Improved instrumental variables estimation of simultaneous equations under conditionally heteroskedastic disturbances

Abstract

AbstractIn this paper we develop estimation techniques and a specification test for the validity of instrumental variables allowing for conditionally heteroskedastic disturbances. We propose modified two‐stage least squares (2SLS) and modified 3SLS procedures where the conditional heteroskedasticity is taken into account, which are natural extensions of the traditional 2SLS and 3SLS estimators and which achieve a lower variance. We recommend the use of these modified 2SLS and 3SLS procedures in practice instead of alternative estimators like limited‐information maximum likelihood/full‐information maximum likelihood, where the non‐existence of moments leads to extreme values, and also for ease of computation. It is shown theoretically and with simulation that in some cases 2SLS, 3SLS and our modified 2SLS and 3SLS procedures can have very severe biases (including the weak instruments case), and we present bias correction procedures to apply in practice along the lines of Flores‐Lagunes (2007). Our new estimation procedures can also be used to extend the test for weak instruments of Stock and Yogo (2005) and to allow for conditional heteroskedasticity. Finally, we show the usefulness of our estimation procedures with an application to the demand and supply of fish. Copyright © 2010 John Wiley & Sons, Ltd.