Instrumental Variables Regression (SW Ch.

10)
Three important threats to internal validity are: omitted variable bias from a variable that is correlated with X but is unobserved, so cannot be included in the regression; simultaneous causality bias (X causes Y, Y causes X); errors-in-variables bias (X is measured with error) Instrumental variables regression can eliminate bias from these three sources.
!-

The IV Estimator with a Single Regressor and a Single Instrument (SW Section 10.1) Yi " ! # Xi # ui $oosely, I% regression brea&s X into two parts: a part that might be correlated with u, and a part that is not. 'y isolating the part that is not correlated with u, it is possible to estimate . This is done using an instrumental variable, Zi, which is uncorrelated with ui.

!-(

 The instrumental variable detects movements in Xi that are uncorrelated with ui, and use these two estimate .

!-)

Terminolog ! endogeneit and e"ogeneit *n endogenous variable is one that is correlated with u *n exogenous variable is one that is uncorrelated with u Historical note: +,ndogenous- literally means +determined within the system,- that is, a variable that is .ointly determined with /, that is, a variable sub.ect to simultaneous causality. 0owever, this definition is narrow and I% regression can be used to address 1% bias and errors-in-variable bias, not .ust to simultaneous causality bias.
!-2

Two conditions #or a $alid instrument Yi " ! # Xi # ui 3or an instrumental variable (an +instrument-) Z to be valid, it must satisfy two conditions: . (. Instrument relevance: corr(Zi,Xi) ! Instrument exogeneity: corr(Zi,ui) " !

4uppose for now that you have such a Zi (we5ll discuss how to find instrumental variables later). 0ow can you use Zi to estimate 6
!-7

The IV Estimator% one X and one Z ,8planation 9 : Two 4tage $east 4:uares (T4$4) *s it sounds, T4$4 has two stages ; two regressions: ( ) 3irst isolates the part of X that is uncorrelated with u: regress X on Z using 1$4 Xi " ! # Z i # v i 'ecause Zi is uncorrelated with ui, ! # Zi is uncorrelated with ui. <e don5t &now ! or but we have estimated them, so=

( )

? , where X ? " >ompute the predicted values of Xi, X i i ?! # ? Zi, i " ,=,n.
!-@

? in the regression of interest: (() Aeplace Xi by X i ? using 1$4: regress Y on X i ? # ui Yi " ! # X i

(()

? is uncorrelated with ui in large samples, so 'ecause X i

the first least s:uares assumption holds Thus can be estimated by 1$4 using regression (() This argument relies on large samples (so ! and are

well estimated using regression ( )) This the resulting estimator is called the +Two 4tage
? TSLS . $east 4:uares- (T4$4) estimator,
!-B

Two Stage &east S'uares% ctd. 4uppose you have a valid instrument, Zi. 4tage :
? Aegress Xi on Zi, obtain the predicted values X i

4tage (:
? ; the coefficient on X ? is the T4$4 Aegress Yi on X i i ? TSLS . estimator, ? TSLS is a consistent estimator of . Then
!-C

The IV Estimator% one X and one Z% ctd. ,8planation 9(: (only) a little algebra Yi " ! # Xi # ui Thus, cov(Yi,Zi) " cov(! # Xi # ui,Zi) " cov(!,Zi) # cov( Xi,Zi) # cov(ui,Zi) " ! # cov( Xi,Zi) # ! " cov(Xi,Zi) where cov(ui,Zi) " ! (instrument e8ogeneity); thus
cov(Yi , Z i ) " cov( X i , Z i )
!-D

The IV Estimator% one X and one Z% ctd

cov(Yi , Z i ) " cov( X i , Z i )

The I% estimator replaces these population covariances with sample covariances:

? TSLS " sYZ , s XZ

sYZ and sXZ are the sample covariances. This is the T4$4 estimator ; .ust a different derivation.
!- !

Consistenc o# the TS&S estimator

? TSLS " sYZ s XZ
p

The sample covariances are consistent: sYZ cov(Y,Z) and sXZ cov(X,Z). Thus,
? TSLS " sYZ p cov(Y , Z ) " s XZ cov( X , Z )
p

The instrument relevance condition, cov(X,Z) !, ensures that you don5t divide by Eero. E"am(le )1! Su((l and demand #or butter
!-

I% regression was originally developed to estimate demand elasticities for agricultural goods, for e8ample butter: ln(Qibutter ) " ! # ln( Pi butter ) # ui " price elasticity of butter " percent change in :uantity for a F change in price (recall log-log specification discussion) Gata: observations on price and :uantity of butter for

different years The 1$4 regression of ln(Qibutter ) on ln( Pi butter ) suffers from simultaneous causality bias (why6)
!- (

4imultaneous causality bias in the 1$4 regression of ln(

Qibutter ) on ln( Pi butter ) arises because price and :uantity are

determined by the interaction of demand and supply

!- )

This interaction of demand and supply produces=

Would a regression using these data produce the de and curve!

!- 2

<hat would you get if only supply shifted6

T4$4 estimates the demand curve by isolating shifts in price and :uantity that arise from shifts in supply. Z is a variable that shifts supply but not demand.
!- 7

T4$4 in the supply-demand e8ample: ln(Qibutter ) " ! # ln( Pi butter ) # ui $et Z " rainfall in dairy-producing regions. Is Z a valid instrument6 ( ) ,8ogenous6 corr(raini,ui) " !6 Plausibly: whether it rains in dairy-producing regions shouldn5t affect demand (() Aelevant6 corr(raini,ln( Pi )) !6 Plausibly: insufficient rainfall means less graEing means less butter
!- @

butter

TS&S in the su((l *demand e"am(le% ctd. ln(Qibutter ) " ! # ln( Pi butter ) # ui Zi " raini " rainfall in dairy-producing regions.
P butter ) 4tage : regress ln( Pi butter ) on rain, get ln( i P butter ) isolates changes in log price that arise ln( i

from supply (part of supply, at least)

P butter ) 4tage (: regress ln(Qibutter ) on ln( i

The regression counterpart of using shifts in the supply curve to trace out the demand curve.
!- B

E"am(le )+! Test scores and class si,e The >alifornia regressions still could have 1% bias (e.g. parental involvement). This bias could be eliminated by using I% regression (T4$4). I% regression re:uires a valid instrument, that is, an instrument that is: ( ) relevant: corr(Zi,ST"i) ! (() e8ogenous: corr(Zi,ui) " !

