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Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Primary drawback of simple regression analysis is that the key assumption SLR.3 is often unrealistic. Multiple regression analysis allows to explicitly control for many other factors that simultaneously aect the dependent variable. It is more amenable to ceteris paribus analysis. (1) If we add more factors that are useful for explaining y , then more of the variation in y can be explained. (2) Multiple regression analysis can incorporate fairly general functional forms. it allows for much more exibility.
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
wage is determined by 2 independent variables, education and experience, and by other factors contained in u . We are still primarily interested in the eect of educ on wage . (1) takes exper out of u and puts it explicitly in the equation. Can measure the eect of educ on wage , holding exper xed. We dont need to assume exper is uncorrelated with educ . 2 measures ceteris paribus eect of exper on wage .
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
It can generalize functional relationships between variables. cons = 0 + 1 inc + 2 inc 2 + u (4) Consumption depends on only 1 observed factor, income. This model is not a a simple regression model because it has 2 independent variables, x1 = inc and x2 = inc 2 . In (1), 1 is the ceteris paribus eect of educ on wage . In (4), marginal propensity to consume is approximated by cons 1 + 22 inc inc
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
The key assumption about how u is related to x1 and x2 is E (u |x1 , x2 ) = 0 For any values of x1 and x2 , the average unobservable is equal to 0. E.g., in (1), this assumption is E (u |educ , exper ) = 0. Other factors aecting wage are not related on average to educ and exper .
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(5)
(6) requires that all factors in the unobserved error term be uncorrelated with the explanatory variables.
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(7)
(8)
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
The OLS rst order conditions can be obtained by the method of moments: Under assumption (6), E (u ) = 0 and E (xj u ) = 0, j = 1, 2, ..., k , Equations (8) are the sample counterparts of these population moments.
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(9)
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(10)
Holding x2 , ..., xk xed implies that 1 x1 y = 1 measures the change in y or due to a one-unit increase in x1 , holding all other independent variables xed. j has a ceteris paribus interpretation. Each
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Goodness-of-Fit
As with simple regression, we can dene n )2 is the total sum of squares (SST), i =1 (yi y n i y )2 is the explained sum of squares (SSE), i =1 (y n i 2 is the residual sum of squares (SSR). i =1 u Then SST = SSE + SSR Assuming that the total variation in y is nonzero, we can divide (12) by SST to get 1 = SSE /SST + SSR /SST (12)
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Goodness-of-Fit (cont.)
As in simple regression, the R-squared is SSE SSR R2 =1 SST SST R 2 implies the proportion of the sample variation in y that is explained by the model. 0 R2 1 R 2 never decreases and usually increases when another independent variable is added to a regression. Because SSR never increases when additional regressors are added to the model.
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Goodness-of-Fit (cont.)
E.g., GPA1. hsGPA and ACT together explain about 17.6% of the variation in colGPA for this sample. We must remember that there are many other factors family background, personality, quality of high school education, anity for college that contribute to a students college performance. A low R 2 does not mean that the equation is useless. It is still possible that the OLS estimates are reliable estimates of the ceteris paribus eects of xj on y .
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Unbiasedness of OLS
We turn to the statistical properties of OLS which have nothing to do with a particular sample, but with the properties of estimators when random sampling is done repeatedly. Unbiasedness of OLS is established under a set of assumptions: Assumption MLR.1 (Linear in Parameters) The population model is linear in parameters as y = 0 + 1 x1 + 2 x2 + ... + k xk + u (14)
where 0 , 1 , 2 , ..., k are unknown parameters of interest, and u is an unobservable random error term.
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Assumption MLR.3 can fail if the functional relationship between y and x s is misspecied. E.g., we forget to include inc 2 , use wage instead of log (wage ). When Assumption MLR.3 holds, we often say that we have exogenous explanatory variables. If xj is correlated with u , then xj is said to be an endogenous explanatory variable.
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(16)
OLS are unbiased estimators of the population parameters. When we say OLS is unbiased, we mean the procedure by which the OLS estimates are obtained is unbiased.
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Assume the model satises Assumptions MLR.1 thru MLR.4. Suppose our primary interest is in 1 , the partial eect of x1 on y . E.g., y is hourly wage, x1 is education, x2 is a measure of innate ability. To get an unbiased estimator of 1 , we should run a regression of y on x1 and x2 . wage = 0 + 1 educ + 2 abil + u
Le Van Chon Applied Econometrics
(18)
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(19)
Since (17) is the true model, we write y for each obs i as yi = 0 + 1 xi 1 + 2 xi 2 + ui (20) Plug (20) in the numerator of (19):
n
(xi 1 x 1 )(0 + 1 xi 1 + 2 xi 2 + ui )
i =1 n n n
= 1
i =1
(xi 1 x 1 )2 + 2
i =1
Le Van Chon
(xi 1 x 1 )xi 2 +
i =1
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(22)
1 ) does not generally equal 1 : 1 is biased for 1 . Thus, E ( The ratio multiplying 2 is the slope coecient from the 0 + 1 x1 regression of x2 on x1 : x 2 =
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
We can write (22) as 1 |x1 , x2 ) = 1 + 2 1 E ( 1 is E ( 1 ) 1 = 2 1 , called the omitted The bias in variable bias. 1 is unbiased if: (23) implies there are 2 cases where (i) 2 = 0, that is x2 does not appear in the true model; 1 = 0, that is x1 and x2 are uncorrelated in the sample. (ii) (23)
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Theorem 3.2 (Sampling Variances of OLS Slope Estimators) Under Assumptions MLR.1 through MLR.5, j |x ) = Var ( 2 for j = 1, 2, ..., k SSTj (1 Rj2 ) (24)
where SSTj = n j )2 and Rj2 is the R-squared from i =1 (xij x regressing xj on all other independent variables (and including an intercept). Now we discuss the elements comprising (24).
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Total sample variation in xj , SSTj . The larger the total j ). (This is discussed in variation in xj , the smaller is Var( Chapter 2.) One way to increase SSTj is to increase the sample size. In fact, SSTj increases without bound as the sample size gets larger and larger. Extreme case: no sample variation in xj , SSTj = 0, is not allowed by Assumption MLR.4.
Le Van Chon
Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
When 2 = 0, (26) excludes a relevant variable and in Section 1 unless x1 and x2 are uncorrelated. 3.3, this induces a bias in
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
2 Var (1 |x ) = SST1
1 |x ) < Var ( 1 |x ) unless x1 (27) and (28) shows that Var ( and x2 are uncorrelated in the sample.
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
(29)
Term n k 1 in (29) is the degrees of freedom (df) with n observations and k + 1 estimated parameters. Theorem 3.3 (Unbiased estimation of 2 ) Under the Gauss-Markov Assumptions MLR.1 through MLR.5, E ( 2) = 2
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
j : Standard deviation of
j ) relies on Assumption MLR.5, (30) is Note that because se( j ) if the errors exhibit not a valid estimator of sd( heteroskedasticity.
Le Van Chon Applied Econometrics
Motivation for Multiple Regression Mechanics and Interpretation of OLS Expected Values of OLS Estimators Variance of the OLS Estimators Eciency of OLS
Theorem 3.4 (Gauss-Markov Theorem) 0 , 1 , ..., k are Under Assumptions MLR.1 through MLR.5, the best linear unbiased estimators (BLUEs) of 0 , 1 , ..., k , respectively. Best smallest variance, Linear a linear function of the sample data, j ) = j . Unbiased E( If the assumptions hold, use OLS.
Le Van Chon
Applied Econometrics