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You are on page 1of 22

Professor Janna E. Johnson

Humphrey School of Public Affairs

University of Minnesota

1 / 22

Why metrics?

Applied Econometrics: economists use of data to answer

cause-and-effect questions

Consists of disciplined data analysis paired with the machinery of

statistical inference

This class will provide you with the foundations of metrics

Most important foundation: distinction between causality and

correlation

Even with the most advanced metrics methods, it is exceedingly

difficult to achieve causality

Mistakenly interpreting metrics results as causal is one of the easiest

and most dangerous errors one can make

2 / 22

Economists use metrics to try to answer very important questions

Will mandatory health insurance really make Americans healthier?

Is it better in terms of lifetime earnings to attend a public university

or a private college that costs 4 times as much?

Do smaller class sizes increase student test scores?

Do conditional cash transfer programs in developing countries really

improve child health and education outcomes?

The methods we cover in this class (and PA 5033) have the potential to

provide definitive causal answers to these questions, but doing so is

extremely difficult

When our methods provide us with a result we can interpret as causal,

economists say we have identification

3 / 22

Identification

People that have more schooling earn more than those with less

schooling

Is this relationship causal?

A defensible model in economics is that human capital (knowledge)

represents an investment in people that employers are often willing to

pay for. Schooling is one way to accumulate human capital

While the observation that those who go to school longer make more

is consistent with the human capital model, there are other

interpretations

4 / 22

and have other traits (persistence, conscientiousness) that are valued

by employers

The correlation between earnings and schooling is spurious: more able

people are paid more but they also happen to get more schooling

Put differently, how do we know how much, if any, of the higher

earnings of people with more schooling is actually caused by the

schooling itself?

This, in a nutshell, is the fundamental problem of social science: how

do we know the differences in outcomes we observe are the result of

differences in observed choices that people make?

Economists and other social scientists refer to this conundrum as the

identification problem or the selection problem

5 / 22

Suppose there are two occupations: economists and accountants

Suppose that both professions are equally pleasant

The earnings of the ith person in accounting is given by y0i where

y0i N (65, 000, 5, 0002 )

The earnings of the ith person in economics is given by y1i where

y1i N (60, 000, 10, 0002 )

In addition, we assume the correlation between accounting and

economist wages is high: 0.84. If youre going to be a good

economist, its very likely youll also be good at accounting.

6 / 22

doesnt have a preference between accounting and doing economics, she

picks the one that pays the most. Her observed earnings are

yi = max (y0i , y1i )

Note that here Yi is written in lower case because it is the realization of a

random variable. Because both Y0i and Y1i are lower-case on the

right-hand side of the equation, we are assuming that our agent knows

what her earnings would be in each occupation before she decides to be an

economist or accountant. Let Di = 1 indicate she chooses economics.

Now, were going to play God and do something we cant do in real life:

pretend to observe the potential earnings of the entire population.

7 / 22

Accounting earnings

Economics earnings

N

Accountants

63,985

56,599

78,414

Economists

68,690

72,317

21,586

Mean(Total)

65,001

59,992

100,000

You usually only observe the bolded elements, which are the realized

outcomes.

We, as economists, want to know what impact choosing to be an

economist has on economists earnings relative to the counterfactual of

them being accountants.

8 / 22

Because everyone isex ante identical, you might try to estimate the impact

of being an economist by comparing the observed earnings, or

N = y 1,D =1 y 0,D =0 = 72, 317 63, 985 = 8, 332

This is nave because it has implicitly assumed that

E (Y0 |D = 1) = E (Y0 |D = 0) or that a good estimate of economists

counterfactual accounting earnings is the observed accountants

accounting earnings.

Since we got to observe all potential outcomes in this exercise, we can

calculate what the real gain from becoming economists is for the people

who become economists.

ATET = y 1,D =1 y 0,D =1 = 72, 317 68, 690 = 3, 627

9 / 22

economists for those who actually became accountants, in which case the

nave estimator implicitly assumed that E (Y1 |D = 0) = E (Y1 |D = 1).

For accountants, the impact on earnings if they had become economists

instead is

ATEN = y 1,D =0 y 0,D =0 = 56, 599 63, 985 = 7, 386

It looks like those who became accountants made the right choice: they

would have been worse off if they had become economists! This again

shows why the nave estimator is so incredibly horrible.

