Chapter 5: Binary Variables and Structural Change

Academic year 2012-2013

Contents 1. Defining Structural Change 2. Modeling Structural Change with Binary (or Dummy) Variables
2.1 Definition 2.2 A Single Dummy Independent Variable 2.3 Interactions involving Dummy Variables

3. Chow test

References Wooldridge: Chapter 7(sections 7.1, 7.2, 7.3 and 7.4) Gujarati: Chapter 9 (section 9.8), 10 y 12

1. Defining Structural Change

Binary or Dummy variables Dummy variables (or binary or "dummy") are used for qualitative factors as: A person is female or male
A person is or is not married

A company belongs to the industry or to the service sector A company trades or not in the stock market

1. Defining Structural Change

Dummy variables are used in regression models to see if the effect of X on Y depends on some characteristic of the population as: sex race company size Dummy variables are used to analyze "structural changes" in the model. We define structural change as differences in regression functions (model parameters) across subpopulations. The dummy variable takes value 1 in one category and 0 otherwise. For example: 5

1. Defining Structural Change

1 if a person is female Woman = 0 if a person is male 1 if a person is male Men = 0 if a person is female 1 if a company is small Small = 0 otherwise 1 if a company is medium size Medium = 0 otherwise

1 if a company is large Large = 0 otherwise

2. Modeling Structural Change with Binary (or Dummy) Variables

2.1 Definition: We define structural change as differences in regression functions (model parameters) across subpopulations. Structural changes may occur for a variety of reasons: Differences in individual tastes Changes in economic policy Changes in economic conditions

2. Modeling Structural Change with Binary (or Dummy) Variables

2.2 A Single Dummy Independent Variable: We use dummy variables to model changes in the constant term or intercept of the model. As an example, consider the multiple regression model:
wi = 0 + 1edui + 2mujeri + i i = 1,.., n

where: wi = wage edui = years of education

1 if a person is female mujeri = 0 if a person is male
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2. Modeling Structural Change with Binary (or Dummy) Variables

We have that:

wi = 0 + 1edui + 2mujeri + i
then:

i = 1,.., n

E ( wi edui , mujeri ) = 0 + 1edui + 2mujeri

y

E ( wi edui , mujer ) = E ( wi edui , mujeri = 1) = ( 0 + 2 ) + 1edui

2 = E ( wi edui , mujer ) E ( wi edui , hom bre)

How can we interpret 2?

E ( wi edui , hom bre) = E ( wi edui , mujeri = 0) = 0 + 1edui

2 is the difference, on average, between the wage of a woman and a man, having the same level of education. Assuming 2 < 0
E ( wi edui , mujeri = 0) = 0 + 1edui

2. Modeling Structural Change with Binary (or Dummy) Variables

E (wi edui , mujeri = 1) = (0 + 2 ) + 1edui

edu

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2. Modeling Structural Change with Binary (or Dummy) Variables

What other alternative formulations of the model can we propose? wi = 0 + 1edui + 2mujeri + i i = 1,.., n Model 1: Where: wi = wage edui = years of education
1 if a person is female mujeri = 0 if a person is male

Alternative formulation: Model 2: wi = 0 + 1edui + 2 hom brei + i

1 si i es hom bre hombrei = 0 si i es mujer

i = 1,.., n

E(wi/edui, mujer)= ? E(wi/edui, hombre)= ?

How can we interpret 2? What other alternative formulation of models 1 y 2 can we propose? 11

2. Modeling Structural Change with Binary (or Dummy) Variables

Alternative formulation: Model 2: wi = 0 + 1edui + 2 hom brei + i
1 if a person is male hombrei = 0 if a person is female

i = 1,.., n

E ( wi edui , mujer ) = E ( wi edui , hom brei = 0) = 0 + 1edui E ( wi edui , hom bre) = E ( wi edui , hom brei = 1) = ( 0 + 2 ) + 1edui

2 = E ( wi edui , hom bre) E ( wi edui , mujer )

2 is the difference, on average, between a man and a woman wage, for the same level of education.
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2. Modeling Structural Change with Binary (or Dummy) Variables

What relationship can we establish between the coefficients of the two models? 1 model: wi = 0 + 1edui + 2 mujeri + i i = 1,.., n
E ( wi edui , mujer ) = E ( wi edui , mujeri = 1) = ( 0 + 2 ) + 1edui E ( wi edui ,hom bre) = E ( wi edui , mujeri = 0) = 0 + 1edui