!- C

E"am(le )+! Test scores and class si,e% ctd. 0ere is a (hypothetical) instrument: some districts, randomly hit by an earth:ua&e, +double up- classrooms: Zi " Qua#ei " if hit by :ua&e, " ! otherwise

$o the two conditions %or a valid instru ent hold6 The earth:ua&e ma&es it as i% the districts were in a random assignment e8periment. Thus the variation in ST" arising from the earth:ua&e is e8ogenous. The first stage of T4$4 regresses ST" against Qua#e, thereby isolating the part of ST" that is e8ogenous (the part that is +as if- randomly assigned) We&ll go through other e'a ples later(
!- D

In#erence using TS&S In large samples, the sampling distribution of the T4$4 estimator is normal Inference (hypothesis tests, confidence intervals) proceeds in the usual way, e.g. .D@S) The idea behind the large-sample normal distribution of the T4$4 estimator is that ; li&e all the other estimators we have considered ; it involves an average of mean Eero i.i.d. random variables, to which we can apply the >$T. 0ere is a s&etch of the math (see 4< *pp. !.) for the details)...
!-(!

TSLS

sYZ n " " s XZ n

(Y Y )( Z ( X
i= i= n i i

Z)

X )( Z i Z )

How substitute in Yi " ! # Xi # ui and simplify: 3irst, Yi ; Y " (Xi ; X ) # (ui ; u ) so

n

(Y Y )( Z
i= i

Z) "
n i

I ( X
i=

X ) + (u i u )J( Z i Z )

"

( X
i=

X )( Z i Z ) +

(u u )( Z
i= i

Z ).

!-(

Thus
? TSLS " n n

(Y Y )( Z ( X
i= i i= n i i

Z)

X )( Z i Z ) n

"

( X
i= n

X )( Z i Z ) + n

(u u )( Z
i= i

Z)

( X
i= i

X )( Z i Z )

" #

n n

(u u )( Z ( X
i= i= n i i

Z)

X )( Z i Z )

4ubtract from each side and you get,

!-((

n TSLS ? ; " n

(u u )( Z ( X
i= i= n i i

Z)

X )( Z i Z )

Kultiplying through by n and ma&ing the appro8imation that n

n

n yields: Z)

? TSLS ; ) n (

(u u )( Z n (X n
i= n i= i i

X )( Z i Z )

!-()

? TSLS ; ) n (

(u u )( Z n (X n
i= n i= i i

Z)

X )( Z i Z )

3irst consider the numerator: in large samples,

(u u )( Z n
i= i n i

Z ) is dist5d *(!,varI(Z;Z)uJ)

He8t consider the denominator:

( X i X )( Z i Z ) cov(X,Z) by the $$H n
p i= n

where cov(X,Z) ! because the instrument is relevant (by assumption) (What i% it isn&t relevant! +ore later.)
!-(2

Lut this together:

? TSLS ; ) n (
n

(u u )( Z n (X n
i= p n i= i i

Z)

X )( Z i Z )

( X i X )( Z i Z ) cov(X,Z) n
i=

(u u )( Z n
i= i

Z ) is dist5d *(!,varI(Z;Z)uJ)

4o finally:
( TSLS ? is appro8. distributed *( , ? TSLS ),

where

( ? TSLS

varI( Z i Z )ui J " . n Icov( Z i , X i )J(

!-(7

In#erence using TS&S% ctd.

( TSLS ? is appro8. distributed *( , ? TSLS ),

4tatistical inference proceeds in the usual way. The .ustification is (as usual) based on large samples This all assumes that the instruments are valid ; we5ll discuss what happens if they aren5t valid shortly. Important note on standard errors:
o

The 1$4 standard errors from the second stage regression aren5t right ; they don5t ta&e into account
? is estimated). the estimation in the first stage ( X i

o Instead, use a single specialiEed command that computes the T4$4 estimator and the correct S)s.
!-(@

o as usual, use heteros&edasticity-robust S)s - com(lete digression! The earl histor o# IV regression 0ow much money would be raised by an import tariff on animal and vegetable oils (butter, fla8seed oil, soy oil, etc.)6 To do this calculation you need to &now the elasticities of supply and demand, both domestic and foreign This problem was first solved in *ppendi8 ' of <right ( D(C), +The Tariff on *nimal and %egetable 1ils.!-(B

3igure 2, p. (D@, from *ppendi8 ' ( D(C):

!-(C

<ho wrote *ppendi8 ' of Lhilip <right ( D(C)6 =this appendi8 is thought to have been written with or by his son, 4ewall <right, an important statistician. (4<, p. ))2) <ho were these guys and what5s their story6

!-(D

.hili( Wright (1/01*1123) obscure econo ist and poet K* 0arvard, ,con, CCB $ecturer, 0arvard, D )- D B

Sewall Wright (1//1*11//) %a ous genetic statistician 4cG 0arvard, 'iology, D 7 Lrof., M. >hicago, D)!- D72
!-)!

Example! 4emand #or Cigarettes 0ow much will a hypothetical cigarette ta8 reduce cigarette consumption6 To answer this, we need the elasticity of demand for cigarettes, that is, , in the regression, ln(Qicigarettes ) " ! # ln( Pi cigarettes ) # ui <ill the 1$4 estimator plausibly be unbiased6 Why or why not!

