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Instrumental
Variables
(Chapter 13.213.3)
Agenda
Review
Randomization
Instrumental Variables (Chapter 13.2)
Using Instrumental Variables
(Chapter 13.2)
19-2
Review
If we relax the assumption that explanators
are fixed across samples, we confront a
number of serious complications.
Stochastic explanators render the
mathematics of finding unbiased estimators
intractable.
Instead, econometricians search for
consistent estimators.
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reserved.
19-3
Review (cont.)
The most problematic condition for OLS
to be consistent is
E(xi i ) 0
which, by the Law of Large Numbers,
1
implies p lim xi i 0.
n
19-4
Review (cont.)
xiYi
xi [ 0 1 X 1 i ]
p lim( 1 ) p lim
p lim
2
2
x
i
i
n i i
xi i
1 p lim
1 p lim
2
1
x
i
xi2
n
p lim xi
i
0
n
1
1 1
Q
1 2
p lim xi
n
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reserved.
19-5
Review (cont.)
Asking that key variances be non-zero
and bounded is often reasonable
(except in certain time series cases).
19-6
Review (cont.)
How reasonable an assumption is E(Xi i ) 0
(i.e. Xi and i are uncorrelated)?
In practice, this assumption is often terrible.
When an explanator is correlated with the
error term, we call the explanator a
troublesome variable.
19-7
Review (cont.)
We have examined four complications
that induce correlation between X and
1. Omitted Variables Bias
2. Measurement Error
3. Simultaneous Causality
4. Using Lagged Values of the Dependent
Variable as Explanators, in the presence
of serial correlation
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reserved.
19-8
Review (cont.)
Omitting a variable creates a bias only if:
1. X2 is an explanator of Y (so, when
omitted, it becomes a component of the
error term).
2. X2 is correlated with X1 (so that X2
creates a correlation between X1 and the
error term).
19-9
Review (cont.)
Measurement error also induces a
correlation between our included
explanator and the error term
Instead of observing Xi , we observe
M i Xi vi
19-10
Review (cont.)
Model: Yi 0 1 X 1 i
Instead of observing X i , we observe M i X i vi
We regress Yi 0 1M i i
Var ( X i )
X2
p lim(1 ) 1
1 2
Var ( X i ) Var (vi )
X v2
19-11
Review (cont.)
Mismeasuring X leads to
ATTENUATION BIAS. The estimated
coefficient is biased towards 0.
The magnitude of the bias depends on
the relative variances of X and v.
19-12
Review (cont.)
Under simultaneous causality, X and
Y are jointly determined.
Because X and Y are determined
simultaneously, X can adjust in
response to shocks to Y ().
Thus X will be correlated with
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-13
Review (cont.)
Using lagged dependent variables as
explanators is another potential source
of correlation between an explanator
and the error term.
If there is first-order serial correlation in
the error terms, then t-1 is correlated
with t
Therefore Yt-1 is correlated with t
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-14
Randomization
In practice, correlation between X and
is endemic.
Much of econometric work involves
studying the process determining the
explanators, to see how they might be
correlated with .
19-15
Randomization (cont.)
The ideal X variable has been
randomly assigned.
If X has been randomly assigned, then
it contains no information about .
19-16
Randomization (cont.)
If X has been randomly assigned, then
E( | X) 0
It follows that E( X) 0
Moreover, if E( | X) 0 , then OLS
is unbiased.
19-17
Randomization (cont.)
Laboratory scientists typically work with
randomly assigned explanators.
In an experiment, the scientist
randomly assigns different subjects to
different treatments.
19-18
Randomization (cont.)
Economists have been making increasing use
of experiments.
Some economists construct carefully
controlled markets in computer laboratories
(usually with undergraduate subjects).
Other economists insert randomization into
actual programs in the field, for example
randomly assigning participants to different
health care plans.
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reserved.
19-19
Randomization (cont.)
See Chapter 15 for a discussion of
controlled experiments.
Most econometric research, however,
studies field data.
The econometrician observes variables
as they are naturally determined, and
attempts to draw inferences.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-20
Randomization (cont.)
Occasionally, variables are naturally
determined by random chance.
When nature assigns X randomly,
econometricians can study a
natural experiment.
19-21
Randomization (cont.)
For example, Alvin Roth studies centralized
computer matching programs to assign
medical school graduates to hospital training
programs. Graduates and hospitals each
submit preference lists, and a computer sorts
through the lists and creates matches.
Game theory suggests key properties for
such a matching program.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-22
Randomization (cont.)
Roth noticed that in the United Kingdom,
each region of the country ran its own
centralized matching program.
In some of the regions, organizers had
happened to adopt a matching program
that possessed good game theoretic
properties. Other regions did not adopt
good designs.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-23
Randomization (cont.)
Roth speculated that the choice of program
design was reasonably random, at least in the
sense that program design was not
systematically linked to any other properties
of the region.
Programs with good game theoretic
properties were much more likely to be
successful. Centralized programs with poor
properties fell into disuse.
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reserved.
19-24
Randomization (cont.)
In Roths study, advanced econometric
methods were unnecessary.
The data naturally provided the
experiment he needed to observe.
Of course, it is Roths duty to argue
compellingly that the program rules
really are uncorrelated with other
aspects of the regions.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-25
Randomization (cont.)
Nature often provides a certain degree
of randomization.
For example, suppose we are studying the
effect of military service on earnings.
During the Vietnam War, the draft lottery was a
largely random process.
Thus, a study of Vietnam War veterans
would be more random than a study of veterans
from the more recent all-volunteer American
army.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-26
Randomization (cont.)
However, service in Vietnam was determined
by more than simple random chance.