10 / 22

Finally, you may want to know what the impact would be if we made

everyone become economists. If you used the nave estimator, youd be

implicitly assuming that E (Y1 ) = E (Y1 |D = 1) and

E (Y0 ) = E (Y0 |D = 0). Because the data is made up, we can calculate

the real ATE:

ATE = y 1 y 0 = 59, 992 65, 001 = 5, 009

All three of these parameters are meaningful, and our nave estimator gives

us none of them.

11 / 22

tragically wrong. While I have done this in terms of the selection of

occupation, think about how this is relevant for public policy:

Job training programs

The returns to education (President Obamas new proposal for free

community college)

Programs to prevent recidivism

Programs to prevent dropping out of high school

Finally, notice that people who choose to be an accountant benefit from

being an accountant; people who choose to be an economist benefit from

being an economist. Mr. Roy reminds us that people are utility

maximizers and we forget that at our own (and their) peril

12 / 22

What is going on here? We need a model to think about this. The model

is

y1i = g1 (xi , ui )

y0i = g0 (xi , ui )

where xi is a vector of observed variables we will call covariates or

observables, and ui is a vector of unobserved variables we call

unobservables

The functions gi () are two unknown functions that depend on D

13 / 22

most) only one of the two outcome states. This makes estimation of

causal effects really hard

Why does this make things so hard? Agents are making optimal choices

with information not available to the econometrician

The nave estimator ignores the nonrandom selection into the two regimes

and results in biased estimates of the parameters. Social scientists say that

such estimates suffer from a selection bias. There are two forms of

selection bias: (1) selection on unobservables and (2) selection on

unobservables

14 / 22

Selection on observables is the easier of the two (but hard enough to keep

us occupied for a while). Ordinary Least Squares (OLS) regressions are

one means of trying to account for selection on observables

Selection on unobservables is extremely difficult. This is the problem that

keeps people like me employed. If you take the follow-up to this course,

Multivariate Analysis, youll learn about some of the techniques one can

use to try to deal with selection on unobservables. Fixed effects models,

instrumental variables, and selection models are a few of the more

common methods.

15 / 22

To make this discussion a bit more concrete, consider two youths (with the

same observables) making the decision to drop out of high school: one

drops out and one sticks it out and completes high school

Suppose that the one who stays in high school has high earnings, does not

get arrested, and gets married. The one that drops out has low earnings,

gets arrested, and never gets married

16 / 22

include

Drug addiction

Differences in standardized test scores

Criminal activity

Lousy high schools

High paying job

Before making that judgment, at a minimum you would want to know a

great deal about the decision-making process of the two youths

17 / 22

sample and why do I think it (or some of it) is not related to the outcome

I am studying?

Why are these observations useful for estimating the missing

counterfactual?

18 / 22

Keeping with the dropout story, let D = 0 indicate the student drops out

of high school and let D = 1 indicate that the student finishes high school

There are two possible outcomes for the students: y1 , the outcome if they

finish high school, and y0 , the outcome if they do not finish high school

There are two parameters you might be interested in:

(D = 1) E (y1 |D = 1) E (y0 |D = 1)

(D = 1) E (y1 |D = 0) E (y0 |D = 0)

19 / 22

have to estimate those. How?

Well, you just use the nave estimator and assume

E (y0 |D = 1) = E (y0 |D = 0)

E (y1 |D = 0) = E (y1 |D = 1)

But if you claim to believe this, people will look at you like you said you

believe in Santa Claus

20 / 22

E (y0 |x, D = 1) = E (y0 |x, D = 0)

E (y1 |x, D = 0) = E (y1 |x, D = 1)

This will allow you to identify the parameter

(x, D = 1) E (y1 |x, D = 1) E (y0 |x, D = 1)

(x, D = 1) E (y1 |x, D = 0) E (y0 |x, D = 0)

21 / 22

What we do most of the time is make parametric assumptions that make

life a lot easier. Suppose we assume

E (y1 |x ) = g1 (x )

E (y0 |x ) = g0 (x )

With this assumption, now all we have to do is estimate the functions

g1 (x ) and g0 (x ) and we solve all of our problems, subject of course to

some huge assumptions.

What we do typically is use Ordinary Least Squares (OLS) to estimate

these functions, which means we apply a linear functional form.

22 / 22

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