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2.4 Units of measurement & fn. form

Effects of changing units of measurement
Example 2.3, CEO salary and Return on Equity

Econometrics I, Lecture 3

Yasushi Kondo

y = salary, annual salary in thousands of dollars

x = roe, the average ROE for the prev. 3 years in %
y = salarydol, salary in dollars = 1000 salary
(2.26) & (2.40)
0, 1

1000

0 , 1000 1

x = roedec, decimal equivalent of roe = roe / 100

(2.26) & (2.41)
0, 1

0 , 100 1

Fn. form; What does linear mean?

Linear in parameters

Chapter 3
Multiple Regression Analysis: Estimation
Primary drawback of simple regression analysis

Multiple regression analysis

See Examples 2.10 & 2.11

Two or more independent variables

Explicitly control for many factors that simultaneously affect
the dependent variable
Build better models for prediction
Incorporate fairly general functional forms

Remember the Weierstrass approximation theorem

3.1. Motivation for Multiple Regression

Example: Wage equation

SLR.4: E
=0
The key assumption SLR.4 often fails.
Omitted variables (other factors included in the error term, u)
are likely correlated with x.
Difficult to draw ceteris paribus conclusions.

3.1. Motivation for Multiple Regression

Example: Consumption fn. general fn. form

,
, unobserved factors in u
Primary interest = effect of
on

measures the change in

w.r.t.
,
holding
fixed.

Marginal effect, MPC, is not constant, or can vary across

income

+2

if

=0

The zero conditional mean assumption

,
=E
=0
E

The key assumption, zero conditional mean,

,
= 0.
should be E

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3.2 Mechanics and Interpretation of

Ordinary Least Squares

k-variable multiple regression model

MLR (3.6)

1 1

+ +

2 2

log

log

Fitted values

| 1,

2, ,

0, 1, ,

to get OLSE

linear means linear in parameters, not in variables

=1
CEO tenure

Zero conditional mean assumption (3.8),

Minimize (3.12)

Example: CEO salary (3.7)

Obtaining OLS Estimates

Residuals

=0

=
=

+ +

= 1, ,

= 1, ,

3.2 Mechanics and Interpretation of

Ordinary Least Squares

Obtaining OLS Estimates

FOC (3.13); compare this with FOC (2.14) & (2.15)

Interpreting OLS Regression Equation

An OLS slope estimate measures the partial effect,

holding all other variables fixed.

=0

(3.16)
(3.17)

=
=

=0

(3.18)

+
1

+ 2 2 + +

1 + 2 2 + +
1 1

=1
1
=1

if

==

=0

This does not hold, e.g., if

1 1

=0

We controlled for the variables , , ,

when estimating the effect of
on .

=1
9

10

The Meaning of Holding Other Factors

Fixed in Multiple Regression

Example 3.2: Hourly Wage Equation

Eq. (3.19)

log

= 0.284 + 0.092

+ 0.0041

+ 0.022

educ = the years of education

exper = the years of labor market experience
tenure = the years with the current employer
Ceteris paribus interpretation:
Another year of education increases wage by 9.2%, when
exper and tenure are fixed.

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No data collection with holding other factors fixed

Data by random sampling are available

Experimental data collected with holding other factors

fixed Apply Simple Regression

Non-experimental data Apply Multiple Regression

to get ceteris paribus interpretation, or
to mimic Simple Regression with experimental data

Semi-elasticity obtained in Log-level specification; see Table 2.3

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OLS Fitted Values and Residuals

Partialling Out interpretation

Properties similar to Simple Regression

(3.22)
1

Sample average of residuals = 0

Avg. of = Avg. of
The point of averages , , , ,
regression line (hyper-plane)

is always on the OLS

Sample covariance between OLS fitted values and residuals = 0

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MLR

1 1

SLR

1 1

OLSE in MLR can be obtained by regressing

Comparison of SLR and MLR estimates

2 2

and

Example 3.3 (p. 75): Participation in 401(k) pension plans

= 80.12 + 5.52

1 1

2 1

corr

SLR and MLR give the same results

1

if

= 0 or

=0

is irrelevant or uncorrelated with

15

SST = SSE + SSR

R-squared = SSE/SST
R-squared = {corr(y, y-hat)}2

= 83.08 + 5.86
,
= 0.12

Homework assignment
SST = =1
SSE = =1
SSR = =1

2
2

R-squared never decreases when any variable (even

irrelevant one) is added to a regression

Perform a statistical test to check if partial effects are

zeros, to decide whether explanatory variables should be
added; do not use R-squared for this purpose.
Use adjusted R-squared, to compare goodness-of-fit of
regression models that have different numbers of s.
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Age of the plan

Match rate: The rate of firms contribution
to insurance premium paid by worker

MLR (5.52) and SLR (5.86) give similar results because

and
are little correlated, although age is
relevant.

Problems 3, 9 and 11 in Chapter 2 (repeated)

Computer exercises C2, C3 and C5 of Chapter 3

+ 0.243

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Goodness-of-fit

on

The Frisch-Waugh-Lovell theorem

Eq. (3.23): Relationship between OLSEs by MLR and SLR

1

2, ,

Part of
that is uncorrelated with the other s
after the effects of the other s are partialled out, or
netted out.

Participation rate of the plan

on

14

Comparison of SLR and MLR estimates

Residual,

=1

1 : residual by reg.

Sample covariance between s and residuals = 0

21

1
=1

Sum of residuals = 0

Would be explained in the TA session this week.

Part (iv) of C3 is advanced because it is related to the topics
that will be covered in the next lecture.

You do not have to submit these assignments.

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