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Estimating Dynamic Programming Models Katsumi Shimotsu 1 Ken Yamada 2 1 Department of Economics Hitotsubashi University 2 School of Economics Singapore Management University Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 1 / 42

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Page 1: Estimating Dynamic Programming Modelsstat.econ.osaka-u.ac.jp/~suryo/201105/JEA_tutorialslides2.pdf · t+1)p(ds t+1js t;a) ˙: U(a;s t; ): today ... Nested Fixed Point (NFXP) algorithm

Estimating Dynamic Programming Models

Katsumi Shimotsu1 Ken Yamada2

1Department of EconomicsHitotsubashi University

2School of EconomicsSingapore Management University

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 1 / 42

Page 2: Estimating Dynamic Programming Modelsstat.econ.osaka-u.ac.jp/~suryo/201105/JEA_tutorialslides2.pdf · t+1)p(ds t+1js t;a) ˙: U(a;s t; ): today ... Nested Fixed Point (NFXP) algorithm

Dynamic Programming (Structural) Models

For assessing various policy proposals (e.g.pension reform, export subsidy), understandingthe dynamic response of individuals and firms isimportant.

Regression models are subject to the Lucas critic.

It is desirable to model dynamic optimizingbehavior on individuals/firms explicitly, along withhow the state of economy evolves.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 2 / 42

Page 3: Estimating Dynamic Programming Modelsstat.econ.osaka-u.ac.jp/~suryo/201105/JEA_tutorialslides2.pdf · t+1)p(ds t+1js t;a) ˙: U(a;s t; ): today ... Nested Fixed Point (NFXP) algorithm

Dynamic Programming Models: Examples

Rust (1987): bus engine replacement

Rust and Rothwell (1995): nuclear plant operation

Rust and Phelan (1997): retirement decision andpension/health plan

Keane and Wolpin (1997): schooling, work and occupationalchoice

Imai and Keane (2004): labor hours choice with humancapital accumulation

Possible to quantitatively assess the impact of public policiesthat have never been implemented (counter-factual simulation)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 3 / 42

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Machine Replacement Model (Rust, 87)

Consider a mechanic who maintains a computer.His objective is to maximize the discounted sum of utilities

maxa1,a2,...

E

[∞∑

t=1

βtU(at , xt , εt ; θ)

].

at ∈ {0,1}: machine replacement decision

xt : observable state variable (machine age)

εt : state variable observable to the mechanic, but not toeconometrician: additional information on machine condition

θ: parameter of interest

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 4 / 42

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Machine Replacement Model (Rust, 87)

The utility function:

U(at , xt , εt ; θ) = −mc(xt ; θ)− at rc(xt ; θ) + εt .

mc(xt ; θ): machine maintenance cost

rc(xt ; θ): machine replacement cost

εt : unobserved (to econometrician) state variable

Transition of xt : xt = at−1 + (1− at−1)(xt−1 + 1).

The state variable evolves according to(xt , εt) ∼ p(xt , εt |xt−1, εt−1,at−1; θ)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 5 / 42

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Machine Replacement Model (Rust, 87)

maxa1,a2,...

E

[∞∑

t=1

βtU(at , xt , εt ; θ)

], (xt , εt) ∼ p(xt , εt |xt−1, εt−1,at−1; θ)

We want to estimate θ from the data {at , xt},t = 1, . . . ,n.

From the mechanic’s point of view, he can solve this problemto obtain an optimal decision rule: a = δ(x , ε; θ).

Because ε is unobservable to econometrician, the empiricalimplication of the model is the conditional choiceprobabilities (cf. probit model):

P(a|x ; θ) =

∫I {a = δ(x , ε; θ)}g(dε)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 6 / 42

Page 7: Estimating Dynamic Programming Modelsstat.econ.osaka-u.ac.jp/~suryo/201105/JEA_tutorialslides2.pdf · t+1)p(ds t+1js t;a) ˙: U(a;s t; ): today ... Nested Fixed Point (NFXP) algorithm

How to compute P(a|x ; θ)

Let st = (xt , εt). Define the value function as

Wθ(st) = maxat ,at+1,...

E

[∞∑

s=t

βsU(as, ss; θ)

∣∣∣∣∣ st

].

