AE 6809

Special Topics in Applied Economics

Economics of Conflict

Eik Swee
AY2022/2023 Trimester 1

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Data & Methods

▶ This lecture is meant to help you recap a few key statistical

and econometric concepts
▶ You should already possess the theoretical foundations in
statistics and econometrics, so we only have three simple
goals:
▶ Recap some key statistical and econometric concepts
▶ Brush up on econometric “intuition”
▶ Understand when and how to apply econometric techniques
▶ It is hopefully a more relaxed way of re-learning what you
should have mastered the first time

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Data & Methods

This first rule of using data is to understand data

▶ Suppose we observe a cross section of human stature from
205 households (205 moms, 205 dads, 928 adult children)
▶ It is probably fair to assume that every observation of height
is drawn from the same distribution
▶ But, we might transmute female height ×1.08 to make it
comparable with male height
▶ We could create a simple average of mom and dad (call this
mid-parent) and assign it to every corresponding child
▶ What might we see if we try to map parental height onto
child height?

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Data & Methods

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Data & Methods

▶ Red dotted lines represent sample averages

▶ Mid-parent height: 69.22 inches (standard deviation 1.82)
▶ Child height: 69.23 inches (standard deviation 2.60)
▶ On average, the second generation is just a tad bit taller, but
with a larger spread
▶ Black is 45-degree line: if an observation lies on this line, then
the child is a clone of the mid-parent
▶ Orange is OLS regression line: it minimises the sum of
squared errors, where error is vertical distance between line
and every observation
▶ Notice that the regression line always intersects the two
sample means

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Data & Methods

▶ The regression line has a positive slope of 0.73 (0.04), so child

and parental height are statistically correlated
▶ But the orange line is flatter than the black line, so
taller-than-average parents tend to have children who are
shorter than them, while shorter-than average parents tend to
have children who are taller than them
▶ Francis Galton (1886) termed this phenomenon “the law of
regression towards mediocrity” (or in modern terms,
regression to the mean)
▶ Thanks to him, we now call the OLS a regression line, even
though he never used the term for this purpose!

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Data & Methods

▶ Galton was a statistician, and in his time there is no such

discipline as econometrics
▶ He merely fitted a linear model to demonstrate a very
powerful statistical concept: if one sample of a random
variable is extreme, the next sampling of the same variable is
likely to be closer to its mean
▶ It was not his intent to establish a causal story about genetic
heredity ...
▶ ... but his work did provide a key cautionary tale for using
repeated observations in econometrics: if one wishes to
identify the causal impact of an intervention, one needs to
eliminate sample selection bias

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Data & Methods
▶ To see how sample selection can confound causal
interpretations, consider another example in history
▶ During WWII, American aircraft that returned from missions
over German positions were covered in bullet holes along their
main bodies and wings

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Data & Methods

▶ Seeing this, the US military told its engineers to add more

armour to these parts of the plane
▶ A statistician named Abraham Wald disagreed
▶ He argued that the engineers should do exactly the opposite:
protect the engines and the cockpit
▶ He had deduced something crucial: the missing planes must
have crashed because their engines and cockpits were hit
▶ This is classic sample selection: to establish the cause of what
crashed the planes, the US military should have focused on
the missing planes, not the surviving planes

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Data & Methods

▶ The vast majority of applied micro-econometric research is

focused on identifying causal impacts i.e. what is the causal
effect of x on y ?
▶ Always remember:
▶ Correlation does not imply causality
▶ Subsequence does not imply consequence
▶ When two random variables x and y are correlated, it could
mean one of five things:
1. x causes y
2. y causes x
3. Both #1 and #2
4. Something else z causes both x and y
5. Purely coincidental

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Data & Methods

▶ While OLS is not the only way to fit a relationship, we know

that it gives the Best Linear Unbiased Estimator (BLUE)
under the Gauss-Markov assumptions
A1. Linearity in parameters
A2. Random sampling: observed data represents a random sample
of the population
A3. No perfect multicollinearity: variation in x exists
A4. Error has zero conditional mean: E (ϵ|x) = 0; this implies strict
exogeneity of x, i.e. cov (x, ϵ) = 0
A5. Homoscedasticity: var (ϵ|x) = σϵ2 ; this assumption gives rise to
lowest variance, making OLS the “best” linear estimator

— You may have come across an assumption A6. Normality of

errors. Do you know what is its purpose?

