Handout 9: Instrumental variable II

Yichong Zhang1

1 School of Economics

Singapore Management University

Econ 107 Handout 9 (SMU) Introduction to Econometrics 1 / 18

Empirical Example: Demand for Cigarettes

Policy debate over the health risks from smoking often revolves
around government intervention.
One policy option is to tax cigarettes heavily, so that smoking will be
discouraged.
But how big a tax hike is needed to make a dent in cigarette
consumption?
The answer depends on the elasticity of demand for cigarettes
How much (by what %) will consumption decrease if price increases by
1%?

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Empirical Example: Demand for Cigarettes (Cont’d)

Here, we will use 2SLS to estimate the elasticity of demand for

cigarettes using state level data from 1995.
Cigarette consumption (Qi ) is the number of packs of cigarettes sold
per capita in each state.
The price (Pi ) is the average real price per pack including all taxes.

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Empirical Example: Demand for Cigarettes (Cont’d)

Our model of demand is then

ln Qi = β 0 + β 1 ln Pi + ui

Since this is a model of demand (which is determined simultaneously

with supply), OLS will be inconsistent (ln P will be correlated with u).
To use 2SLS, we pick an instrument, SalesTax, which is the portion
of the tax on cigarettes arising from the general sales tax (measured
in dollars per pack).

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Empirical Example: Demand for Cigarettes (Cont’d)

Is it relevant (Cov (Zi , Xi ) 6= 0)?

It seems good: taxes clearly increase the sales price.
Is it exogenous (Cov (Zi , ui ) = 0)?
Maybe.
Is SalesTax correlated with Q only through P?
That is, does it affect the demand for cigarettes only through price?
Perhaps, but taxes can be affected by the same local conditions that
influence demand (attitudes towards smoking, tobacco lobbyists, etc.).
However, this is probably more of a problem for cigarette specific taxes
than sales taxes.
Also, wealthy states might not need such high taxes (an omitted
variables problem).

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1 First Stage Regression (i.e. Xi = π0 + π1 Zi + vi ):

ln
d Pi = 4.62 + 0.031 SalesTaxi
(0.03) (0.005)

2 Second Stage Regression (i.e. Yi = β 0 + β 1 Xbi + ui ):

Qi = 9.72 − 1.08ln
lnd d Pi
Econ 107 Handout 9 (SMU) Introduction to Econometrics 6 / 18
Empirical Example: Demand for Cigarettes (Cont’d)

Can we test relevance?

 2
F = t2 = .031
.005 = (6.35)2 = 38.44 > 10, which looks quite good.
Can we test exogeneity?
Not in this case (we are exactly identified).
Also, you should not use the SE’s from the second stage regression,
because they don’t account for the first stage.

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Empirical Example: Demand for Cigarettes (Cont’d)

We can estimate the two stages together (and get the correct HR
standard errors) by using the TSLS command in EViews.
Notice that you need to tell EViews which variable(s) are endogenous
and what you will be using for the instrument(s).

Qi = 9.72 − 1.08 ln Pi
lnd
(1.53) (0.32)

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Empirical Example: Demand for Cigarettes (Cont’d)

Since cigarettes are addictive, this seems like a very high elasticity (an
increase in the price of 1% reduces consumption by 1.08%), but
exogeneity might be a problem...
We should also worry about omitted variables.
We probably need to include more variables (some W ’s).

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Empirical Example: Demand for Cigarettes (Cont’d)
An obvious candidate for an omitted variable that’s possibly important
is income. We’ll use the log of real per capita state income (ln Inci ).
Cigarette demand probably depends on income,
and it may also affect the tax structure (and level) used by the state.
Here we will include it as a control: so it will appear in both stages!
With one instrument (SalesTax), we are still exactly identified and
the 2SLS estimates are:

Qi = 9.43 − 1.14 ln Pi + 0.21 ln Inci

lnd
(1.26) (0.37) (0.31)

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Empirical Example: Demand for Cigarettes (Cont’d)

Relevance? You need to look at the first stage regression

ln
d Pi = 3.59 + 0.389 ln Inci + 0.027 SalesTaxi
(0.173) (0.065) (0.004)

.027 2
Our first stage F = t 2 =


.004 = 44.7 > 10, which looks good.
Exogeneity?
We still can’t test it (we’re still exactly identified).
However, another candidate instrument is available: cigarette specific
taxes (CigTax).
Let’s see what happens when we use both.

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Empirical Example: Demand for Cigarettes (Cont’d)

With two instruments (SalesTax, CigTax ), we are now over-identified

and the 2SLS estimates are:

Qi = 9.89 − 1.28 ln Pi + 0.28 ln Inci

lnd
(0.96) (0.24) (0.25)

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 Relevance? Again, you need to look at the first stage regression

ln
d Pi = 4.10 + 0.108 ln Inci + 0.011 SalesTaxi + 0.009 CigTaxi
(0.088) (0.040) (0.002) (0.001)

We need to test the joint hypothesis that the coefficients on SalesTax

& CigTax are both equal to zero.

Our first stage F -stat ≈ 210 > 10, which looks very good.

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The Scary Regression (Weak Instruments)

As we all now know, labor economists are always interested in

estimating the effect of education on earnings.
The problem is that education is correlated with an omitted variable,
namely ability.
Can we use IV to solve this problem?
Well, what would our instrument be?

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The Scary Regression (Weak Instruments)

Here’s a clever idea:

Laws require students to stay in school until their 16th birthday.
If you turn 16 in January, while you are in 10th grade you can drop out
without completing 10th grade.
If you turn 16 in July, you will have to complete 10th grade.
So your date of birth is an exogenous instrument (it should have no
direct effect on earnings, other than through more time in school).

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The Scary Regression (Weak Instruments)

Angrist and Krueger (1991) used data from the US Census (with
n = 329, 000) and instrumented for education using birth quarter
(interacted with many other variables) in the wage regression

ln Wagei = β 0 + β 1 educi + OtherStuff + ui

They found a return to education of about 8%.

This is actually higher than the estimate from OLS, which is surprising
since we expect OLS to over-estimate the effect of education (why?)
The t-stat on βb1 was also quite large (> 5).
But is there a problem?

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The Scary Regression (Weak Instruments)

Even though n = 329, 000 (a huge sample!), the F -stat from the first
stage was less than 2, implying that their instruments were very weak.
In fact, if you replace birth quarter with a randomly generated birth
quarter (definitely irrelevant), you get nearly the same results.
This was scary to labor economists since the 2SLS SEs computed
using the real data suggested that the effect of education was
precisely estimated, but so did the SEs from the fake data!

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Weak Instruments

The Angrist and Krueger paper generated a long - and still evolving -
literature on weak instruments
The main lesson is that you should always check the significance of
the instruments in the first stage
You should also avoid the temptation to add lots of marginally
significant instruments.

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