Question: During the 1880s. a cartel known as the Joint Executive Committee (JEC) controlled the rail transport of grain from the Midwest to eastern cities in the United States. The cartel preceded the Sherman Antitrust Act of 1890, and it legally operated to increase the price of grain above what would have been the competitive price. From time to time, cheating by members of the cartel brought about a temporary collapse of the collusive price-setting agreement. In this exercise, you will use variations in supply associated with the cartel's collapses to estimate the elasticity of demand for rail transport of grain. On the textbook Web site www.pearsonhighered.com/stodc_watson, you will find a data file JEC that contains weekly observations on the rail shipping price and other factors from 1880 to 1886.4 A detailed description of the data is contained in JEC_Description available on the Web site.
Suppose that the demand curve for rail transport of grain is specified
a. Estimate the demand equation by OLS. What is the estimated value of the demand elasticity and its standard error?
b. Explain why the interaction of supply and demand could make the OLS estimator of the elasticity biased.
c. Consider using the variable cartel as instrumental variable for ln(P). Use economic reasoning to argue whether cartel plausibly satisfies the two conditions for a valid instrument.
d. Estimate the first-stage regression. Is cartel a weak instrument?
e. Estimate the demand equation by instrumental variable regression. What is the estimated demand elasticity and its standard error?
f. Does the evidence suggest that the cartel was charging the profit-maximizing monopoly price? Explain. (Hint What should a monopolist do if the price elasticity is less than 1?)