Use of instrumental variables in the presence of heterogeneity and self‐selection: an application to treatments of breast cancer patients

Instrumental variable (IV) methods are widely used in the health economics literature to adjust for hidden selection biases in observational studies when estimating treatment effects. Less attention has been paid in the applied literature to the proper use of IVs if treatment effects are heterogeneous across subjects and individuals select treatments based on expected idiosyncratic gains or losses from treatments. In this paper we compare conventional IV analysis with alternative approaches that use IVs to estimate treatment effects in models with response heterogeneity and self‐selection. Instead of interpreting IV estimates as the effect of treatment at an unknown margin of patients, we identify the marginal patients and we apply the method of local IVs to estimate the average treatment effect and the effect on the treated on 5‐year direct costs of breast‐conserving surgery and radiation therapy compared with mastectomy in breast cancer patients. We use a sample from the Outcomes and Preferences in Older Women, Nationwide Survey which is designed to be representative of all female Medicare beneficiaries (aged 67 or older) with newly diagnosed breast cancer between 1992 and 1994. Our results reveal some of the advantages and limitations of conventional and alternative IV methods in estimating mean treatment effect parameters. Copyright © 2007 John Wiley & Sons, Ltd.