Two-stage residual inclusion estimation: Addressing endogeneity in health econometric modeling

The paper focuses on two estimation methods that have been widely used to address endogeneity in empirical research in health economics and health services research—two-stage predictor substitution (2SPS) and two-stage residual inclusion (2SRI). 2SPS is the rote extension (to nonlinear models) of the popular linear two-stage least squares estimator. The 2SRI estimator is similar except that in the second-stage regression, the endogenous variables are not replaced by first-stage predictors. Instead, first-stage residuals are included as additional regressors. In a generic parametric framework, we show that 2SRI is consistent and 2SPS is not. Results from a simulation study and an illustrative example also recommend against 2SPS and favor 2SRI. Our findings are important given that there are many prominent examples of the application of inconsistent 2SPS in the recent literature. This study can be used as a guide by future researchers in health economics who are confronted with endogeneity in their empirical work.