!-)

Example! Cigarette demand% ctd. ln(Qicigarettes ) " ! # ln( Pi cigarettes ) # ui Lanel data: *nnual cigarette consumption and average prices paid (including ta8) 2C continental M4 states, DC7- DD7 Lroposed instrumental variable: Zi " general sales ta8 per pac& in the state " SalesTa'i Is this a valid instrument6 ( ) Aelevant6 corr(SalesTa'i, ln( Pi )) !6 (() ,8ogenous6 corr(SalesTa'i,ui) " !6
!-)(

cigarettes

3or now, use data for DD7 only. 3irst stage 1$4 regression:
P cigarettes ) " 2.@) # .!) SalesTa'i, n " 2C ln( i

4econd stage 1$4 regression:

Q cigarettes ) " D.B( ; .!C ln( P cigarettes ) , n " 2C ln( i i

>ombined regression with correct, heteros&edasticityrobust standard errors:

Q cigarettes ) " D.B( ; .!C ln( P cigarettes ) , n " 2C ln( i i

( .7)) (!.)()
!-))

ST,T, Example! Cigarette demand% 5irst stage Instrument " Z " rta'so " general sales ta8 (real NOpac&)
X Z . reg lravgprs rtaxso if year==1995, r; Regression with robust standard errors Number of obs = "# 1, $% = (rob ) " = R*s+uared = Root -./ = ! &.'9 &.&&&& &. ,1& .&9'9

****************************************************************************** 0 Robust lravgprs 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** rtaxso 0 .&'&,7!9 .&& !'5 $.'5 &.&&& .&7&995$ .& & $71 89ons 0 .$1$5 $ .&7!91,, 159.$ &.&&& .55!''! .$, ,55 ****************************************************************************** X-hat . predi9t lravphat; Now we have the predicted values from the 1st stage

!-)2

Second stage
Y X-hat . reg lpa9:p9 lravphat if year==1995, r; Regression with robust standard errors Number of obs = "# 1, $% = (rob ) " = R*s+uared = Root -./ = 1&.5 &.&&77 &.1575 .77$ 5 !

****************************************************************************** 0 Robust lpa9:p9 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** lravphat 0 *1.&!'5!$ .'''$9 9 *'.75 &.&&7 *1.,557,9 *. 11!9'7 89ons 0 9.,19!,5 1.59,119 $.&9 &.&&& $.5&5& 7 17.9' ,1 ******************************************************************************

These coefficients are the T4$4 estimates The standard errors are wrong because they ignore the fact that the first stage was estimated
!-)7

>ombined into a single command:

Y X Z . ivreg lpa9:p9 #lravgprs = rtaxso% if year==1995, r; 4; #7.<.% regression with robust standard errors Number of obs = "# 1, $% = (rob ) " = R*s+uared = Root -./ = ! 11.5 &.&&1 &. &11 .19&'5

****************************************************************************** 0 Robust lpa9:p9 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** lravgprs 0 *1.&!'5!, .'1!91!' *'. & &.&&1 *1.,755'$ *. 1$',' 89ons 0 9.,19!,$ 1.57!'77 $.'$ &.&&& $.$ '575 17.,9$7' ****************************************************************************** 4nstrumented= lravgprs This is the endogenous regressor 4nstruments= rtaxso This is the instrumental varible ****************************************************************************** OK, the change in the SEs was small this time...but not always!

Q cigarettes ) " D.B( ; .!C ln( P cigarettes ) , n " 2C ln( i i

( .7)) (!.)()
!-)@

Summar o# IV Regression with a Single X and Z * valid instrument Z must satisfy two conditions: ( ) relevance: corr(Zi,Xi) ! (() e'ogeneity: corr(Zi,ui) " ! ? , then T4$4 proceeds by first regressing X on Z to get X ?. regressing Y on X variation in X that is uncorrelated with u If the instrument is valid, then the large-sample sampling distribution of the T4$4 estimator is normal, so inference proceeds as usual
!-)B

The &ey idea is that the first stage isolates part of the

The 6eneral IV Regression 7odel (SW Section 10.+) 4o far we have considered I% regression with a single endogenous regressor (X) and a single instrument (Z). <e need to e8tend this to: o multiple endogenous regressors (X ,=,X#) o multiple included e8ogenous variables (W ,=,Wr) These need to be included for the usual 1% reason o multiple instrumental variables (Z ,=,Z ) Kore (relevant) instruments can produce a smaller variance of T4$4: the "( of the first stage ?. increases, so you have more variation in X
!-)C

E"am(le! cigarette demand *nother determinant of cigarette demand is income; omitting income could result in omitted variable bias >igarette demand with one X, one W, and ( instruments (( Z5s):
cigarettes cigarettes Q P ln( i ) " ! # ln( i ) # (ln(-nco ei) # ui

Z i " general sales ta8 component onlyi Z(i " cigarette-specific ta8 component onlyi 1ther W5s might be state effects andOor year effects (in panel data. later=)
!-)D

The general IV regression model! notation and 8argon Yi " ! # X i # = # #X#i # ## W i # = # #/rWri # ui Yi is the dependent variable X i,=, X#i are the endogenous regressors (potentially correlated with ui) W i,=,Wri are the included exogenous variables or included exogenous regressors (uncorrelated with ui) !, ,=, #/r are the un&nown regression coefficients Z i,=,Z i are the instrumental variables (the excluded exogenous variables)
!-2!