2 model: wi = 0 + 1edui + 2 hom brei + i

i = 1,.., n

E ( wi edui , mujer ) = E ( wi edui ,hom brei = 0) = 0 + 1edui

E ( wi edui ,hom bre) = E ( wi edui ,hom brei = 1) = ( 0 + 2 ) + 13 1edui

Obviously: 1 = 1 0 = 0 + 2 0 + 2 = 0

2. Modeling Structural Change with Binary (or Dummy) Variables

Now, the third possible formulation: Model 3.- wi = 1edui + 2mujeri + 3 hom brei + i E(wi/edui, mujeri ,hombrei)= ? E(wi/edui, mujer)= ? E(wi/edui, hombre)= ? then:

i = 1,.., n

3 2 = E ( wi edui , hom bre) E ( wi edui , mujer )

How can we interpret this coefficient?
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2. Modeling Structural Change with Binary (or Dummy) Variables

We have that:
E ( wi edui , mujeri , hom brei ) = 1edui + 2mujeri + 3 hom brei

then:
E ( wi edui , mujer ) = E ( wi edui , mujeri = 1, hom brei = 0) = 2 + 1edui E ( wi edui , hom bre) = E ( wi edui , mujeri = 0,hom brei = 1) = 3 + 1edui

3 2 = E ( wi edui , hom bre) E ( wi edui , mujer )

It is the difference, on average, between the wage of a man 15 and a woman, for the same level of education.

What relationship can we establish between the coefficients of the three models? 1 model: wi = 0 + 1edui + 2mujeri + i i = 1,.., n E ( wi edui , mujer ) = E ( wi edui , mujeri = 1) = ( 0 + 2 ) + 1edui E ( wi edui , hom bre) = E ( wi edui , mujeri = 0) = 0 + 1edui 2 model: wi = 0 + 1edui + 2 hom brei + i i = 1,.., n E ( wi edui , mujer ) = E ( wi edui , hom brei = 0) = 0 + 1edui E ( wi edui , hom bre) = E ( wi edui , hom brei = 1) = ( 0 + 2 ) + 1edui 3 model: wi = 1edui + 2mujeri + 3 hom brei + i i = 1,.., n E ( wi edui , mujer ) = E ( wi edui , mujeri = 1, hom brei = 0) = 2 + 1edui 16 i E ( wi edui , hom bre) = E ( wi edui , mujeri = 0, hom brei = 1) = 3 + 1edu

2. Modeling Structural Change with Binary (or Dummy) Variables

2. Modeling Structural Change with Binary (or Dummy) Variables

Obviously:

1 = 1 = 1

2 = 0 = 0 + 2
3 = 0 + 2 = 0
Careful: The following model would be wrong!
wi = 0 + 1edui + 2mujeri + 3 hom brei + i

Why? How could we test if there are differences, on average, between the wage of a man and a woman, for the same level of 17 education in each model?

2. Modeling Structural Change with Binary (or Dummy) Variables

The following model would not be correct because there would be perfect collinearity because: mujeri + hom brei = 1 i
wi = 0 + 1edui + 2mujeri + 3 hom brei + i

We estimate all those models and test in the usual way the following hypothesis:
H0: 2 = 0 wi = 0 + 1edui + 2mujeri + i H0: 2 = 0 wi = 0 + 1edui + 2 hom brei + i wi = 1edui + 2mujeri + 3 hom brei + i H0: 2 = 3

How can we model changes in the effect of X on Y (on the slope of the model)? How can we model that changes in education can generate, on average; different effect on the wage for men and women? 18

2.3 Interactions Involving Dummy Variables: We can also use dummy variables to model changes in the effect of X on Y (on the slope of the model). An example with dummy independent variables and interactions between dummy variables with explanatory variables: wi = 0 + 1edui + 2mujeri + 3edui mujeri + i i = 1,.., n
1 if a person is female mujeri = 0 if a person is male
edui if a person is female edui x mujeri = 0 if a person is male

2. Modeling Structural Change with Binary (or Dummy) Variables

E(wi/edui, mujeri, edui* mujeri)=? E(wi/edui, mujer)=? E(wi/edui, hombre)= ? 1. How can we interpret 2 y 3? 2. If education (edu) varies one unit, how will, on average, the wage of men and women change? 3. Represent the wage equation for men and women in one Cartesian 19 coordinate system (edu / w) if 2<0 and 3<0

2. Modeling Structural Change with Binary (or Dummy) Variables

E ( wi edui , mujeri , edui mujeri ) = 0 + 1edui + 2mujeri + 3edui mujeri

We have that: then:

E ( w i edui , mujer ) = ( 0 + 2 ) + ( 1 + 3 )edui

E ( wi edui , hom bre) = 0 + 1edui

2 measures the difference between the constant term in men and woman. 3 measures the difference in the slope between men and women: If education (edu) increases one unit, the wage will change, on average: 1+3 units for woman 20 1 units for men

2. Modeling Structural Change with Binary (or Dummy) Variables

Suponiendo 2 < 0 y 3 < 0 w E ( wi edui ,hom bre) = 0 + 1edui

E ( wi edui , mujer ) = ( 0 + 2 ) + ( 1 + 3 )edui

21

edu

2. Modeling Structural Change with Binary (or Dummy) Variables

How could we test if a variation of one unit in education generates the same effect, on average, on the wage of men and women? We estimate the following model and test in the usual way the hypothesis:
wi = 0 + 1edui + 2mujeri + 3edui mujeri + i
E ( w i edui , mujer ) = ( 0 + 2 ) + ( 1 + 3 )edui E ( wi edui ,hom bre) = 0 + 1edui

i = 1,.., n

H0: 3 = 0

How could we test if the constant term or intercept is the same 22 for men and women?

