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9 Price and Substitution Elasticities of... > Simultaneous Equations - Pg. 281

Simultaneous Equations 281 SIMULTANEOUS EQUATIONS Even if the identification problem has been dealt with adequately, simultaneous system bias is a second problem that can be encountered with simultaneous sys- tems, such as the supply­demand model in Equations (9.68) and (9.69). Also known as an endogeneity problem (as both price and quantity are contained in both equations and are endogenous variables), it renders inconsistent estima- tion by OLS (and biased estimates) so that an alternative method must be employed. This is discussed in more detail later. For now, let us understand this issue further. Basic economic theory dictates that both price (P) and output (Q) are deter- mined simultaneously in equilibrium. That is, as displayed in Equations (9.68) and (9.69), the system of supply and demand equations constitutes an interde- pendent system of equations in which price and quantity are determined endo- genously--within the system of equations. In a nutshell, price affects quantity and quantity affects price. Consider the following system of equations: Supply: Q tS = 1 + 2 P t + 3 P t -1 + t Demand: (9.74)