Assignment 9

Due: Tuesday Nov 30th , 5 PM.

Use the data in WAGE2.dta.

(i) You are interested in estimating the returns to education. Estimate the following
simple regression model using OLS:

log(wage) = β0 + β1 educ + u

What is the estimated return to an additional year of schooling? If we believe that

the variable educ is endogenous because it is positively correlated with the omitted
ability, what is the direction of omitted variable bias in the OLS estimates above?

(ii) Use a 2SLS routine to estimate the equation:

log(wage) = β0 + β1 educ + u

where sibs, the number of siblings, is the IV for educ. [Type ‘help ivreg’ to familiarize
yourself with the IV estimation in Stata. In particular, note the order in which you
must specify the x variables.]

(iii) Compare the above IV estimate of β1 with the (biased) OLS estimate of β1 in part
(i)? Is the change in coefficient estimate, relative to the OLS estimate, as expected.
(See Example 15.2 in the textbook for a discussion)

(iv) To convince yourself that the 2SLS estimates are not the same as replacing educ with
sibs and running an OLS regression, run the regression of log(wage) on sibs and
compare the estimates.

(v) The variable brthord is birth order (=1 for the first-born, =2 for the second-born and
so on). Explain why educ and brthord might be negatively correlated. Regress educ
on brthord to determine if there is a statistically significant correlation.

(vi) Use brthord as an IV for educ in the above equation (part (i)). Report and interpret
the results.

(vii) Now suppose that we include the number of siblings as an explanatory variable in
the wage equation to control for the family background (to some extent):

log(wage) = β0 + β1 educ + β2 sibs + u

Suppose that we want to use brthord as an IV for educ, assuming that sibs is exoge-
nous. The reduced form for educ is
 educ = π0 + π1 sibs + π2 brthord + v

Can the above reduced form equation be estimated using OLS? State and test the
identification assumption for the modified structural equation above.

(viii) Estimate the structural equation from part (vii) using brthord as an IV for educ (and
sibs as its own IV). Comment on the standard errors for β̂educ as compared to the
standard errors on the earlier IV estimates in (vi).

(ix) Using the fitted values from the reduced form equation estimated in part (vii), educ,
d
compute the correlation between the educ
d and sibs. Now what explains the standard
errors in part (viii).