The general IV regression model% ctd. Yi " ! # X i # = # #X#i # ## W i # = # #/rWri # ui <e need to introduce some new concepts and to e8tend some old concepts to the general I% regression model: Terminology: identi%ication and overidenti%ication T4$4 with included e8ogenous variables o one endogenous regressor o multiple endogenous regressors *ssumptions that underlie the normal sampling distribution of T4$4 o Instrument validity (relevance and e8ogeneity)
!-2

o Peneral I% regression assumptions

!-2(

Identi#ication In general, a parameter is said to be identified if different values of the parameter would produce different distributions of the data. In I% regression, whether the coefficients are identified depends on the relation between the number of instruments ( ) and the number of endogenous regressors (#) Intuitively, if there are fewer instruments than endogenous regressors, we can5t estimate ,=,# 3or e8ample, suppose # " but " ! (no instruments)Q
!-2)

Identi#ication% ctd. The coefficients ,=,# are said to be: exactly identified if =,#0 overidentified if R #. There are more than enough instruments to estimate " #. There are .ust enough instruments to estimate ,

,=,#0 -% so. you can test whether the instru ents are valid (a test o% the 1overidenti%ying restrictions-) 2 we&ll return to this later underidentified if S #.

!-22

There are too few enough instruments to estimate , =,#0 -% so. you need to get ore instru ents3

!-27

6eneral IV regression! TS&S% 1 endogenous regressor Yi " ! # X i # (W i # = # /rWri # ui Instruments: Z i,=,Z 3irst stage o Aegress X on all the e8ogenous regressors: regress X on W ,=,Wr,Z ,=,Zm by 1$4
o

? , i " ,=,n >ompute predicted values X i ? ,W ,=,Wr by 1$4 Aegress Y on X

4econd stage
o

o The coefficients from this second stage regression are the T4$4 estimators, but S)s are wrong
!-2@

 To get correct S)s, do this in a single step

!-2B

Example! 4emand #or cigarettes ln(Qicigarettes ) " ! # ln( Pi cigarettes ) # (ln(-nco ei) # ui Z i " general sales ta8i Z(i " cigarette-specific ta8i

cigarettes P ,ndogenous variable: ln( i ) (+one X-)

Included e8ogenous variable: ln(-nco ei) (+one W-) Instruments (e8cluded endogenous variables): general sales ta8, cigarette-specific ta8 (+two Zs-) -s the de and elasticity overidenti%ied. e'actly identi%ied. or underidenti%ied!
!-2C

Example! Cigarette demand% one instrument

Y W X Z . ivreg lpa9:p9 lperin9 #lravgprs = rtaxso% if year==1995, r; 4; #7.<.% regression with robust standard errors Number of obs = "# 7, 5% = (rob ) " = R*s+uared = Root -./ = ! !.19 &.&&&9 &. 1!9 .1!95,

****************************************************************************** 0 Robust lpa9:p9 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** lravgprs 0 *1.1 '',5 .',7'&75 *'.&, &.&& *1.!9'7'1 *.'9'5191 lperin9 0 .71 515 .'11, $, &.$9 &. 95 *. 1'',5 .! 7 &5 89ons 0 9. '&$5! 1.759'97 ,. 9 &.&&& $.!9 117 11.9$,7 ****************************************************************************** 4nstrumented= lravgprs 4nstruments= lperin9 rtaxso STATA lists A the e!ogenous regressors as instruments " slightl# different terminolog# than we have been using . ******************************************************************************

Aunning I% as a single command yields correct S)s

!-2D

 Mse , r for heteros&edasticity-robust S)s

!-7!

Example! Cigarette demand% two instruments

Y W X Z1 Z7 . ivreg lpa9:p9 lperin9 #lravgprs = rtaxso rtax% if year==1995, r; 4; #7.<.% regression with robust standard errors Number of obs = "# 7, 5% = (rob ) " = R*s+uared = Root -./ = ! 1$.1, &.&&&& &. 79 .1!,!$

****************************************************************************** 0 Robust lpa9:p9 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** lravgprs 0 *1.7,, 7 .7 9$&99 *5.17 &.&&& *1.,!&1$ *.,, $!', lperin9 0 .7!& & 5 .75'!!9 1.1& &.7,5 *.7'&955 .,91,$ 1 89ons 0 9.!9 955 .95971$9 1&.'7 &.&&& ,.9$799' 11.!7$97 ****************************************************************************** 4nstrumented= lravgprs 4nstruments= lperin9 rtaxso rtax STATA lists A the e!ogenous regressors as $instruments% " slightl# different terminolog# than we have been using . ******************************************************************************

!-7

T4$4 estimates, Z " sales ta8 ( " )

Q cigarettes ) " D.2) ; . 2 ln( P cigarettes ) # !.( ln(-nco ei) ln( i i

( .(@) (!.)B)

(!.) )

T4$4 estimates, Z " sales ta8, cig-only ta8 ( " ()

Q cigarettes ) " D.CD ; .(C ln( P cigarettes ) # !.(Cln(-nco ei) ln( i i

(!.D@) (!.(7) 4maller S)s for

(!.(7)

" (. Msing ( instruments gives more

information ; more +as-if random variation-. $ow income elasticity (not a lu8ury good); income elasticity not statistically significantly different from !
!-7(

 4urprisingly high price elasticity 6eneral IV regression! TS&S with multi(le endogenous regressors Yi " ! # X i # = # #X#i # ## W i # = # #/rWri # ui Instruments: Z i,=,Z How there are # first stage regressions: o Aegress X on W ,=, Wr, Z ,=, Z by 1$4
o

? , i " ,=,n >ompute predicted values X i ? , i " ,=,n >ompute predicted values X (i
!-7)

o Aegress X( on W ,=, Wr, Z ,=, Z by 1$4

o

? , X ? ,=, X ? Aepeat for all X5s, obtaining X i (i #i

!-72

TS&S with multi(le endogenous regressors% ctd. 4econd stage

o

? , X ? ,=, X ? , W ,=, Wr by 1$4 Aegress Y on X i (i #i

o The coefficients from this second stage regression are the T4$4 estimators, but S)s are wrong To get correct S)s, do this in a single step What would happen in the second stage regression i% the coe%%icients were underidenti%ied 4that is. i% 5instru ents 6 5endogenous variables78 %or e'a ple. i% # 9 :. 9 ;!