We may compute the value function by finding the fixedpoint of the Bellman equation

Wθ(st) = maxa∈A

{U(a, st , θ) + β

∫Wθ(st+1)p(dst+1|st ,a)

}.

U(a, st , θ): today’s utility

Wθ(st+1): maximum future utility when tomorrow’s state isst+1

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 7 / 42

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How to compute P(a|x ; θ)

Bellman equation

Wθ(st) = maxa∈A

{U(a, st , θ) + β

∫Wθ(st+1)p(dst+1|st ,a)

}.

When εt is continuously distributed, finding a fixed point ofthis Bellman equation becomes difficult

The space of st can be very large⇒ need to evaluate Wθ(s)at many points

Numerical integration in computing∫

Wθ(st+1)p(dst+1|st ,a)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 8 / 42

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How to compute P(a|x ; θ)

Conditional Independence Assumption:the transition of xt and εt can be written as

p(xt+1, εt+1|st ,at) = g(εt+1|xt+1)f (xt+1|xt ,at).

Any statistical dependence between εt and εt+1 istransmitted entirely through xt+1.

The probability density of xt+1 depends only on xt and not εt .εt is a noise “superimposed" on xt .

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 9 / 42

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How to compute P(a|x ; θ)

Define the integrated value function as

Vθ(xt) =

∫Wθ(xt , εt)dg(εt |xt)

Vθ(x) satisfies another Bellman equation

Vθ(x)

= maxa∈A

{∫U(a, x , ε, θ)dg(ε|x) + β

∫Vθ(x ′)f (dx ′|x ,a)

}.

Vθ(x) is a fixed point of a separate mapping on the reducedspace of x rather than the space of s = (x , ε).

Under some assumptions on U(a, x , ε), one does not needto use numerical integration to compute the right hand side.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 10 / 42

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How to compute P(a|x ; θ)

Example: U(a, x , ε; θ) = u(a, x ; θ) + ε(a), and ε(a) followsextreme value dist’n (logit error), independent across a.

Then one does not need to use numerical integration tocompute the right hand side of the Bellman equation.

Further, P(a|x ; θ) admits a multinomial logit formula

P(a|x ; θ) =exp[u(a, x ; θ) + EVθ(a, x)]∑Jj=1 exp[u(j , x ; θ) + EVθ(j , x)]

,

where EVθ(a, x) =∫

Vθ(x ′)f (dx ′|x ,a) = the maximum futureutility when the pair of the current action and observablestate is (a, x)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 11 / 42

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Nested Fixed Point (NFXP) algorithm (Rust, 87)Given a (cross-sectional) data set {ai , xi}n

i=1, the NFXP solves

Inner loop: for each candidate value of θ, solve theintegrated Bellman equation to compute EVθ(a, x) and thencompute the equilibrium conditional choice probabilitiesP(a|x ; θ).

Outer loop: maxθ N−1∑Ni=1 ln P (ai |xi ; θ)

Then, θ̂ is the MLE.

Computational cost depends on the size of the state space(the support points of x and a).

Computationally intensive when x may take many differentvalues.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 12 / 42

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Alternate fixed point mapping

Hotz and Miller (1993, ReStud), Aguirregabiria and Mira(2002, ECMA; 2007, ECMA)

Computationally attractive alternative to the NFXP

These procedures use the fixed point in the space of P(a|x):the conditional choice probability of action a given x .

Unlike the value function, we can obtain a good “guess" ofP(a|x) from the data, typically from a frequency estimator.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 13 / 42

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Relation between value function and P(a|x)

Given the value function, computing P(a|x) is not verydifficult (logit formula).

But computing the value function

W (st) = maxat ,at+1,...

E

[∞∑

s=t

βsU(as, ss; θ)

∣∣∣∣∣ st

]

directly from P(a|x) is difficult, even with simulations.

Assume additive separability:

U(a, s) = u(a, x) + ε.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 14 / 42

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Alternate fixed point mapping

The Bellman equation

W (st) = maxa∈A

{u(xt ,a) + ε(a) + β

∫W (st+1)p(dst+1|st ,a)

}.

