Endogeneity

The endogeneity problem
Proxy variables
Instrumental variables
STATA
Endogeneity
Gabriel V. Montes-Rojas
Gabriel Montes-Rojas Endogeneity

Proxy variables
STATA
Consider the wage equation model
log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

Proxy variables
STATA
Our primary interest is in the estimation of β 1 and β 2 .

However, we know that if abil is not observed, we would
obtain biased estimators of them (Why? See Omitted
Variables Bias).

Proxy variables
STATA

Variables Bias).
In practice, we can only estimate the model
log(wage ) = β 0 + β 1 educ + β 2 exper + v

Proxy variables
STATA

Variables Bias).
In practice, we can only estimate the model
log(wage ) = β 0 + β 1 educ + β 2 exper + v
Here, the main problem is that educ and exper are not
exogenous, or they are endogenous:
Cov (educ, v ) 6= 0, Cov (exper , v ) 6= 0.
Proxy variables
STATA
There are 3 possible solutions to this problem:

1 Measure abil. But this is almost impossible, how can you
measure it?

Proxy variables
STATA

measure it?
2 Find a proxy variable for ability.

Proxy variables
STATA

measure it?
2 Find a proxy variable for ability.
3 Find an instrumental variable for the endogenous variables.

Proxy variables
STATA
Proxy variables

Proxy variables
STATA
Proxy variables
A proxy variable for abil is IQ.

Proxy variables
STATA
Proxy variables

A proxy variable should satisfy:

Proxy variables
STATA
Proxy variables

1 abil = δ0 + δ3 IQ+v3 , where v3 is uncorrelated with educ,
exper and IQ

Proxy variables
STATA
Proxy variables

exper and IQ
2 u is uncorrelated with educ, exper and abil.

Proxy variables
STATA
Proxy variables

exper and IQ
2 u is uncorrelated with educ, exper and abil.
The we can estimate
y = ( β 0 + β 3 δ0 ) + β 1 educ + β 2 exper + β 3 δ3 IQ + u + β 3 v3

Proxy variables
STATA
Example 9.3: IQ as a Proxy for Ability (WAGE2 database)

Ind.vars (1) (2) (3)
educ .065 .054 .018
(.006) (.007) (.041)
exper .014 .014 .014
(.002) (.002) (.003)
tenure .012 .011 .011
(.002) (.002) (.002)
married .199 .200 .201
(.039) (.039) (.039)
south -.091 -.080 -.080
(.026) (.026) (.026)
urban .184 .182 .184
(.027) (.027) (.027)
black -.188 -.143 -.147
(.038) (.039) (.040)
IQ - .0036 -.0009
(.0010) (.0052)
educ.IQ - - -.00034
(.00038)
Proxy variables
STATA
Bias when using a proxy

Assume that
abil = δ0 + δ1 educ + δ2 exper + δ3 IQ + v3
⇒ y = ( β 0 + β 3 δ0 ) + ( β 1 + β 3 δ1 )educ
+( β 2 + β 3 δ2 )exper + β 3 δ3 IQ + u + β 3 v3

Proxy variables
STATA
Consider the model
y = β0 + β1 x + u
where Cov (x, u ) 6= 0 (i.e. x is endogenous)
A good instrumental variable (say z) satisfies these two conditions:
1. It is not correlated with the error term: Cov (z, u ) = 0
2. It is correlated with the endogenous variable: Cov (x, z ) 6= 0

Proxy variables
STATA
How can we estimate β 1 using z?

Note that
Cov (z, y )
β1 =
Cov (z, x )
Why?
Cov (z, y ) = Cov (z, β 0 + β 1 x + u )

= Cov (z, β 0 ) + Cov (z, β 1 x ) + Cov (z, u )

Proxy variables
STATA
IV as a two step least squares estimator
x = γ0 + γ1 z + v (1)
x̂ = γ̂0 + γ̂1 z (2)
y = β 0 + β 1 x̂ + u (3)

Proxy variables
STATA
Instrumental variables: multiple regression model
Consider the model
y = β 0 + β 1 x1 + β 2 x2 + u
where Cov (x1 , u ) 6= 0 (i.e. x1 is endogenous) and Cov (x2 , u ) = 0.
A good instrumental variable (say z) satisfies these two conditions:
1. It is not correlated with the error term: Cov (z, u ) = 0
2. It is correlated with the endogenous variable: Cov (x1 , z ) 6= 0

Proxy variables
STATA
Testing for endogeneity
The 2SLS estimator is less efficient (i.e. larger variance) than OLS
when the explanatory variables are exogenous.
Therefore, it is important to test for endogeneity first, in order to
avoid using an IV estimator that is:
1 more computationally intensive (2 stages is more difficult than
1)
2 less efficient

