Instrumental Variables Correction for Management Measurement Error
Standard Ordinary Least Squares (OLS) or fixed-effects estimates systematically understate the impact of management practice adoption on firm performance due to measurement error in practice scores and endogenous implementation timing, where firms adopt new practices during performance downturns.
Picture this
Imagine trying to measure how much a medicine helps sick patients by looking at regular hospital records. Because doctors give the medicine primarily when patients get extremely ill, simple statistical comparisons make the medicine look weak or useless. By using an external event—like a lottery that randomly decides which patients receive the medicine—statisticians can isolate the true power of the medicine without the confusion caused by who was sickest when taking it.
What the evidence says
The IV point estimate for Total Factor Productivity (TFP) was 0.477 (p < 0.05, First-stage F-stat = 86.00) compared to an OLS estimate of 0.167, while the IV effect on quality defects was -1.694 compared to -0.558 under OLS, proving that uninstrumented estimates suffer from substantial downward attenuation bias.
- Who
- 20 experimental manufacturing plants across 17 large cotton textile firms in India tracked weekly over ~100 weeks per plant.
- How
- Panel regression comparing fixed-effects OLS estimates against Instrumental Variables (IV) estimates using cumulative weeks of randomized consulting treatment as the instrument for the 38-practice management adoption index.
What to do
Instrument self-reported or observed management practice indices with exogenous random assignment variables when evaluating productivity impacts to avoid downward attenuation bias.
From the source
"We find that the fixed-effects estimates tend to understate the gain in performance from better management, which is consistent with changes in management being more likely to be implemented when outcomes are declining."
541 Management in India QJE.pdf
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