School of Economics and Finance tepna Lazarov

Queen Mary, University of London Semester 2, 2012/13

ECN 225 ECONOMETRICS 2
Solutions: Class 4
1. Sales in a company are 196 million in 2003 and increase to 198 million
in 2004.
(a) Compute the percentage increase in sales using the usual formula
100
Sales
2004
Sales
2003
Sales
2003
. Compare this value to the approximation
100 (ln (oc|c:
2004
) ln (oc|c:
2003
)).
(b) Repeat part (a) assuming oc|c:
2004
= 205; oc|c:
2004
= 250;
oc|c:
2004
= 500.
(c) How good is the approximation when the change is small? Does the
quality of the approximation deteriorate as the percentage change
increases?
Answer:
(a) The percentage increase in sales is
198 196
196
= 0.010204 = 1.0204%.
The approximation is
ln 198 ln 196 = 0.01052 = 1.0152%.
The percentage and its approximation are quite close to each
other.
(b) When oc|c:
2004
= 205, the percentage increase is
205196
196
= 4.5918%
and the approximation is ln 205 ln 196 = 4.4895%.
When oc|c:
2004
= 250, the percentage increase is
250196
196
= 27.
551% and the approximation is ln 250 ln 196 = 24.335%.
When oc|c:
2004
= 500, the percentage increase is
500196
196
= 155.1%
and the approximation is ln 500 ln 196 = 93.649%.
(c) The approximation works well when the change is small. The
quality of the approximation deteriorates as the percentage change
increases.
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2. Consider the regression model 1
i
= ,
0
+ ,
1
A
1i
+ ,
2
A
2i
+ n
i
. Transform
the regression so that you can use a t-statistic to test
(a) ,
1
= ,
2
,
(b) ,
1
+ c,
2
= 0, where c is a constant,
(c) ,
1
+ ,
2
= 1. (Hint: You must redene the dependent variable in
the regression.)
Answer:
(a) Testing H
0
: ,
1
= ,
2
is equivalent to testing H
0
: ,
1
,
2
= 0.
Transform the regression in such a way that (,
1
,
2
) is one of
the coecients by writing
1
i
= ,
0
+ ,
1
A
1i
,
2
A
1i
+ ,
2
A
1i
+ ,
2
A
2i
+ n
i
1
i
= ,
0
+ (,
1
,
2
) A
1i
+ ,
2
(A
1i
+ A
2i
) + n
i
1
i
= ,
0
+ A
1i
+ ,
2
\
i
+ n
i
where = ,
1
,
2
and \
i
= A
1i
+A
2i
. Testing H
0
: ,
1
,
2
= 0
in the original model is now equivalent to testing H
0
: = 0 in the
transformed model.
(b) Proceeding in a similar way as in part (a), estimate
1
i
= ,
0
+ A
1i
+ ,
2
\
i
+ n
i
where = ,
1
+c,
2
and \
i
= A
2i
cA
1i
, and test whether = 0.
(c) Again, as in (a) and (b), estimate
2
i
= ,
0
+ A
1i
+ ,
2
\
i
+ n
i
where 2
i
= 1
i
A
1i
, = ,
1
+,
2
1 and \
i
= A
2i
A
1i
and test
whether = 0. Note that in this case, the dependent variable is
transformed as well.
3. Suppose that a researcher collects data on houses that have sold in a
particular neighbourhood over the past year and obtains the regression
results in the table shown on page 4.
(a) Using the results in column (1), what is the expected change in
price of building a 500-square-foot addition to a house? Construct
a 95% condence interval for the percentage change in price.
2
(b) Comparing columns (1) and (2), is it better to use oi.c or ln (oi.c)
to explain house prices?
(c) Using column (2), what is the estimated eect of pool on price?
(Make sure you get the units right.) Construct a 95% condence
interval for this eect.
(d) The regression in column (3) adds the number of bedrooms to
the regression. How large is the estimated eect of an additional
bedroom? Is the eect statistically signicant? Why do you think
the estimated eect is so small? (Hint: What other variables are
being held constant?)
(e) Is the quadratic term ln (oi.c)
2
important?
Answer:
(a) According to the regression results in column (1), the house price
is expected to increase by
0.00042 500 = 0.21 = 21%
with an additional 500 square feet and other factors held constant.
The 95% condence interval for the percentage change is
500 (0.00042 1.96 0.000038) = (17.276%. 24.724%) .
(b) Because the regressions in columns (1) and (2) have the same de-
pendent variable, we can use

1
2
to compare the t of these two
regressions. The log-log regression in column (2) has the higher

1
2
, so it is better to use ln (oi.c) to explain house prices.
(c) The house price is expected to increase by
0.071 1 = 0.071 = 7.1%
if the house has a swimming pool with other factors held constant.
The 95% condence interval for this eect is
0.071 1.96 0.034 = (0.436%. 13.764%) .
(d) The house price is expected to increase by
0.0036 1 = 0.36%
3
with an additional bedroom while other factors are held constant.
The eect is not statistically signicant at a 5% signicance level
because
t =
0.0036
0.037
= 0.0973
is smaller than the 5% two-sided critical value 1.96. The eect
is small since we have held the size of the house constant while
considering the eect of adding an additional bedroom.
(e) The quadratic term ln (oi.c)
2
is not important. The coecient
estimate is not statistically signicant at the 5% signicance level
because
t =
0.0078
0.14
= 0.0557.
4
Dependent variable: ln (1:icc)
Regressor (1) (2) (3) (4)
oi.c 0.00042
(0.000038)
ln (oi.c) 0.69 0.68 0.57
(0.054) (0.087) (2.03)
ln (oi.c)
2
0.0078
(0.14)
1cd:oo:: 0.0036
(0.037)
1oo| 0.082 0.071 0.071 0.071
(0.032) (0.034) (0.034) (0.036)
\ icn 0.037 0.027 0.026 0.027
(0.029) (0.028) (0.026) (0.029)
Co:ditio: 0.13 0.12 0.12 0.12
(0.045) (0.035) (0.035) (0.036)
1:tc:ccjt 10.97 6.60 6.63 7.02
(0.069) (0.39) (0.53) (7.50)
Summary Statistics
o11 0.102 0.098 0.099 0.099

1
2
0.72 0.74 0.73 0.73
Variable denitions: 1:icc = sale price (s); oi.c = house size (in square
feet); 1cd:oo:: = number of bedrooms; 1oo| = binary variable (1 if house
has a swimming pool, 0 if not); \ icn = binary variable (1 if house has a nice
view, 0 if not); Co:ditio: = binary variable (1 if realtor reports house is in
excellent condition, 0 if not).
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