Proxy variables
STATA
Testing for endogeneity

Consider the model
y1 = β 0 + β 1 y2 + β 2 z1 + β 3 z2 + u
where y2 is (possibly) endogenous; z3 and z4 are IVs
In order to test for endogeneity:
I . y2 = π0 + π1 z1 + π2 z2 + π3 z3 + π4 z4 + v2 compute residuals v̂2
II . y1 = β 0 + β 1 y2 + β 2 z1 + + β 3 z2 + δ1 v̂2 + error
III. Test for the significance of v̂2 in the latter model. If we reject
H0 : δ1 = 0, then there is evidence that u and v2 are correlated,
therefore y2 is endogenous!!!
Proxy variables
STATA
Testing for the Validity of the Instruments:

Overidentification Restrictions − > Hansen or Sargan tests
This is a test that will tell you if the instruments are uncorrelated
with the error term, an essential condition for the validity of the
IVs.
Requirement: You need more IVs than endogenous variables.
In the model above, we can run the 2SLS with z3 as the only IV;
compute û3 = y1 − β̂ 0 − β̂ 1 y2 − β̂ 2 z1 − β̂ 3 z2 ; and then evaluate
the regression model û3 = δ0 + δ1 z4 , in particular, test the
significance of z4 .
This is a valid test for the validity of z4 as an IV. BUT it needs to
assume that z3 is a valid IV.

Proxy variables
STATA
Testing for the validity of the instruments:

Overidentification restrictions − > Hansen test
1 Estimate the full 2SLS model with all IVs, obtain the residuals
û.
2 Regress û on ALL exogenous variables (i.e. the exogenous
variables and the IVs)
3 Consider the F-test of significance of the regression. H0 can be
interpreted as exogeneity of all variables in the model. Then if
you reject H0 one (or more) of your IVs are not exogenous.

Proxy variables
STATA
How to do it in STATA?
Assume that x1 is endogenous and x2 is exogenous. Moreover
assume that you have two instruments available: z1 and z2

Proxy variables
STATA
ivregress 2sls y (x1=z1 z2) x2 (instrumental variables
estimation)

Proxy variables
STATA
estimation)
ivregress 2sls y (x1=z1 z2) x2, first (idem - request that
the first-stage regression results are shown)

Proxy variables
STATA
estimation)
estat firststage (test for the significance of the instruments -
thumb-rule F > 10)

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STATA
estimation)
thumb-rule F > 10)
estat overid (test for the validity of the instruments: need more
instruments than endogenous variables...)

Proxy variables
STATA
estimation)
thumb-rule F > 10)
estat endogenous (test for the exogeneity of all variables)

Proxy variables
STATA
estimation)
thumb-rule F > 10)
estat endogenous (test for the exogeneity of all variables)
reg x1 z1 z2
test z1 z2 (test for the significance of the instruments -
thumb-rule F > 10)
Proxy variables
STATA
An intuitive way of understanding the IV estimator is to run a

two stage regression model. For instance suppose you want to
obtain:
ivreg y (x1=z1 z2) x2
You can obtain the same results by:
reg x1 z1 z2 x2
predict x1hat
reg y x1hat x2

Proxy variables
STATA
See examples in Chapter 15
http://fmwww.bc.edu/gstat/examples/wooldridge/wooldridge15.html

Endogeneity

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The endogeneity problem

Gabriel Montes-Rojas Endogeneity

The endogeneity problem

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

Gabriel Montes-Rojas Endogeneity

The endogeneity problem

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

Our primary interest is in the estimation of β 1 and β 2 .

Gabriel Montes-Rojas Endogeneity

The endogeneity problem

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

Our primary interest is in the estimation of β 1 and β 2 .

log(wage ) = β 0 + β 1 educ + β 2 exper + v

Gabriel Montes-Rojas Endogeneity

The endogeneity problem

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

Our primary interest is in the estimation of β 1 and β 2 .

log(wage ) = β 0 + β 1 educ + β 2 exper + v

There are 3 possible solutions to this problem:

Gabriel Montes-Rojas Endogeneity

There are 3 possible solutions to this problem:

Gabriel Montes-Rojas Endogeneity

There are 3 possible solutions to this problem:

Gabriel Montes-Rojas Endogeneity

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

Gabriel Montes-Rojas Endogeneity

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

A proxy variable for abil is IQ.

Gabriel Montes-Rojas Endogeneity

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

A proxy variable for abil is IQ.

Gabriel Montes-Rojas Endogeneity

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

A proxy variable for abil is IQ.

Gabriel Montes-Rojas Endogeneity

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

A proxy variable for abil is IQ.

Gabriel Montes-Rojas Endogeneity

Consider the wage equation model

log(wage ) = β 0 + β 1 educ + β 2 exper + β 3 abil + u

A proxy variable for abil is IQ.

Gabriel Montes-Rojas Endogeneity

Example 9.3: IQ as a Proxy for Ability (WAGE2 database)

Bias when using a proxy

abil = δ0 + δ1 educ + δ2 exper + δ3 IQ + v3

Gabriel Montes-Rojas Endogeneity

Consider the model

Gabriel Montes-Rojas Endogeneity

How can we estimate β 1 using z?

Cov (z, y ) = Cov (z, β 0 + β 1 x + u )

Gabriel Montes-Rojas Endogeneity

IV as a two step least squares estimator

x̂ = γ̂0 + γ̂1 z (2)

Gabriel Montes-Rojas Endogeneity