A Control Function Approach to Endogeneity in Consumer Choice Models

Endogeneity arises for numerous reasons in models of consumer choice. It leads to inconsistency with standard estimation methods that maintain independence between the model’s error and the included variables. The authors describe a control function approach for handling endogeneity in choice models. Observed variables and economic theory are used to derive controls for the dependence between the endogenous variable and the demand error. The theory points to the relationships that contain information on the unobserved demand factor, like the pricing equation and the advertising equation. The authors’ approach is an alternative to the commonly-used Berry, Levinsohn, Pakes (1995) product-market controls for unobserved quality. The authors apply both methods to examine households' choices among television options, including basic and premium cable packages, where unobserved attributes, such as quality of programming, are expected to be correlated with price. Without correcting for endogeneity, aggregate demand is estimated to be upward-sloping, suggesting omitted attributes are positively correlated with demand. Both the control function method and the product-market controls method produce downward-sloping demand estimates that