Define the integrated value function as

V (xt) =

∫W (xt , εt)dp(εt |xt)

With additive separability, V (x) satisfies another Bellmanequation

V (x)

=

∫maxa∈A

{u(x ,a) + ε(a) + β

∫V (x ′)f (dx ′|x ,a)

}dp(εt |x).

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 15 / 42

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Alternate fixed point mapping

Mapping from P(a|x) to the value function

V (x) =∑a∈A

P(a|x)

{u(x ,a) + E [ε(a)|x ,a] + β

∫X

V (x ′)f (dx ′|x ,a)

}where E [ε(a)|x ,a] is the expected value of ε conditional onaction a is chosen.

E [ε(a)|x ,a] admits a simple closed-form representation.

Combining this with the mapping from the value function toP gives a mapping Ψ(θ,P): P(a|x){a,x} → P(a|x){a,x}.

True P is the fixed point of this mapping.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 16 / 42

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Nested pseudo-likelihood (NPL) estimator(Aguirregabiria and Mira, 02, 07)

Define P = P(a|x){a,x}: vector of conditional choiceprobabilities for all a and x .

Start from a guess of P, P̃0. Typically, a frequency estimator.

Estimate θ by

θ̃1 = arg maxn∑

i=1

ln Ψ(θ, P̃0)(ai |xi).

Update P by P̃1 = Ψ(θ̃1, P̃0).

Update θ and P further byθ̃2 = arg max

∑ni=1 ln Ψ(θ, P̃1)(ai |xi), P̃2 = Ψ(θ̃2, P̃1), ...

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 17 / 42

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Nested pseudo-likelihood (NPL) estimator(Aguirregabiria and Mira, 02, 07)

Once P is fixed, evaluating Ψ(θ,P) for different θ does notrequire computing a fixed point.

In a single agent model (for example, bus engine model),θ̃1 is first-order equivalent to the MLE.

θ̃j approaches to the MLE in a higher-order sense as jincreases. (Kasahara and Shimotsu, 2008)

In multiple agent (game-theoretic) model, θ̃1 is not the MLE.Iterating the updating may give a better estimator.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 18 / 42

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Game-theoretic models

We may view the bus engine model as a model with a fixedpoint constraint

θ̂ML = arg maxθ∈Θ

1n

n∑i=1

ln P (ai |xi ; θ)

s.t . P = Ψ(θ,P)

Game-theoretic models are also characterized by a fixedpoint.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 19 / 42

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Game-theoretic models

Many markets are characterized as a competition among afew firms with differentiated products.

In such markets, strategic interaction between firms becomeimportant.

We want to understand how firms compete with each otherin such markets.

Implications for competition policy, entry regulation, etc.

“Structural economic models" explicitly model firms’strategic interaction (and dynamic choice)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 20 / 42

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Simple static game of entry

Two potential entrants to a market (for example, 5thgeneration smartphone, Docomo and KDDI).

If both firms enter, both firms earn positive profit. If only onefirm enters, it earns larger profit.

Payoff matrix

firm 2in out

firm 1 in (1,1) (3,0)out (0,3) (0,0)

Nash equilibrium: given the other player’s action,I have no incentive to change my action⇒ (in,in)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 21 / 42

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Games with private information

But firm 1 may not know everything about firm 2.

Payoff matrix with a random component

firm 2in out

firm 1 in (ε1 − θ, ε2 − θ) (ε1,0)out (0, ε2) (0,0)

ε1 and ε2 are drawn independently from uniformdistribution[0,1]. Both firms know θ.

Only firm 1 observes ε1, and only firm 2 observes ε2 (privateinformation).

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 22 / 42

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How to determine the equilibrium

firm 2in out

firm 1 in (ε1 − θ, ε2 − θ) (ε1,0)out (0, ε2) (0,0)

Suppose firm 1 thinks that firm 2 enters with probability P2 =firm 1’s subjective probability (“belief")

Firm 1 enters the market ifP2(ε1 − θ) + (1− P2)ε1 > 0⇒ ε1 > θP2

Because ε1 ∼ U[0,1], firm 1 enters the market withprobability 1− θP2 when his belief is P2.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 23 / 42

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How to determine the equilibrium

Firm 1 enters the market with probability 1− θP2 when hisbelief is P2.

Firm 2 enters the market with probability 1− θP1 when hisbelief is P1.

