Observed Choice, Estimation, and Optimism about Policy Changes

Eric Bennett Rasmusen, Kelley School of Business, Indiana University

Abstract

A policy will be used more heavily in a particular time and place where its marginal cost is lower. The analyst who treats times and places as identical will overestimate the policy's net benefit, especially for policy intensities greater than exist in his sample. In regression analysis, the problem can be solved by instrumental variables and a correction for heteroskedasticity. In an example using state- level data, the technique substantially increases the estimated responsiveness of the illegitimacy rate to transfer payments.