Problems with Instrumental Variable Estimation - Essay Example

The number of variables is dependent on the scope and the nature of the problem being researched. To be able to understand the dynamics of a problem it is important, to begin with determining the number of variables involved and the relationship between each variable and the problem. It is also important to understand how the involved variables affect each other or one another. The attempt of various researchers to understand the existing relationship has been unsuccessful under non-experimental scenery (Bound, Jaeger & Baker 443).

The reason for the failure is the fact that some of the variables are endogenous. In other words, the variables are subject to the same factors that influence the research problem. The endogeneity trait of variables makes the ordinary least square biased and inconsistent, therefore, making the research conclusion unreliable. Fortunately, there is a method of reducing the influence of variable endogeneity on research outcomes has been determined. The method involves the use of an instrumental variable estimation. However, the method also experiences some problems. First, insufficient explanation of the variation of the endogenous explanatory variables. This could increase the error standard thus invalidating the research outcome. Secondly, the approximated limited samples are biased in the same magnitude as OLS when the coefficient of determination, (R2), between the instrument and the variables, diminishes (Bound, Jaeger & Baker 443)

To conclude, the problems with instrumental variable estimation are insufficient explanation in the deviation of the endogenous variables and the biases of finite samples when the R2 between the instrument and the variables decreases to zero.