Some men voluntarily enlisted; others
received draft deferments (or simply evaded
the draft).
The decision to volunteer, or to avoid being
drafted, would undoubtedly be correlated with
many other variables.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-27
Randomization (cont.)
Military service in Vietnam, then,
consists of two elements:
1. A clean random element determined by
the draft lottery, that would be
uncorrelated with in an earnings
regression; and
2. An unclean element, determined by
active decision-making on the agents
part, that could easily be correlated with .
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-28
Randomization (cont.)
Vietnam War military service is
partially determined by an obviously
random process.
Nonetheless, a simple OLS estimate of
the effect of military service on earnings
would be inconsistent. Military service is
also partially determined non-randomly.
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reserved.
19-29
Randomization (cont.)
Fortunately, econometricians have
discovered a method for separating out
the random elements of explanators
from the elements that may be
correlated with .
Unfortunately, this method requires the
data to include an instrumental
variable with certain key properties.
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reserved.
19-30
E( Zi Xi ) 0
2.
E( Zi i ) = 0
19-31
19-32
19-33
19-34
19-35
19-36
19-37
19-38
19-39
19-40
19-41
19-42
19-43
19-44
19-45
19-46
19-47
19-48
19-49
19-50
19-51
Checking Understanding
Suppose you are studying the effect of price
on the demand for cigarettes, using a
cross-section of different states cigarette
consumption and average price.
You would like to regress
CigarettesSoldi 0 1 Pricei i
where i indexes each state
19-52
2.
3.
19-53
19-54
19-55
19-56
19-57
19-58
19-59
E( i ) 0
Var( i ) 2
Cov( i , j ) 0 for i j
E( X i i ) 0,
M i X i vi
1
(xi 2 ) 2X <
n
E(vi ) 0
Var(vi )
Cov(vi ,v j ) 0 for i j
2
v
Cov(vi , X i ) 0
Cov(Z i , X i ) 0
Cov(Z i , i ) 0
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reserved.
19-60
19-61
IV
ziYi
zi mi
19-62
19-63
IV
ziYi
zi xi
19-64
Checking Understanding
IV
ziYi
zi xi
IV
OLS
19-65
zi xi
ziYi
OLS
2
zi
19-66
E ( 1 ) E
E
zi xi
zi xi
zi X i
zi i
1 E
E
zi xi
zi xi
zi i
1 E
zi xi
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reserved.
19-67
E ( ) 1 E
zi xi
Because Cov( X i , i ) 0, the
bias term cannot be eliminated.
IV is biased in the same direction
as the bias in OLS.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-68
ziYi
IV
n
p lim( ) p lim
z
x
i i
p lim zi xi
n
1
p lim zi ( 0 1 X i i )
n
1
p lim zi xi
n
19-69
p lim( 1 )
1
p lim zi xi
n
By the Law of Large Numbers....
1Cov( Z i , X i ) Cov ( Z i , i )
1
Cov( Z i , X i )
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reserved.
19-70
p lim( 1 ) 1
Cov( Z i , X i ) Cov( Z i , X i )
If Cov( Z i , X i ) 0, the denominator equals 0,
and the p lim does not exist.
If Cov( Z , ) 0, then IV is inconsistent.
i
19-71
n
1
p lim zi xi
n
1 2 Var(Z i )
n Cov(Z i , X i )2
19-72
19-73
19-74
19-75
19-76
Review (cont.)
In practice, correlation between X and
is endemic.
Much of econometric work involves
studying the process determining the
explanators, to see how they might be
correlated with
19-77
Review (cont.)
The ideal X variable has been
randomly assigned.
If X has been randomly assigned,
then it contains no information about
However, true randomization is
relatively uncommon.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-78
Review (cont.)
Often, an explanator is partially
determined in a way that is random, or
at least uncorrelated with
However, the explanator is also
influenced by omitted variables, or
determined endogenously, or is in some
other way correlated with
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-79
Review (cont.)
Fortunately, econometricians have
discovered a method for separating out
the random elements of explanators
from the elements that may be
correlated with .
Unfortunately, this method requires the
data to include an instrumental
variable with certain key properties.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-80
Review (cont.)
An Instrumental Variable is a
variable that is correlated with X but
uncorrelated with .
If Zi is an instrumental variable:
1. E(ZiXi ) 0
2. E(Zii ) = 0
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reserved.
19-81
Review (cont.)
If Xi were uncorrelated with i , we
would want to weight more heavily
observations with a high xi value.
We know that Zi is correlated with the
clean part of Xi , so now we want to
weight more heavily observations with
a high zi value.
Copyright 2006 Pearson Addison-Wesley. All rights
reserved.
19-82
Review (cont.)
IV
ziYi
zi xi
19-83
Review (cont.)
What is the probability limit of IV?
Cov( Z i , X i ) Cov( Z i , i )
IV
p lim( 1 ) 1
1
Cov( Z i , X i ) Cov( Z i , X i )
If Cov( Z i , X i ) 0, the denominator equals 0,
and the p lim does not exist.
If Cov( Z , ) 0, then IV is inconsistent.
i
19-84
Review (cont.)
The asymptotic variance of IV is
1 2
p lim zi
1 2
n
n
1
p lim zi xi
n
1 2 Var(Z i )
n Cov(Z i , X i )2
19-85
Review (cont.)
To estimate a multiple regression
consistently, we need at least one
instrumental variable for each
troublesome explanator.
19-86
Review (cont.)
When we have just enough instruments for
consistent estimation, we say the regression
equation is exactly identified.
When we have more than enough
instruments, the regression equation is
over identified.
When we do not have enough instruments,
the equation is under identified
(and inconsistent).
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reserved.
19-87