!-77

Sam(ling distribution o# the TS&S estimator in the general IV regression model Keaning of +valid- instruments in the general case The I% regression assumptions Implications: if the I% regression assumptions hold, then the T4$4 estimator is normally distributed, and inference (testing, confidence intervals) proceeds as usual

!-7@

- 9$alid: set o# instruments in the general case The set of instruments must be relevant and e8ogenous: . Instrument relevance: Special case o% one X *t least one instrument must enter the population counterpart of the first stage regression. (. Instrument e8ogeneity All the instruments are uncorrelated with the error term: corr(Z i,ui) " !,=, corr(Z ,ui) " !

!-7B

9Valid: instruments in the general case% ctd. ( ) Peneral instrument relevance condition: <eneral case. ultiple X&s 4uppose the second stage regression could be run using the predicted values from the population first stage regression. Then: there is no perfect multicollinearity in this (infeasible) second stage regression Special case o% one X *t least one instrument must enter the population counterpart of the first stage regression.
!-7C

The IV Regression -ssum(tions Yi " ! # X i # = # #X#i # ## W i # = # #/rWri # ui . )(uiTW i,=,Wri) " ! (. (Yi,X i,=,X#i,W i,=,Wri,Z i,=,Z i) are i.i.d. ). The X5s, W5s, Z5s, and Y have nonEero, finite 2th moments 2. The W5s are not perfectly multicollinear 7. The instruments (Z i,=,Z i) satisfy the conditions for a valid set of instruments. 9 says +the e8ogenous regressors are e8ogenous. 9( ; 92 are not new; we have discussed 97.
!-7D

Im(lications! Sam(ling distribution o# TS&S If the I% regression assumptions hold, then the T4$4 estimator is normally distributed in large samples. Inference (hypothesis testing, confidence intervals) proceeds as usual. Two notes about standard errors: o The second stage S)s are incorrect because they don5t ta&e into account estimation in the first stage; to get correct S)s, run T4$4 in a single command o Mse heteros&edasticity-robust S)s, for the usual reason. ,ll this hinges on having valid instru ents(
!-@!

Chec;ing Instrument Validit (SW Section 10.2) Aecall the two re:uirements for valid instruments: . "elevance (special case of one U) *t least one instrument must enter the population counterpart of the first stage regression. (. )'ogeneity All the instruments must be uncorrelated with the error term: corr(Z i,ui) " !,=, corr(Z i,ui) " ! What happens i% one o% these re=uire ents isn&t satis%ied! How can you chec#! ,nd what do you do!
!-@

Chec;ing -ssum(tion )1! Instrument Rele$ance <e will focus on a single included endogenous regressor: Yi " ! # Xi # (W i # = # /rWri # ui 3irst stage regression: Xi " ! # Z i #=# iZ i #
# i

W i #=#

##i

W#i # ui

The instruments are relevant if at least one of ,=, are nonEero. The instruments are said to be weak if all the ,=, are either Eero or nearly Eero. Weak instruments e8plain very little of the variation in X, beyond that e8plained by the W5s
!-@(

What are the conse'uences o# wea; instruments< >onsider the simplest case: Yi " ! # Xi # ui Xi " ! # Zi # ui
? TSLS " The I% estimator is sYZ s XZ

If cov(X,Z) is Eero or small, then sXZ will be small: <ith wea& instruments, the denominator is nearly Eero.

? TSLS (and its tIf so, the sampling distribution of

statistic) is not well appro8imated by its large-n normal appro8imation=

!-@)

-n e"am(le! the distribution o# the TS&S t*statistic with wea; instruments

Gar& line " irrelevant instruments Gashed light line " strong instruments
!-@2

Why does our trusty normal approximation fail us! !

? TSLS "

sYZ s XZ

If cov(X.Z) is small, small changes in sXZ (from one

? TSLS sample to the ne8t) can induce big changes in

4uppose in one sample you calculate sXZ " .!!!! Q

Thus the large-n normal appro8imation is a poor

? TSLS appro8imation to the sampling distribution of ? TSLS is distributed as the * better appro8imation is that

ratio of two correlated normal random variables (see 4< *pp. !.2) If instruments are wea&, the usual methods of inference are unreliable ; potentially very unreliable.
!-@7

7easuring the strength o# instruments in (ractice! The #irst*stage !*statistic The first stage regression (one X): Aegress X on Z ,..,Z ,W ,=,W#. Totally irrelevant instruments all the coefficients on Z ,=,Z are Eero. The first"stage !"statistic tests the hypothesis that Z , =,Z do not enter the first stage regression. <ea& instruments imply a small first stage >-statistic.

!-@@

Chec;ing #or wea; instruments with a single X >ompute the first-stage >-statistic. #ule"of"thumb$ If the first stage !"statistic is less than %&' then the set of instruments is weak( If so, the T4$4 estimator will be biased, and statistical inferences (standard errors, hypothesis tests, confidence intervals) can be misleading. Hote that simply re.ecting the null hypothesis of that the coefficients on the Z5s are Eero isn5t enough ; you actually need substantial predictive content for the normal appro8imation to be a good one. There are more sophisticated things to do than .ust compare > to ! but they are beyond this course.
!-@B

What to do i# ou ha$e wea; instruments< Pet better instruments (Q) If you have many instruments, some are probably wea&er than others and it5s a good idea to drop the wea&er ones (dropping an irrelevant instrument will increase the first-stage >) Mse a different I% estimator instead of T4$4 o There are many I% estimators available when the coefficients are overidentified. o $imited information ma8imum li&elihood has been found to be less affected to wea& instruments. o all this is beyond the scope o% this course(
!-@C