Bayesian perfect equilibrium: both players’ belief must beconsistent with their action.

P1 = 1− θP2, P2 = 1− θP1 ⇒ P1 = P2 = 1/(1 + θ)

Best response mapping: [0,1]2 → [0,1]2

Ψ(θ,P) = (1− θP2,1− θP1)′.Then BPE is a fixed point of Ψ : P∗ = Ψ(θ,P∗)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 24 / 42

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Estimation of θ in this model

Suppose we have iid data of the entry decision (a1i ,a2i) fori = 1, . . . ,n, and we want to estimate the value of θ.

If we assume the data are in the equilibrium,we can estimate θ by

θ̂ =12

[1− P̂1

P̂1+

1− P̂2

P̂2

].

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 25 / 42

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Dynamic discrete game

N firms = potential entrants

Entry/exit choice: ait ∈ A = {0,1}.Firm i’s profit in period t :

Π̃i(at ,St ,ai,t−1, εt ; θ)

I All the firms’ current decision: at = (a1t , ...,aNt)′

I Market demand condition: St (observable)I Past entry decision: ai,t−1

I Private shocks: εt = (ε1t , ..., εNt)′.

θ: parameter of interest

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 26 / 42

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Dynamic discrete game

Profit function of firm i :

Π̃i(at ,St ,at−1, εit ; θ) = θRS ln St − θFC,i − θEC(1− ai,t−1)

− θRN ln(1 +∑j 6=i

ajt) + εit1

θRS: Revenue parameterθFC,i : Operating costθEC: Entry costθRN : Degree of strategic substitution

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 27 / 42

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Dynamic discrete game

Dynamic optimization by firm i

maxai1,ai2,...

E

[∞∑

t=0

βtΠi(at ,St ,ai,t−1, εt ; θ)|St ,at−1; θ

]

Assume the state variable follows a Markov process

Markov decision problem given his belief

Stationary solution

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 28 / 42

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Dynamic discrete game

Empirical implication: firm i ’s conditional choice probabilities= Pi(a|x).

Pi = {Pi(a|x)}(a,x): firm i ’s conditional choice probabilities forall possible x

The conditional choice probabilities of all the firms:P = (P1, . . . ,PN)

For a given θ, an equilibrium is characterized by a fixed pointof the best response mapping

P = Ψ(θ,P)

We assume Ψ(θ,P) has a unique fixed point for the moment.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 29 / 42

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P can be large

For example,

5 potential entrants

all the firms’ entry status in the previous period:25 = 32 support points

market condition takes 10 different values

xt takes 10× 32 = 320 different values

Length of P = 320× 5 = 1600

⇒ finding a fixed point of Ψ can be computationally costly

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 30 / 42

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Economic models with a fixed point constraint

When P = P(a|x) is the choice probability of a discreteaction a conditional on x , the log-likelihood function is

Qn(θ) =n∑

i=1

ln P(ai |xi) s.t . P = Ψ(θ,P)

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 31 / 42

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Constraint optimization approach (Su and Judd, 2012)

Write down the Lagrangian

L(θ,P, λ) =1n

n∑i=1

ln P (ai |xi) + λ(P −Ψ(θ,P))

Solve the first-order condition

∇θL(θ∗,P∗, λ∗) = 0,∇PL(θ∗,P∗, λ∗) = 0,P∗ −Ψ(θ∗,P∗) = 0

According to the authors, one can solve this problem usingthe “NEOS Server, a free internet service which gives theuser access to several state-of-the-art solvers."

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 32 / 42

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NPL estimator (Aguirregabiria and Mira, 2007)

P̃0: initial guess of P

Step 1: Given P̃k−1,

1n

n∑i=1

ln[Ψ(θ, P̃k−1)](ai |xi).

can be viewed as a pseudo log-likelihood function. So,estimate θ by maximizing this objective function⇒ θ̃k

Step 2: Given θ̃k , update the estimate of P by

P̃k = Ψ(θ̃k , P̃k−1).

Iterate Steps 1-2: {θ̃k , P̃k}∞k=1

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 33 / 42

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NPL Fixed Points: {θ̌, P̌}

If the sequence {θ̃k , P̃k}∞k=1 converges, its limit satisfies

θ̌ = arg maxθ

1n

n∑i=1

ln[Ψ(θ, P̌)](ai |xi),

P̌ = Ψ(θ̌, P̌).

