Solved – Covariance, bernoulli distribution and instrumental variables

bernoulli-distributioncovarianceinstrumental-variables

my problem is from the following book on page 94 (http://www.development.wne.uw.edu.pl/uploads/Main/recrut_econometrics.pdf).

They say the covariance between a single dummy instrument variable (z), which is one with probability p, and the dependent variable (y) is: Cov(y,z) = (E(y I z=1) – E(y I z=0))p(1-p). They say this is easy to show, but i cant figure it out. I tried using the usual covariance formulas, but it didnt help. Does anybody know an answer?

Best Answer

The standard formula does work, just needs a bit of manipulation

$$Cov(y,z) = E(yz) - E(y)E(z) = E(yz\mid z=1)P(z=1) - E(y)p$$

$$[E(y\mid z=1) - E(y)]p = \Big[E(y\mid z=1) - \big[E(y|z=1)p + E(y\mid z=0)(1-p)\big]\Big]p$$

$$=\Big[ E(y \mid z=1)(1-p) - E(y \mid z=0)(1-p) \Big]p$$

$$=\Big[ E(y \mid z=1) - E(y \mid z=0) \Big]p(1-p)$$

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