# An example of Instrumental Variables use

In the following example of Greene's Econometric Analysis, he writes at a certain moment: «If the number of weeks worked, and the accepted wage offer are determined jointly, then $ln Wage_{it}$ and $u_{it}$ in this equation are correlated». Why is that?  In the supply equation, $u$ is the weather. But weather also changes the demand, which has a price effect. In this model, you can see that the wage-hours gradient will be biased downward relative to the supply curve, and may even slope the wrong way, because of the correlation between $u$ and the observed wage.
• I think i understand your answer. Adapting it to my example, you're saying that since weather affects wage through $\epsilon_{it}$ and also the number of weeks worked, $Wks_{it}$, through $u_{it}$, then wages and weather are correlated, i.e., $lnWage_{it}$ and $u_{it}$, $\epsilon_{it}$. The problematic correlation being between $lnWage_{it}$ and $u_{it}$, since wages are used as a regressor where u is the error term. – An old man in the sea. Apr 26 '15 at 8:52