The NPL estimator is defined as (θ̌, P̌) that achieves thehighest pseudo-likelihood value.

Easy to implement: standard optimization and policyiteration

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Convergence of the NPL algorithm?

Convergence of {θ̃k , P̃k}∞k=1?

Empirical researchers report non-convergence of the NPLalgorithm.

For example, it can exhibit a 2-period cycle.

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Property of NPL updating (Kasahara and Shimotsu,2012)

In a neighborhood of P0,

θ̃j − θ̂NPL = Op(||P̃j−1 − P̂NPL||),

P̃j − P̂NPL = MΨθΨP(P̃j−1 − P̂NPL) + smaller order terms,

whereΨP = ∇PΨ(θ,P) = Jacobian of Ψ(θ,P)

MΨθ= I −Ψθ(Ψ′θ∆PΨθ)

−1Ψ′θ∆P

The convergence of P̃k depends on the dominanteigenvalue of MΨθ

ΨP .

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Dynamic Game Example (continued)

Profit function of firm i :

Π̃i(at ,St ,at−1, εit ; θ) = θRS ln St − θFC,i − θEC(1− ai,t−1)

− θRN ln(1 +∑j 6=i

ajt) + εit1

θRS: Revenue parameterθFC,i : Operating costθEC: Entry costθRN : Degree of strategic substitution

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Dominant eigenvalue of ΨP and MΨθΨP

θRN ρ(ΨP) ρ(MΨθΨP)

1 0.337 0.2922 0.693 0.5954 1.184 1.1806 1.479 1.478

Note: dim(P) = 144 and dim(θ) = 2.

Strong strategic substitutability

→ {θ̃k , P̃k} diverges away from (θ0,P0).

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What if Ψ is not locally contractive around P0?(Kasahara and Shimotsu, 2012)

(1) Relaxation method:

[Λ(θ,P)](a|x) = {[Ψ(θ,P)](a|x)}αP(a|x)(1−α), α ∈ (0,1)

— easy, works in some cases

(2) Recursive Projection Method

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References I

Aguirregabiria, V. and P. Mira (2002). Swapping the nested fixedpoint algorithm: a class of estimators for discrete Markov decisionmodels. Econometrica 70, 1519-1543.

Aguirregabiria, V. and Mira, P. (2007). Sequential estimation ofdynamic discrete games. Econometrica 75, 1-53.

Aguirregabiria, V. and Mira. P. (2010). Dynamic discrete choicestructural models: A survey. Journal of Econometrics 156, 38-67.

Hotz, J. and R. A. Miller (1993). Conditional choice probabilitiesand the estimation of dynamic models. Review of EconomicStudies 60, 497-529.

Imai, S., Keane, M. P. (2004). Intertemporal labor supply andhuman capital accumulation. International Economic Review 45,601-641.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 40 / 42

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References II

Kasahara, H. and K. Shimotsu (2008) Pseudo-likelihoodEstimation and Bootstrap Inference for Structural Discrete MarkovDecision Models. Journal of Econometrics 146, 92-106.

Kasahara, H. and K. Shimotsu (2012) Sequential Estimation ofStructural Models with a Fixed Point Constraint. Econometrica 80,2303-2319.

Keane, M. P. and K. I. Wolpin (1997). The Career Decisions ofYoung Men. Journal of Political Economy, 105, 473-522.

Rust, J. (1987). Optimal replacement of GMC bus engines: anempirical model of Harold Zurcher. Econometrica 55, 999-1033.

Rust, J., Rothwell, G. (1995). Optimal Response to a Shift inRegulatory Regime: The Case of the US Nuclear Power Industry.Journal of Applied Econometrics 10, S75-S118.

Katsumi Shimotsu, Ken Yamada DP models JEA 2011 tutorial session 41 / 42

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References III

Rust, J., Phelan. C. (1997). How Social Security and MedicareAffect Retirement Behavior In a World of Incomplete Markets.Econometrica 65, 781-831.

Su, Che-Lin and Judd, K. L. (2012). Constrained optimizationapproaches to estimation of structural models. Econometrica 80,2213-2230.

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