimation of the first structural equation (which is
over-identified) is:

• We first estimate the reduced form equations by OLS; that is, we regress y2 on z1, z2 and
z3 using OLS and obtain ̂𝑦1 .
• We then replace y2 by ̂𝑦1 and estimate equation two by OLS, that is, we apply OLS to:

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