[MUSIC] Earlier we looked at a paper by Acemoglu, Johnson, and Robinson who asked what's the
effect of having strong property rights on economic development?
And in the data, we saw that countries with strong property rights tended to have higher
economic development.
But we know that might not be a causal effect because of confounding variables and other
things.
So in fact, in the paper the authors write, “to estimate the impact of institutions
on economic performance, we need a source of exogenous variation in institutions.”
So what are they going to do?
They are going to do an instrumental variables analysis.
Now remember the unit of analysis is countries.
Their outcome variable is a measure of economic development: GDP per Capita in the Year 1995.
Their treatment variable is a measure of property rights: The Average Protection Against Expropriation
Risk.
So we need a third variable, the instrument, to do an instrumental variables analysis.
What are they going to use?
European settler mortality during the colonial era.
So what do I mean exactly, and what’s their idea?
Well, between the years 1600 and 1800, European countries were sailing around the world and
colonizing various parts of the world.
Some of these places had had more diseases and other things that made it a more hostile
environment to live in, and so mortality was higher in these places.
So in the places that had lower settler mortality, where it was more likely for the European
settlers to stay alive, they were more likely to get permanent European establishments,
and those places then imported institutions from Europe that protected property rights
that then persisted to the year 1995.
So that first argument suggests that the relevance assumption holds, that places with lower settlement
mortality in the colonial era (1600 to 1800) actually implied that those countries have
higher property rights in the year 1995.
So the instrument - settler mortality - actually affects the treatment variable, property rights.
That's the first assumption we needed.
The second assumption is that settler mortality - the instrument - does not directly affect
economic development in 1995 (GDP).
So that is plausible, because you think that, well, although the institutions persisted
over hundreds of years, GDP today probably doesn't depend directly on whether settlers
were dying in the year 1600 or not.
So finally, the third assumption they need is exogeneity.
And they argued that this holds because the fact that some parts of the world have higher
risk of disease and some parts of the world had lower risk is just unrelated to other
factors that would affect GDP in the year 1995.
So that suggests that the third assumption exogeneity holds.
So with all of these assumptions, they can then proceed to do an instrumental variables
analysis to learn about the effects of property rights on economic development.
So before we go there, I’ll just note that this paper is very well known and also it's
quite contentious, and that's pretty common with an instrumental variable analysis because,
as we've talked about in another module, two of the three assumptions are unrefutable,
you cant refute them with the data you have, you have to use other arguments to show that
they hold.
Another issue that arises here is how do we even measure the instrument?
How do we measure settler mortality in the years 1600, 1700 or 1800?
That was a long time ago.
So there are issues with this analysis, but it's been very influential, and we'll put
these issues aside and just see what they get.
So the first thing, remember the main idea behind instrumental variable analysis is that
we look at the correlation between the Instrument and the outcome, and that correlation reflects
the true causal effect of the treatment on the outcome.
So here on the horizontal axis, we've plotted the instrument log settler mortality.So countries
with higher mortality are over here, like Mali.
Countries with lower settler mortality are over here, like Australia and the US.
On the vertical axis, we've plotted our outcome variable, log GDP per Capita in 1995, so countries
down here like Mali have lower GDP per capita in 1995, countries up here have higher GDP
per capita in 1995, like the Australia and the US.
And you can see there is a correlation between these two variables: Countries that have lower
mortality tended to have higher GDP in 1995.
Now remember, this is a variable that's measured in the year 1600 to 1800, this is a variable
that's measured in the year 1995.
So assuming that this instrumental variable satisfies those three assumptions, we know
that this correlation here reflects the true causal effect of property rights on economic
development.
So in the next module, we'll see how they compute that exact effect by using two-stage
least squares.