Endogeneity and Individual Consumer Choice

Abstract

In many markets, there is likely to be correlation both across periods in terms of the choices of one consumer and across consumers in terms of their choices in each period. The former is caused by consumer heterogeneity, and the latter may be the result of demand common shocks across consumers. Furthermore, if firms partially observe these common shocks, their market decisions may end up being endogenous and correlated with the common shocks. Because researchers cannot typically fully observe consumer heterogeneity and the common shocks, the estimation method must account for the endogeneity of firms’ decisions. In this article, the authors present a test for endogeneity under unobserved consumer heterogeneity and common shocks, which is based on a quasi-likelihood estimation method, to estimate the model parameters consistently when endogenous firm behavior, unobserved heterogeneity, and common shocks are present. The test examines the differences in general method of moments coefficient estimates of a model with and without instrumenting for the explanatory variables. The authors show theoretically that in their estimation method, unobserved heterogeneity does not affect the consistency of the parameter estimates, but if it is not accounted for, endogeneity may bias the results. They present estimation results from simulated and scanner panel data.