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Development Economics I Dr. Elisabetta Gentile: Orientation Tutorial

This document discusses issues that can arise when estimating causal relationships using regression analysis and how to address them. It notes that correlation does not imply causation and that endogeneity bias can occur if explanatory variables are correlated with the error term. To address endogeneity, the document recommends using instrumental variable estimation, which involves finding an instrument that is correlated with the endogenous explanatory variable but not with the error term. It provides examples of how instrumental variable estimation works and notes important assumptions about instrument exogeneity and relevance that must be tested.

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Chiew Jun Siew
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47 views11 pages

Development Economics I Dr. Elisabetta Gentile: Orientation Tutorial

This document discusses issues that can arise when estimating causal relationships using regression analysis and how to address them. It notes that correlation does not imply causation and that endogeneity bias can occur if explanatory variables are correlated with the error term. To address endogeneity, the document recommends using instrumental variable estimation, which involves finding an instrument that is correlated with the endogenous explanatory variable but not with the error term. It provides examples of how instrumental variable estimation works and notes important assumptions about instrument exogeneity and relevance that must be tested.

Uploaded by

Chiew Jun Siew
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Development Economics I

Dr. Elisabetta Gentile

orientation tutorial

Recall: correlation does not imply


causation!
A positive correlation between two variables, X and
Y, could be explained as:
X causes Y: the causation may be direct, or it may
operate through a chain of causal links;
Y causes X (reverse causation): one might think that X
causes Y when its really the opposite;
Causation runs in both directions;
There is no causal relationship between X and Y: some
third variable Z causes both X and Y.

Endogenous explanatory variables


Consider the following simple regression equation:
y = 0 + 1x + u
Estimate of 1 will be biased if:
1. reverse causation: xy and yx (e.g., policecrime
crimepolice), leading to simultaneity bias;
2. there is some omitted variable v that affects both y and x
(e.g., educationwage, but unobserved
abilityeducation and abilitywage);
3. one or more of the explanatory variables is measured
with error, leading to attenuation bias.

Addressing endogeneity
When faced with the prospect of unobserved endogeneity,
we can:
1. ignore the problem, and suffer the consequences of biased and
inconsistent estimators;
2. try to find and use a suitable proxy variable for the unobserved
variable (e.g., IQ is a good proxy for ability in the regression of
wage on education);
3. assume that the unobservables do not change over time, and use
fixed effects or first-differencing;
4. leave the unobserved variable in the error term, but use
instrumental variables estimation, (a.k.a. two-stage least squares,
or 2SLS), which recognizes the presence of the omitted variable.

Instrumental Variable (IV)


estimation
Consider the simple regression equation again:
y = 0 + 1x + u
Violation of the assumption that Cov(x,u) = 0 has
serious consequences for the OLS estimator:
when one or more of the explanatory variables is
correlated with the error term u, we have both E(u|x) 0
and E(xu) 0, so the OLS estimator will be both biased
and inconsistent.

Instrumental Variable (IV)


estimation
Suppose that we have an observable variable z
that satisfies the following assumptions:
1. Exogeneity: Cov(z,u) = 0; i.e. z should have no partial
effect on y (after x and omitted variables have been
controlled for), an z should be uncorrelated with the
omitted variable;
2. Relevance: Cov(z,x) 0; i.e. z must be related, either
positively or negatively, to the endogenous explanatory
variable x;

Then we call z an instrument for x.

Testing for instrument relevance


Because the exogeneity assumption involves the
covariance between z and the unobserved error u, we
cannot test it, but rather we make an argument for it;
The relevance assumption can (and will) be tested in all
empirical papers using IV estimation:
Estimate a simple regression between x and z:
x = 0 + 1z +
z fulfills the relevance assumption if we are able to reject the null
hypothesis that:
H0: 1 = 0 at a sufficiently small significance level (i.e. 5% or 1%).

How IV estimation works


Given the linear regression:
y = 0 + 1x1 + 2x2 + 3x3 + u
Assume Cov(x1,u) 0, but we have an instrument z:
Stage 1: regress x1 on z, x2 and x3, to obtain x1 :
x1 = 0 + 1z + 2x2 + 3 x3 +
Stage 2: plug the fitted values of x1 into the original linear
regression equation:
y = 0 + 1 x1+ 2x2 + 3x3 +
where is a composite error term that is uncorrelated
with x1, x2 and x3.
8

Sample table

Table X: the title will specify what regressions we are looking at


Model
(1)

Model
(2)

Model
(3)

Independent variable of
interest

Coefficient
(standard error)

Coefficient
(standard error)

Coefficient
(standard error)

Control 1

Coefficient
(standard error)

Coefficient
(standard error)

Coefficient
(standard error)

Control 2

Coefficient
(standard error)

Coefficient
(standard error)

Coefficient
(standard error)

Number

Number

Number

Y/N

Y/N

Y/N

Number of observations
Fixed effects

Statistical significance
The most common convention to convey statistical
significance is to place a number of stars next to
the estimated coefficient as follows:
* for 10% significance;
** for 5% significance;
*** for 1% significance;

Sometimes the Authors do not highlight statistically


significant coefficients in their tables:
In such cases, it is up to you to point out statistical
significance, at least for the independent variable of
interest.
10

Questions?

11

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