2. Modeling Structural Change with Binary (or Dummy) Variables

How could we test if the constant term (or intercept) is the same for
men and women?

We estimate the following model and test in the usual way the hypothesis:
wi = 0 + 1edui + 2mujeri + 3edui mujeri + i
E ( w i edui , mujer ) = ( 0 + 2 ) + ( 1 + 3 )edui E ( wi edui , hom bre) = 0 + 1edui

i = 1,.., n

H0: 2 = 0

How could we test if the wage model is the same for men and
women?
23

2. Modeling Structural Change with Binary (or Dummy) Variables

How could we test if the wage model is the same for men and women? We estimate the following model and test in the usual way the hypothesis:
wi = 0 + 1edui + 2mujeri + 3edui mujeri + i
E ( w i edui , mujer ) = ( 0 + 2 ) + ( 1 + 3 )edui

i = 1,.., n

E ( wi edui , hom bre) = 0 + 1edui

H0: 2 = 3 = 0

What other alternative formulations of the same model are there?

24

 As we have seen with models with dummy variables as independent variables, there are several alternative formulations of the same model. For example: wi = 0 + 1edui + 2 hom brei + 3edui hom brei + i
1 if a person is male hombrei = 0 if a person is female
edui if a person is male edui x hombrei = 0 if a person is female

2. Modeling Structural Change with Binary (or Dummy) Variables

or alternatively
wi = 1mujeri + 2 hom brei + 3edui mujeri + 4 edui hom brei + i

Which model would not be valid?

25

2. Modeling Structural Change with Binary (or Dummy) Variables

The following model would not be valid (as there is perfect collinearity):
wi = 1mujeri + 2 hom brei + 3edui mujeri + 4edui hom brei + + 5edui + i

as:

edui mujeri + edui hom brei = edui i

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2. Modeling Structural Change with Binary (or Dummy) Variables

We could have more than two categories. For example:
Vi = 0 + 1S1i + 2 S 2i + 3 Pi + 4 ( Pi S1i ) + 5 ( Pi S 2i ) + i

where: Vi: sales of the company ,Pi: advertising expenditures of the company
1 if i belongs to sector 1 S1i = 0 otherwise
1 if i belongs to sector 2 S2i = 0 otherwise

E(vi/Pi, Sector 1)= ? E(vi/Pi, Sector 2)= ? E(vi/Pi, Sector 3)= ?

27

Vi = 0 + 1S1i + 2 S 2i + 3 Pi + 4 ( Pi S1i ) + 5 ( Pi S 2i ) + i

2. Modeling Structural Change with Binary (or Dummy) Variables

where: Vi: sales of the company, Pi: advertising expenditures of the company
1 if i belongs to sector 1 S1i = 0 if i belongs to sector 2 or 3 1 if i belongs to sector 2 S2i =

0 if i belongs to sector 1 or 3

E (Vi Pi , Sector 1) = ( 0 + 1 ) + ( 3 + 4 ) P i E (Vi Pi , Sector 2) = ( 0 + 2 ) + ( 3 + 5 ) P i E (Vi P i , Sector 3) = 0 + 3 P i

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2. Modeling Structural Change with Binary (or Dummy) Variables

3. Chow test 3.1 Methodology When we want to test for differences in regression functions (differences in all the parameters) across groups, we use a particular expression of the F test known as the Chow test. Unrestricted Model (with structural change)
Yi = 0A + 1A X1i + 2A X 2i +...+ kA X Ki + i Submuestra A

Yi = 0B + 1B X1i + 2B X 2i +...+ kB X Ki + i

Submuestra

Restricted model (without structural change)

Yi = 0 + 1 X1i + 2 X 2i +...+ K X Ki + i

What is the null hypothesis?