Chec;ing -ssum(tion )+! Instrument E"ogeneit Instrument e8ogeneity: All the instruments are uncorrelated with the error term: corr(Z i,ui) " !,=, corr(Z i,ui) " ! If the instruments aren5t correlated with the error term, the first stage of T4$4 doesn5t successfully isolate a component of X that is uncorrelated with the ? is correlated with u and T4$4 is error term, so X inconsistent. regressors, it is possible to test ; partially ; for instrument e8ogeneity.
!-@D

If there are more instruments than endogenous

Testing o$eridenti# ing restrictions >onsider the simplest case: Yi " ! # Xi # ui, 4uppose there are two valid instruments: Z i, Z(i Then you could compute two separate T4$4 estimates. Intuitively, if these ( T4$4 estimates are very different from each other, then something must be wrong: one or the other (or both) of the instruments must be invalid. The ?-test of overidentifying restrictions ma&es this comparison in a statistically precise way. This can only be done if 9Z5s R 9X5s (overidentified).
!-B!

4uppose 9instruments "

R 9 X5s " # (overidentified)

Yi " ! # X i # = # #X#i # ## W i # = # #/rWri # ui The )*test o# o$eridenti# ing restrictions . 3irst estimate the e:uation of interest using T4$4 and all
?, instruments; compute the predicted values Y i ? 5s used to estimate the using the actual X5s (not the X second stage)
(. ).

? ?i " Yi ; Y >ompute the residuals u i

?i against Z i,=,Z i, W i,=,Wri Aegress u 2. >ompute the >-statistic testing the hypothesis that the coefficients on Z i,=,Z i are all Eero; 7. The )"statistic is ? " >
!-B

? " >, where > " the >-statistic testing the coefficients on Z i,=,Z i in a regression of the T4$4 residuals against Z i,=,Z i, W i,=,Wri. 4istribution o# the )*statistic Mnder the null hypothesis that all the instruments are e8ogeneous, ? has a chi-s:uared distribution with ;# degrees of freedom If " #, ? " ! (does this a#e sense!) If some instruments are e8ogenous and others are endogenous, the ? statistic will be large, and the null hypothesis that all instruments are e8ogenous will be re.ected.
!-B(

-((lication to the 4emand #or Cigarettes (SW Section 10.3) <hy are we interested in &nowing the elasticity of demand for cigarettes6 Theory of optimal ta8ation: optimal ta8 is inverse to elasticity: smaller deadweight loss if :uantity is affected less. ,8ternalities of smo&ing ; role for government intervention to discourage smo&ing o second-hand smo&e (non-monetary) o monetary e8ternalities
!-B)

.anel data set *nnual cigarette consumption, average prices paid by end consumer (including ta8), personal income 2C continental M4 states, DC7- DD7 Estimation strateg 0aving panel data allows us to control for unobserved state-level characteristics that enter the demand for cigarettes, as long as they don5t vary over time 'ut we still need to use I% estimation methods to handle the simultaneous causality bias that arises from the interaction of supply and demand.
!-B2

5i"ed*e##ects model o# cigarette demand

cigarettes ln(Qit ) " i # ln( Pitcigarettes ) # (ln(-nco eit) # uit

i " ,=,2C, t " DC7, DC@,=, DD7 i reflects unobserved omitted factors that vary across

states but not over time, e.g. attitude towards smo&ing 4till, corr(ln( Pitcigarettes ),uit) is plausibly nonEero because of supplyOdemand interactions o Mse panel data regression methods to eliminate i o Mse T4$4 to handle simultaneous causality bias
!-B7

,stimation strategy:

.anel data IV regression! two a((roaches (a) The +n- binary indicators- method (b) The +changes- method (when T"() (a) The 9n*1 binar indicators: method Aewrite
cigarettes cigarettes Q P ln( it ) " i # ln( it ) # (ln(-nco eit) # uit

as
cigarettes ln(Qit ) " ! # ln( Pitcigarettes ) # (ln(-nco eit)

# ($(it # = # 2C$2Cit # uit Instruments: Z it " general sales ta8it

!-B@

Z(it " cigarette-specific ta8it

!-BB

This now fits in the general I% regression model:

cigarettes ln(Qit ) " ! # ln( Pitcigarettes ) # (ln(-nco eit)

# ($(it # = # 2C$2Cit # uit

X (endogenous regressor) " ln( Pitcigarettes ) ln(-nco eit), $(it,=, $2Cit

2C W5s (included e8ogenous regressors) " Two instruments " Z it, Z(it How estimate this full model using T4$4Q

!-BC

 *n issue arises when dynamic response (lagged ad.ustment) is important, as it is here ; it ta&es time to &ic& smo&ing ; how to model lagged effects6 (b) The 9changes: method (when *=+) 1ne way to model long-term effects is to consider !year changes, between DC7 and DD7 Aewrite the regression in +changes- form:
cigarettes Q ln(Qicigarettes ) ; ln( ) DD7 i DC7 cigarettes cigarettes P P " Iln( i DD7 ) ; ln( i DC7 )J

#(Iln(-nco ei DD7) ; ln(-nco ei DC7)J # (ui DD7 ; ui DC7) Kust create + !-year change- variables, for e8ample:
!-BD

!-year change in log price " ln(Pi DD7) ; ln(Pi DC7) Then estimate the demand elasticity by T4$4 using !year changes in the instrumental variables <e5ll ta&e this approach

!-C!

