An illustration of the use of instrumental variables: Do neighborhood conditions affect a young person's chance of finishing high school?

Instrumental variables estimation (IVE) is useful in addressing a variety of estimation problems. In particular, IVE is useful in situations where explanatory variables are measured with error, are correlated with unobserved determinants of the dependent variable, or are simultaneously determined along with the outcome. IVE estimation depends on the analyst's ability to identify an instrument, a variable that influences the troublesome regressor but does not affect the outcome of interest. An illustration of the use of IVE is presented that examines the relationship between the neighborhood dropout rate and an individual's chance of finishing high school. In this illustration, city-level characteristics serve as instruments. The empirical results suggest that the neighborhood dropout rate affects a girl's chance of finishing high school. Tests described in the text suggest that the instruments chosen are invalid for boys.