H0: jA = jB

j = 0,1,..., k

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2. Modeling Structural Change with Binary (or Dummy) Variables

Under H0: jA = jB
F=

j = 0,1,..., K [K+1 linear hypothesis]

( SRR SRS ) (n 2( K + 1)) ~ F k+1,n-2(K+1) K +1 ( SRS )

With SRS=SRA+SRB Applying the asymptotic approximation, we have that under H0:
H0: jA = jB W
0

j = 0,1,..., K

[K+1 linear hypothesis]:

~ k2+ 1
a

SRR SRS ) ( = (n 2( K + 1)) = ( K + 1) F ( SRS )

with SRS=SRA+SRB
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2. Modeling Structural Change with Binary (or Dummy) Variables

3.2 Example U.S. data from 1959 to 1996. Relationship wage/hour versus production/hour Data in constant dollars Possible structural change in 1980 Let us see the graphs for all sample and then the subsample 19591979 and 1980-1996.

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2. Modeling Structural Change with Binary (or Dummy) Variables

110 100 Remuneracin por hora 90 80 70 60 50 40 40 50 60 70 80 90 100 110

Produccin por hora

Nota: ndice =100 en 1992

32

2. Modeling Structural Change with Binary (or Dummy) Variables

110 100 90 Remuneracin 80 70 60 50 40 40 50 60 70 80 90 100 110 1959-1979 Remuneracin 110 100 90 80 70 60 50 40 40 1980-1996

50

60

70

80

90

100 110

Produccin

Produccin

33

2. Modeling Structural Change with Binary (or Dummy) Variables

Example: Y=Wage X=Production
Dependent Variable: REMUNERAC Method: Least Squares Sample: 1959 1996 Included observations: 38 REMUNERAC=C(1)+C(2)*PRODUCC Coefficien Std. Error t-Statistic t C(1) 33.14154 2.540806 13.04372 C(2) 0.691884 0.031062 22.27462 R-squared 0.932351 Mean dependent var 0.930472 S.D. dependent var Adjusted Rsquared S.E. of regression 2.942994 Akaike info criterion Sum squared resid 311.8037 Schwarz criterion Log likelihood -93.91063 F-statistic Durbin-Watson stat 0.115363 Prob(F-statistic)

Prob. 0.0000 0.0000 88.72895 11.16115 5.047928 5.134116 496.1585 0.000000

34

2. Modeling Structural Change with Binary (or Dummy) Variables

110 100 Remuneracin por hora 90 80 70 60 50 40 40

50

60

70

80

90

100 110

Produccin por hora

35

2. Modeling Structural Change with Binary (or Dummy) Variables

Example: Y=Wage X=Production Subsample A=1959-1979
Dependent Variable: REMUNERAC Method: Least Squares Sample: 1959 1979 Included observations: 21 REMUNERAC=C(1)+C(2)*PRODUCC Coefficien Std. Error t-Statistic t C(1) 15.43406 1.461802 10.55825 C(2) 0.963626 0.020876 46.15875 R-squared 0.991161 Mean dependent var 0.990696 S.D. dependent var Adjusted Rsquared S.E. of regression 1.058134 Akaike info criterion Sum squared resid 21.27332 Schwarz criterion Log likelihood -29.93349 F-statistic Durbin-Watson stat 0.450144 Prob(F-statistic)

Prob. 0.0000 0.0000 82.06190 10.97003 3.041284 3.140763 2130.630 0.000000

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2. Modeling Structural Change with Binary (or Dummy) Variables

Example: Y=Wage X=Production Subsample B=1980-1996
Dependent Variable: REMUNERAC Method: Least Squares Simple: 1980 1996 Included observations: 17 REMUNERAC=C(1)+C(2)*PRODUCC Coefficien Std. Error t-Statistic t C(1) 55.24681 3.947315 13.99605 C(2) 0.442976 0.041842 10.58690 R-squared 0.881966 Mean dependent var 0.874098 S.D. dependent var Adjusted Rsquared S.E. of regression 0.954573 Akaike info criterion Sum squared resid 13.66814 Schwarz criterion Log likelihood -22.26772 F-statistic Durbin-Watson stat 1.157740 Prob(F-statistic)

Prob. 0.0000 0.0000 96.96471 2.690247 2.855026 2.953051 112.0825 0.000000

Do we accept or reject the existence of structural change (with F2,34(5%)=3,32)

F=

( SRR SRS ) (n 2( K + 1)) ~ F K+1,n-2(K+1) con SRS=SRA+SRB) ? SRS K + 1 ( )

37

2. Modeling Structural Change with Binary (or Dummy) Variables

Chow test We assume that:
YX
Y X1

~ N (0A + 1A X , 2 ) ~ N (0B + 1B X , 2 )

A B

Then under
F=
F=

H0: jA = jB

j = 0,1 [2 linear hypothesis]

(311,8037 34,94146) (34) = 134,701 > F (5%) 3,32 2 ,34 2 (34,94146)

( SRR SRS ) (38 2(2)) ~ F2,34 2 ( SRS )

SRS=SRA+SRB=21,27332+13,66814=34,94146 We reject H0: jA = jB j = 0,1 There is evidence of structural change 38