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Burcu Eke
UC3M
Endogeneity
Y = 0 + 1 X1 + 2 X2 + . . . + k Xk +
2
Endogeneity
3
Endogeneity Example 1: Measurement Error in
the Explanatory Variables
4
Endogeneity: Example 1
I Substituting X = X v1 , we get
Y = 0 + 1 X + 1 v1
| {z }
u
5
Endogeneity Example 2: Omission of
Explanatory Variables
6
Endogeneity Examples
7
Endogeneity Example 3: Simultaneity
8
Endogeneity Example 3a: Market Equilibrium
Model
I Consider the following system:
Y1 = 1 Y2 + 2 X1 + u1 (Demand)
Y2 = 3 Y1 + 4 X2 + 5 X3 + u2 (Supply)
I The endogenous variables are Y1 =quantity, Y2 =price are
determined by
the exogenous variables, X1 =rent, X2 =salary, and
X3= interest rate
and by the disturbances: u1 =demand shock, and
u2 =supply shock
I The variables Y1 and Y2 , both of which appeared on the
right hand side of the supply and demand equations, are
not orthogonal to their respective shocks:
E[Y1 |Y2 , X1 ] = 1 Y2 + 2 X1 + E[u1 |Y2 , X1 ]
| {z }
6=0
9
Endogeneity Example 3b: Production Function
10
Instrumental Variables
11
Instrumental Variables
12
Instrumental Variables
!
1X
p lim xi yi
n n
i
p lim 1 = !
n 1X 2
p lim xi
n n
i
!
1X
p lim xi (1 xi + i )
n n
i
= !
1X 2
p lim xi
n n
i
!
1 X
p lim x i i
n n
i C(X, )
= 1 + ! = 1 + 6= 1
1X 2 V (X)
p lim xi
n n
13 i
Instrumental Variables: Definition
I In the model:
Y = 0 + 1 X + (1)
, where C(X, ) 6= 0, in order to get consistent estimators
of 0 and 1 , we need additional information in the
form of additional variables.
14
Instrumental Variables: IV Estimation in the
Simple Model
C(Z, Y )
1 =
C(Z, X)
C(Z, Y )
0 = E[Y ] 1 E[X] = E[Y ] E[X]
C(Z, X)
15
Instrumental Variables: IV Estimation in the
Simple Model
0 = Y 1 X
I yi = Yi Y , xi = Xi X, and zi = Zi Z
16
Instrumental Variables: Properties of IV
Estimators in the Simple Model
I Provided that (a) and (b) hold, the IV estimator will be a
consistent estimator:
!
1X
p lim zi yi
n n
i
p lim 1 = !
n 1X 2
p lim zi
n n
i
!
1X
p lim zi (1 zi + i )
n n
i
= !
1X 2
p lim zi
n n
i
C(Z, )
= = 1 + = 1
V (Z)
17
Instrumental Variables: Properties of IV
Estimators in the Simple Model, (a)
18
Instrumental Variables: Properties of IV
Estimators in the Simple Model, (b)
19
Instrumental Variables: The Variance of the IV
Estimator
2 SZ2 2
S2 V 1 = 2 = 2 S2
1 nSZX nrZX X
SZX
where rZX = , is the sample correlation coefficient
SZ SX
between X and Z, which measures the degree of linear
relationship between X and Z in the sample.
20
Instrumental Variables: The Variance of the IV
Estimator
2
S2 = 2
1 nSX
1P 2
where 2 =
n i i
21
Instrumental Variables: The Variance of the IV
Estimator
22
Instrumental Variables: The Variance of the IV
Estimator
I If ZX = 1%
q = 0.01, thenqV (1 ) = 10000V (1 ), and
therefore, V (1 ) = 100 V (1 )
I If ZX = 10%
q = 0.1, then q V (1 ) = 100V (1 ), and
therefore, V (1 ) = 10 V (1 )
23
Instrumental Variables: The Variance of the IV
Estimator
24
Instrumental Variables: Inferences with the IV
Estimator
1 1 asy
N (0, 1)
S1
25
Instrumental Variables: Inferences with the IV
Estimator
1P 2
I where 2 = , and i = Yi 0 + 1 X = yi 1 xi
n i i
26
Instrumental Variables: Goodness of fit under
IV Estimation
27
IV versus OLS
28
Instrumental Variables: Inadequate Instruments
I The IV estimator is consistent if (a) C(Z, ) = 0 and (b)
C(Z, X) 6= 0.