+*A*A$ ,igarette demand 5irst create 910* ear change: $ariables !-year change in log price " ln(Pit) ; ln(Pit; !) " ln(PitOPit; !)
. . . . . . gen gen gen gen gen gen dlpa9:p9 = log#pa9:p9>pa9:p928n*1&5%; dlavgprs = log#avgprs>avgprs28n*1&5%; dlperin9 = log#perin9>perin928n*1&5%; drtaxs = rtaxs*rtaxs28n*1&5; drtax = rtax*rtax28n*1&5; drtaxso = rtaxso*rtaxso28n*1&5; &n-1' is the 1'-#r lagged value

!-C

>se TS&S to estimate the demand elasticit b using the 910* ear changes: s(eci#ication
Y W X Z . ivreg dlpa9:p9 dlperin9 #dlavgprs = drtaxso% , r; 4; #7.<.% regression with robust standard errors Number of obs = "# 7, 5% = (rob ) " = R*s+uared = Root -./ = ! 17.'1 &.&&&1 &.5 99 .&9&97

****************************************************************************** 0 Robust dlpa9:p9 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** dlavgprs 0 *.9'!&1 ' .7&,5&77 * .57 &.&&& *1.'559 5 *.57&&!' dlperin9 0 .5759$9' .''9 9 7 1.55 &.17! *.15,!&,1 1.7&9, $ 89ons 0 .7&!5 97 .1'&779 1.$& &.11$ *.&5', $' . ,&! $ ****************************************************************************** 4nstrumented= dlavgprs 4nstruments= dlperin9 drtaxso ****************************************************************************** N(T)* - All the variables " Y+ X+ W+ and Z,s " are in 1'-#ear changes - )stimated elasticit# - "./0 1S) - .213 " surprisingl# elastic4 - 5ncome elasticit# small+ not statisticall# different from 6ero - 7ust chec8 whether the instrument is relevant9
!-C(

Chec; instrument rele$ance! com(ute #irst*stage !

. reg dlavgprs drtaxso dlperin9 , r; Number of obs = "# 7, 5% = (rob ) " = R*s+uared = Root -./ = ! 1$.! &.&&&& &.51 $ .&$'' Regression with robust standard errors

****************************************************************************** 0 Robust dlavgprs 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** drtaxso 0 .&75 $11 .&& '!,$ 5.!& &.&&& .&1$$7 .&' 79!7 dlperin9 0 *.77 1&', .71!!!15 *1.&7 &.'11 *.$$ 95'$ .71$, $' 89ons 0 .5'719 ! .&795'15 1!.&7 &.&&& . ,7,15' .591$, 7 ****************************************************************************** . test drtaxso; We didn,t need to run $test% here because with m-1 instrument+ the # 1% drtaxso = & :-statistic is the s;uare of the t-statistic+ that is+ "# 1, 5% = ''.$, <.='><.=' - ??.@A (rob ) " = &.&&&& :irst stage : = ''., ) 1& so instrument is not wea:

!-C)

Can we chec; instrument e"ogeneit < -o.m = k What about two instruments (cig*onl ta"% sales ta")<
. ivreg dlpa9:p9 dlperin9 #dlavgprs = drtaxso drtax% , r; 4; #7.<.% regression with robust standard errors Number of obs = "# 7, 5% = (rob ) " = R*s+uared = Root -./ = ! 71.'& &.&&&& &.5 $$ .&9175

****************************************************************************** 0 Robust dlpa9:p9 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** dlavgprs 0 *1.7&7 &' .19$9 '' *$.11 &.&&& *1.599&$! *.!&5,'97 dlperin9 0 . $7&799 .'&9' &5 1. 9 &.1 7 *.1$1&1'! 1.&!5&, 89ons 0 .'$$5'!! .171917$ '.&1 &.&& .17&99 7 .$17&!' ****************************************************************************** 4nstrumented= dlavgprs 4nstruments= dlperin9 drtaxso drtax ****************************************************************************** drtaxso = general sales tax only drtax = 9igarette*spe9ifi9 tax only /stimated elasti9ity is *1.7, even more elasti9 than using general sales tax only
!-C2

With m?k% we can test the o$eridenti# ing restrictions Test the o$eridenti# ing restrictions
. . predi9t e, resid; Bomputes predicted values for most recentl# estimated regression 1the previous TS S regression3 reg e drtaxso drtax dlperin9; Cegress e on Z,s and W,s Number of obs "# ', % (rob ) " R*s+uared ?d@ R*s+uared Root -./ = = = = = = ! 1.$ &.1979 &.1&&! &.&'95 .&!,51

.our9e 0 .. df -. *************6****************************** -odel 0 .&',,$91,$ ' .&175!9,75 Residual 0 .''$9577!9 .&&,$5!&&, *************6****************************** Aotal 0 .', ,71 $5 , .&&,9,7,9,

****************************************************************************** e 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** drtaxso 0 .&17,$$9 .&&$15!, 7.&, &.& .&&&'55 .&751,!9 drtax 0 *.&&'!&,, .&&711,9 *1.!& &.&,9 *.&&!&,$ .&&& $&, dlperin9 0 *.&9' &$7 .79,! 59 *&.'1 &.,55 *.$9'$,57 .5&$!$7, 89ons 0 .&&79'9 .& $1'1 &.&, &.9 ! *.&!$9,7! .&97!5&9 ****************************************************************************** . test drtaxso drtax; # 1% # 7% drtaxso = & drtax = & Bompute D-statistic+ which is m>:+ where : tests whether coefficients on
!-C7

the instruments are 6ero "# 7, % = 7. , (rob ) " = &.&9$$

so D = 7 7. , = .9' >> WACN5NE " this uses the wrong d.f. >>

The correct degrees of freedom for the ?-statistic is ;#: ? " >, where > " the >-statistic testing the coefficients on Z i,=,Z i in a regression of the T4$4 residuals against Z i,=,Z i, W i,=,W i. Mnder the null hypothesis that all the instruments are e8ogeneous, ? has a chi-s:uared distribution with ;# degrees of freedom 0ere, ? " 2.D), distributed chi-s:uared with d.f. " ; the 7F critical value is ).C2, so re.ect at 7F sig. level. In 4T*T*:
. dis BC*stat = B r#df%Dr#"% B p*value = B 9hiprob#r#df%*1,r#df%Dr#"%%;
!-C@

C*stat =

.9'19!5'

p*value = .&7$'$ &1 p*value from 9hi*s+uared#1% distribution

D - 2 2.0A - 0./?

