Introduction

Heckman Model

Selection Models

Joseph T. Halford

University of Wisconsin Milwaukee

October 18, 2014

Joseph T. Halford Selection Models

 Introduction
Heckman Model

Introduction

These slides draw heavily from Li and Prabhala (2007)

Most choices in corporate finance are not random, they are
usually deliberate actions
e.g. Equity/Debt Issuance, IPOs, M&A’s, Chapter 11 vs
Chapter 7 bankruptcy
Decision makers generally have private information that
factors in to their decisions (i.e. firms self-select in to certain
decisions)
The econometrician must control for this information in order
to make valid conclusions regarding the impact of corporate
decision on a particular outcome variable

Joseph T. Halford Selection Models

 Introduction
Heckman Model

Heckman (1979) Model

Suppose we wish to estimate the parameters β of the

regression

Yi = Xi β + i (1)
However all we are able to observe is a sample of firms
conditional on them choosing to undertake some event

Yi |Ei = Xi β + i |Ei (2)

If selection into the event is non-random the OLS estimate of
β is inconsistent
The solution is to explicitly model the selection and outcome
equations and exploit random variation in the selection
variables to estimate β.

Joseph T. Halford Selection Models

 Introduction
Heckman Model

Heckman Continued

Suppose a firm selects into choice E if the net-benefit from

doing so Wi is positive. Thus we have a system of equations

C = E = Wi = Zi γ + η i > 0 (3)
C = NE = Wi = Zi γ + ηi ≤ 0 (4)
Yi = Xi β + i (5)

where
Zi are observable variables that are assumed to be exogenous
Yi is only observed when the firm picks either E or NE (but
not both)
Assume ηi and i are bivariate normal

Joseph T. Halford Selection Models

 Introduction
Heckman Model

Heckman Continued

Suppose that firm i selects choice C , then taking expectations

of (5)

Yi |E = Xi β + (i |Zi γ + ηi > 0) (6)

= Xi β + π(ηi |Zi γ + ηi > 0) + vi (7)

(7) is the result of i |ηi = πηi + vi where π is the regression

coefficient of i on ηi and vi is an orthogonal error term
Taking expectations of (7) when the firm selects E or NE
results in the following

E (Yi |E ) =i β + (ηi |Zi γ + ηi > 0) (8)

E (Yi |NE ) =i β + (ηi |Zi γ + ηi ≤ 0) (9)

Joseph T. Halford Selection Models

 Introduction
Heckman Model

Inverse Mills Ratio

Equations (8) and (9) can be written more compactly as

E (Yi |C ) = Xi β + πλC (Zi γ) (10)

Where
φ(.) φ(.)
λE (.) = Φ(.) and λN E (.) = 1−Φ(.)
λC (.) is known as the inverse mills ratio
φ(.) and Φ(.) are the PDF and CDF of the standard normal
distribution, i.e. ηi is distributed truncated normal
Note that the Inverse Mills Ratio is the expectation of the
unobservable private information, ηi , that determines selection

Joseph T. Halford Selection Models

 Introduction
Heckman Model

Exclusion restrictions

Researchers must identify two sets of variables those

determining selection Zi and those determining outcome Xi
Technically, Zi and Xi can be identical, that is you do not
need an exclusion restriction.
Identification is achieved through the distributional
assumptions of related to ηi and i , that is the model is
identified by “non-linearity” in λC (Z 0 γ)
In general, you will need additional variables in Zi that are not
in Xi . This is because λC (Z 0 γ) is likely to have very little
variation relative to Xi
If the selection variable Wi is not binary one may be able to
include the estimate of ηi in lieu of the Inverse Mills Ratio

Joseph T. Halford Selection Models

 Introduction
Heckman Model

estimation

Two step procedure: estimate Zi0 γ using a probit regression,

estimate λC (.) for each firm, run OLS of Yi on Xi and your
estimate of λC (.)
Requires data for both E and NE firms to estimate λC (.)
Standard errors need to be adjusted because λC (.) is estimated
with error, STATA will do this for you
Only run OLS on those that are treated
Estimate the system selection and outcome equations jointly
by MLE
STATA has several built in functions for estimating selection
models, using two-step estimators or MLE
heckman (outcome is continuous and selection in binary)
biprobit (outcome and selection are binary variables)
etregress (outcome in continuous and selection is binary)

Joseph T. Halford Selection Models