30
Instrumental Variables: Inadequate Instruments
31
Instrumental Variables: Example of Inadequate
Instruments
32
Instrumental Variables: Example of Inadequate
Instruments
R2 0.0350
33
Instrumental Variables: Example of Inadequate
Instruments
Where
35
Instrumental Variables: Example of Inadequate
Instruments
36
Instrumental Variables: Example of Inadequate
Instruments
37
Instrumental Variables: Example of Inadequate
Instruments
38
Instrumental Variables: Example of Inadequate
Instruments
39
Generalization: The 2SLS Estimator for the
Simple Model
I Let the model be: Y = 0 + 1 X + such that
C(X, ) 6= 0,
42
Generalization: The 2SLS Estimator for the
Simple Model
43
Generalization: The 2SLS Estimator,
Interpretation of the Reduced Form
I If the instruments are valid and V (|Z1 , Z2 ) is
homoscedastic, it can be shown that the 2SLS estimators
are consistent and asymptomatically normal.
I That is:
X1 is an exogenous variable
But X2 is endogenous
45
Generalization: The 2SLS Estimator for the
Multiple Model
46
Generalization: The 2SLS Estimator for the
Multiple Model
47
Generalization: The 2SLS Estimator for the
Multiple Model
I In this case, Let Z1 and Z2 be such that
C(Z1 , ) = C(Z2 , ) = 0.
X1 = 10 + 11 X3 + 11 Z1 + 12 Z2 + v1
X2 = 20 + 21 X3 + 21 Z1 + 22 Z2 + v2
H0 : C(X, ) = 0 (exogenous)
H1 : C(X, ) 6= 0 (endogenous)
49
Test of Endogeneity: Hausman Test
C(X, ) = 0 C(v, ) = 0
Y = 0 + 1 X + v + (4)
50
Test of Endogeneity: Hausman Test
I Therefore, if you could estimate (4), we could test
H0 : = 0, which is equivalent to H0 : C(X, ) = 0.
Y = 0 + 1 X + v + 1 (5)
52
Test of Endogeneity: Hausman Test
I where
SSRr is the sum of the squares of the residuals of the
restricted model
SSRun is the sum of the squares of the residues of the full
model, which includes the residuals from each of the
reduced forms as additional regressors
r is the number of potential endogenous variables.
53
Hausman Test Example
X1 = 10 + 11 X3 + 11 Z1 + 12 Z2 + v1
X2 = 20 + 21 X3 + 21 Z1 + 22 Z2 + v2
54
Hausman Test Example
57
Testing Overidentification Restrictions: Sargan
Test
I Intuition of the test: the fitted values of this auxiliary
have zero mean and variance 2 . Under
regression, u, u
conditional homoscedasticity, asymptotically
P u 2
i 2 is the sum of squares of N (0, 1) random variables,
u
out of which only q r are independent. Hence, this
expression follows an asymptotic 2 distribution with q r
degrees of freedom
I In practice, we will replace u2 by its estimator
1 P 2
s2u = u
n i
I Therefore, this statistic also has the same distribution
X 2
u
= nRu2
1 P 2
i u
n i
58
Testing Overidentification Restrictions: Sargan
Test
59
Example: The Wage Equation
60
Example: The Wage Equation
61
Example: The Wage Equation, OLS estimation
62
Example: The Wage Equation, IV estimation (a
single instrument)
I Reduced form:
d = 9.799 + 0.282 educf, R2 = 0.196
educ
(0.198) (0.021)
63
Example: The Wage Equation, IV estimation (a
single instrument)
64
Example: The Wage Equation, IV estimation (a
single instrument)
I Hausman Test
65
Example: The Wage Equation, IV estimation
(multiple instruments)
66
Example: The Wage Equation, IV estimation
(multiple instruments)
67
Example: The Wage Equation, IV estimation
(multiple instruments)
I Sargan Test
68
Example: The Wage Equation, IV estimation
(multiple instruments)
69
Example: The Wage Equation, IV estimation
(multiple instruments)
70
Final Points
71
Final Points
72
Final Points
73