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Endogeneity

Endogeneity refers to the correlation between an explanatory variable and the error term in a regression model, violating OLS assumptions. It can arise from omitted variable bias, simultaneity, or measurement error, leading to biased estimates and incorrect inferences. Solutions include using instrumental variables and two-stage least squares methods to address the issue.

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22 views1 page

Endogeneity

Endogeneity refers to the correlation between an explanatory variable and the error term in a regression model, violating OLS assumptions. It can arise from omitted variable bias, simultaneity, or measurement error, leading to biased estimates and incorrect inferences. Solutions include using instrumental variables and two-stage least squares methods to address the issue.

Uploaded by

Divya Shah
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Endogeneity: Definition and Explanation

Endogeneity is a concept commonly used in econometrics, statistics, and research methodology. It


refers to situations where an explanatory variable is correlated with the error term in a regression
model, which violates one of the classical assumptions of ordinary least squares (OLS) estimation.

🔸 1. Causes of Endogeneity

There are three main reasons why endogeneity may occur:

a. Omitted Variable Bias

 A relevant variable is left out of the model.

 The omitted variable influences both the independent and dependent variables, creating
bias.

b. Simultaneity

 When causality runs both ways.

 Example: Supply and demand influence each other.

c. Measurement Error

 When the explanatory variable is measured inaccurately, leading to a correlation with the
error term.

🔸 2. Consequences of Endogeneity

 Biased and inconsistent OLS estimates.

 Incorrect inferences about relationships between variables.

 Reduces the validity of the model.

🔸 3. Solutions to Endogeneity

a. Instrumental Variables (IV)

 Use variables that are correlated with the endogenous regressor but not with the error
term.

b. Two-Stage Least Squares (2SLS)

 A method that involves estimating the endogenous variable in the first stage, then using the
predicted values in the second

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