The use of instrumental variables in peer effects models

Published on 4 February 2019

While most applications of peer effects that use IV do include the instrument at the individual level and therefore avoid the inconsistency and bias described here, a number of papers have not done so. More generally, we have found no discussion of this issue in the literature. Given the widespread use of IV in peer effects models, we argue that it is important to raise awareness of this among both econometricians and applied researchers.

Instrumental variables are often used to identify peer effects. This paper shows that instrumenting the ‘peer average outcome’ with ‘peer average characteristics’ requires the researcher to include the instrument at the individual level as an explanatory variable. We highlight the bias that occurs when failing to do this.