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Data & Methods

▶ Let’s focus on assumption A4 (exogeneity of x) since it is

typically what worries applied economists
▶ Of course, if you have random assignment of x, e.g. in a
randomised controlled trial (RCT), then A4 is satisfied by
design
▶ However, in a non-experimental setting where one uses
observational data, there are many different ways to violate
assumption A4, for example
▶ Omitted variables
▶ Reverse causality
▶ Measurement error in x
▶ Loosely speaking, the violation of A4 is called an endogeneity
problem

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Data & Methods

▶ There are many empirical (identification) strategies that deal

with the endogeneity problem
▶ Here are a few that we will use in this course
▶ Proxy controls
▶ Fixed effects
▶ Instrumental variable (IV)
▶ Difference-in-differences (DID)

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Data & Methods

Proxy controls:
▶ Suppose you have an omitted variable problem i.e. you know
there is an o that you don’t observe, but that cov (x, o) ̸= 0
and cov (y , o) ̸= 0
▶ If you happen to observe a proxy variable for o, then you may
be able to (at least partially) remove omitted variable bias, by
including the proxy as a control variable
▶ This is usually a partial solution because the proxy would have
to completely absorb the correlation between x and o in order
to completely get rid of the omitted variable bias (not
impossible, but highly unlikely)

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Data & Methods

Fixed effects:
▶ Again, suppose you have an omitted variable problem
▶ If panel data are available, you will be able to directly
corrected for omitted variable bias that is associated with the
observation unit, by including fixed effects (dummy variables)
for each unit
▶ This is again a partial solution because the the fixed effects
cannot get rid of time-varying omitted variables
▶ That being said, it is nonetheless a very effective method that
does not require you to observe everything about the
observation unit, and still be able to parse out all omitted
variables associated with the it

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Data & Methods
Insturmental variable (IV):
▶ Suppose that you observe a z such that
B1. z is partially correlated with x, i.e. cov (z, x) ̸= 0
B2. z is not otherwise correlated with y , i.e. cov (z, ϵ) = 0
▶ Then, you may use z as an instrument for x
▶ The logic being that we can use z to tease out the random
variation in x and use that random variation to identify its
causal effect on y
▶ In practice, 2SLS estimation is the most common way of
operationalising the IV method
▶ The so-called relevance condition B1 is testable, but the
exclusion restriction B2 is usually not testable (unless you
have more instruments than endogenous variables)

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Data & Methods
Difference-in-differences (DID):
▶ When panel data are available, and some observations receive
the intervention (treatment) while others do not (control), it
is possible to design a natural experiment to address
non-random treatment

yit = α + β1 treatmenti × postt + β2 treatmenti + β3 postt + ϵit

▶ Intuition: first, take the difference in y between treatment and

control groups in each period. Then, subtract the
pre-treatment differences from the post-treatment differences
▶ This second differencing thus removes any unobserved baseline
differences in y between treatment and control groups
▶ Equation above is the regression representation of this idea

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Data & Methods

▶ Three assumptions need to be satisfied for the DID

C1. Parallel pre-trends in yit across treatment and control groups
C2. Strict exogeneity: cov (treatmenti × postt , ϵit ) = 0
C3. Stable unit treatment value (SUTVA): the composition of
treatment and control groups must remain stable across time
▶ Assumption C1 ensures that the differencing that we do to get
rid of unobserved baseline differences is of the correct amount
▶ Assumption C2 is the strict exogeneity assumption applied to
the DID; notice it is not the same as cov (treatmenti , ϵit ) = 0
▶ Assumption C3 basically requires that groups do not change
over time and that there are no treatment spillovers to the
control; this is especially important for a long series (T large)

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Data & Methods

▶ In some scenarios we can in fact estimate the fixed-effects

form of a DID regression:

yit = α + β1 treatmenti × postt + αi + γt + ϵit

— What might these scenarios be?

— In what ways is the fixed-effects DID “superior”?

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