Journal Article

Pairwise-Difference Estimation of a Dynamic Optimization Model

Han Hong and Matthew Shum

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 77, issue 1, pages 273-304
Published in print January 2010 | ISSN: 0034-6527
Published online January 2010 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2009.00576.x
Pairwise-Difference Estimation of a Dynamic Optimization Model

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We develop a new estimation methodology for dynamic optimization models with unobserved shocks and deterministic accumulation of the observed state variables. Investment models are an important example of such models. Our pairwise-difference approach exploits two common features of these models: (1) the monotonicity of the agent's decision (policy) function in the shocks, conditional on the observed state variables; and (2) the state-contingent nature of optimal decision making which implies that, conditional on the observed state variables, the variation in observed choices across agents must be due to randomness in the shocks across agents. We illustrate our procedure by estimating a dynamic trading model for the milk production quota market in Ontario, Canada.

Journal Article.  10644 words.  Illustrated.

Subjects: Economics

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