Testing Firm Conduct

TL;DR

This paper examines the use of Rivers and Vuong's model selection method for testing firm conduct in imperfect markets, highlighting issues with weak instruments and proposing diagnostics to improve inference.

Contribution

It introduces a novel framework linking degeneracy to instrument strength, extending diagnostics for weak instruments to model selection in testing firm conduct.

Findings

Weak instruments can invalidate model selection tests.

Strong instruments are necessary for reliable testing of retail pricing behavior.

The proposed diagnostics help identify when instruments are weak.

Abstract

Evaluating policy in imperfectly competitive markets requires understanding firm behavior. While researchers test conduct via model selection and assessment, we present advantages of Rivers and Vuong (2002) (RV) model selection under misspecification. However, degeneracy of RV invalidates inference. With a novel definition of weak instruments for testing, we connect degeneracy to instrument strength, derive weak instrument properties of RV, and provide a diagnostic for weak instruments by extending the framework of Stock and Yogo (2005) to model selection. We test vertical conduct (Villas-Boas, 2007) using common instrument sets. Some are weak, providing no power. Strong instruments support manufacturers setting retail prices.