The data in cigarette.dta contains information related to the demand for cigarettes by state in the US.

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The data in cigarette.dta contains information related to the demand for cigarettes by state in the US. You are interested in estimating the cigarette demand equation where the dependent variable is the per capita log of packs sold log(packpc), with explanatory the log of real per capita income log(perinc), and log of real after tax price per pack log(ravgprs).

 

The log of real after-tax price per pack log(ravgprs) is potentially endogenous, so that the following instruments were collected: average state sales tax (rtaxso), and cigarette specific taxes (rtaxs). 

 

1. Generate the necessary variables for the demand equation of cigarettes.

 

2. Estimate the demand model using ordinary least squares. Interpret the estimated coefficients. Are the signs of the coefficients consistent with your expectations?

 

3. What is the potential source of endogeneity for log(ravgprs)? Explain why rtaxso and rtaxs are conceptually sound instrumental variable candidates for log(ravgprs).

 

4. Using the rtaxso and rtaxs as the instrument-candidates, estimate the demand equation using 2SLS. Compare the results with the OLS and interpret the IV regression coefficients. What are the noticeable differences, if there are any?

 

5. Are the instruments relevant? Support your answer with the appropriate test result.

 

6. Are the instruments exogenous? Support your answer with the appropriate test result.

 

7. Is there evidence to say that log of real after-tax price per pack log(ravgprs) is indeed endogenous?

 

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