Rev Ind Organ (2012) 40:131–138
Collinearity in Linear Structural Models of Market
Jeffrey M. Perloff · Edward Z. Shen
Published online: 3 February 2012
© Springer Science+Business Media, LLC. 2012
Abstract The well-known structural model used to estimate market power suffers
from a severe collinearity problem if both the marginal cost and demand equations are
linear. If the equations hold exactly, the variables are perfectly collinear so the model
cannot be estimated. If the true linear model equations hold with errors, one can esti-
mate the equations, but the estimated coefﬁcients are likely to be highly unstable and
unreliable due to nearly perfect collinearity.
Keywords Collinearity · Estimation · Market power · Structural model
JEL Classiﬁcation L13 · C1
A structural model due to Just and Chern (1980) has been widely used to esti-
mate market power based on market-level data.
linear structural model to illustrate the method and to demonstrate that identiﬁca-
Hundreds of studies have used this New Empirical Industrial Organization (NEIO) approach. For a
partial list, see Bresnahan (1989)orPerloff et al. (2007). There are a number of alternative approaches
that are widely used as well including a variant on the original NEIO approach using mixed logit to
estimate demand equations, nonparametric approaches, dynamic models, and others. See Perloff et al.
(2007) for a description of these alternatives.
J. M. Perloff (
Department of Agricultural and Resource Economics,
University of California, 207 Giannini Hall, MC 3310,
Berkeley, CA 94720-3310, USA
E. Z. Shen
China Minsheng Bank, Beijing, China
J. M. Perloff
Giannini Foundation, 207 Giannini Hall, Berkeley, CA 94720-3310, USA