Simultaneous Equations: What is the relationship between income and smoking?

Master of Economics

Data Source: Introductory Econometrics data sets

One can say that income helps determine how many cigarettes a person smokes, but it could be plausible that smoking, because of its negative health effects can also reduce a persons wages. Whenever there is the possibility of reverse causality estimates of coefficients and their statistical variances should be looked at with a healthy dose of skepticism. Imagine if we looked at the correlation between the number of police officers and crime rates, we might see a high correlation and erroneously conclude that the more police officers in a city the more crime. Of course the causality link between these two variables is reversed, and applying a little common sense would tell you that increases in crime lead to more police officers being hired for the most part. Police and crime rates is a fairly easy problem to decipher and ensure that correlation is…

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