Abstract
This paper studies the role of stratification in the rise of endogeneity bias in multilevel models. The theory is illustrated using educational stratification and its implications on the estimation of multilevel education production functions. Educational stratification results from the functioning of the education market; it transforms a continuum of student characteristics into a continuum of tuition fees. These fees enter students' utility functions and determine the school they attend and its quality. In other words, student characteristics are the major determinants of school quality and the two are correlated. In this paper, I analyze how these correlations arise and what their implications are for multilevel estimation of education production functions. The major problem posed by such correlations is cross-level endogeneity bias. The theory developed in this paper can be extended to any economic phenomenon that exhibits stratification or nesting of smaller units within larger units (employees within firms, residents within neighborhoods, etc.).
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