!-CB

Chec; instrument rele$ance! com(ute #irst*stage !

. X Z1 Z2 W reg dlavgprs drtaxso drtax dlperin9 , r; Number of obs = "# ', % = (rob ) " = R*s+uared = Root -./ = ! $$.$! &.&&&& &.,,,9 .& ''' Regression with robust standard errors

****************************************************************************** 0 Robust dlavgprs 0 1oef. .td. /rr. t ()0t0 2953 1onf. 4nterval5 *************6**************************************************************** drtaxso 0 .&1' 5, .&&'1 &5 .7! &.&&& .&&,17,, .&19,!$' drtax 0 .&&,5,' .&&&!!59 !.55 &.&&& .&&5,!,9 .&&9'5!! dlperin9 0 *.&7!99 ' .17 7'&9 *&.7' &.!1, *.7,9'$5 .771',$, 89ons 0 . 919,'' .&1!'7'' 7$.!5 &.&&& . 55& 51 .57!9&15 ****************************************************************************** . test drtaxso drtax; # 1% # 7% drtaxso = & drtax = & "# 7, % = (rob ) " = !!.$7 &.&&&& !!.$7 ) 1& so instruments arenEt wea:

!-CC

Tabular summary of these results:

!-CD

@ow should we inter(ret the )*test re8ection< ?-test re.ects the null hypothesis that both the instruments are e8ogenous This means that either rta'so is endogenous, or rta' is endogenous, or both The ?-test doesn5t tell us whichQQ You ust thin#3 <hy might rta' (cig-only ta8) be endogenous6 o Lolitical forces: history of smo&ing or lots of smo&ers political pressure for low cigarette ta8es o If so, cig-only ta8 is endogenous This reasoning doesn5t apply to general sales ta8 use .ust one instrument, the general sales ta8
!-D!

The 4emand #or Cigarettes! Summar o# Em(irical Results Mse the estimated elasticity based on T4$4 with the general sales ta8 as the only instrument: ,lasticity " -.D2, S) " .( This elasticity is surprisingly large (not inelastic) ; a F increase in prices reduces cigarette sales by nearly F. This is much more elastic than conventional wisdom in the health economics literature. This is a long-run (ten-year change) elasticity. What would you e'pect a short@run 4one@year change7 elasticity to be 2 ore or less elastic!
!-D

What are the remaining threats to internal $alidit < 1mitted variable bias6 o Panel data esti ator8 probably AB 3unctional form mis-specification o 0mmm=should chec&= o * related :uestion is the interpretation of the elasticity: using !-year differences, the elasticity interpretation is long-term. Gifferent estimates would obtain using shorter differences.

!-D(

Remaining threats to internal $alidit % ctd. Aemaining simultaneous causality bias6 o Hot if the general sales ta8 a valid instrument: relevance6 e8ogeneity6 ,rrors-in-variables bias6 -nteresting =uestion: are we accurately easuring the price actually paid! What about cross@border sales! 4election bias6 (no. we have all the states) 1verall, this is a credible estimate of the long-term elasticity of demand although some problems might remain.
!-D)

Where 4o Valid Instruments Come 5rom< (SW Section 10.A) %alid instruments are ( ) relevant and (() e8ogenous 1ne general way to find instruments is to loo& for e8ogenous variation ; variation that is +as if- randomly assigned in a randomiEed e8periment ; that affects X. o Aainfall shifts the supply curve for butter but not the demand curve; rainfall is +as if- randomly assigned o 4ales ta8 shifts the supply curve for cigarettes but not the demand curve; sales ta8es are +as ifrandomly assigned
!-D2

 0ere is a final e8ample=

!-D7

E"am(le! Cardiac Catheteri,ation Goes cardiac catheteriEation improve longevity of heart attac& patients6 Yi " survival time (in days) of heart attac& patient Xi " if patient receives cardiac catheteriEation, " ! otherwise >linical trials show that CardCath affects Survival$ays. 'ut is the treatment effective +in the field-6
!-D@

Survival$aysi " ! # CardCathi # ui Is 1$4 unbiased6 The decision to treat a patient by cardiac catheteriEation is endogenous ; it is (was) made in the field by ,KT technician depends on ui (unobserved patient health characteristics) If healthier patients are catheteriEed, then 1$4 has simultaneous causality bias and 1$4 overstates overestimates the >> effect Lropose instrument: distance to the nearest >> hospital ; distance to the nearest +regular- hospital

!-DB

 Z " differential distance to >> hospital o Aelevant6 If a >> hospital is far away, patient won5t bet ta&en there and won5t get >> o ,8ogenous6 If distance to >> hospital doesn5t affect survival, other than through effect on CardCathi, then corr(distance,ui) " ! so e8ogenous o If patients location is random, then differential distance is +as if- randomly assigned. o The ;st stage is a linear probability odel: distance a%%ects the probability o% receiving treat ent Aesults (Kc>lellan, KcHeil, Hewhous, ?,+,, DD2): o 1$4 estimates significant and large effect of >> o T4$4 estimates a small, often insignificant effect
!-DC

Summar ! IV Regression (SW Section 10.0) * valid instrument lets us isolate a part of X that is uncorrelated with u, and that part can be used to estimate the effect of a change in X on Y I% regression hinges on having valid instruments: ( ) "elevance: chec& via first-stage > (() )'ogeneity: Test overidentifying restrictions via the ?-statistic * valid instrument isolates variation in X that is +as ifrandomly assigned. The critical re:uirement of at least valid instruments
!-DD

cannot be tested ; you ust use your head0