FUNCTIONAL FORMS AND NON LINEARITY IN

SIMPLE REGRESSIONS
Linear relationships are not nearly general enough for all economic applications. Therefore,
it is rather easy to incorporate non linearities in simple regression.

HOE TO INTERPRETE DIFFERENT MODEL/ ESTIMATOR

In applied social sciences, regression equation appears in logarithmic form. The reason
behind this is quite simple that this gives a constant percentage effect.

Lets take the example of wage- education model

Log(wage) = βo + β1 Edu + µ

Where log(.) denotes the natural logarithm.

If delta µ = , then

%delta wage = (100.β1) delta edu.

The model can be interpreted as each year of education increases wage by a constant
percentage. This implies that the change in wage for an extra year of education increases as
education increases and thus there is an increasing return to education.

It is a straightforward way to estimate the wage education model. The mechanics OLS are
the same as before.

NOTE: the main reason for using the log of dependent variable is to impose a constant
percentage effect of explanatory variable on dependent variable.

CONSTANT ELASTICITY MODEL

The model is estimated by defining both dependent and independent variable in log form
for sample regression.consider the salary scale model:

Log(salary) = βo + β1 (sales) +µ

Log salary = 4.822 + 0.257log(sales)

The coefficient of log (sales) is the estimated elasticity of salary with respect to sales. It is
explained as that 1% increase in firm sales increases CEO salary by about 0.257%. this is
basically a genuine interpretation of elasticity.
It is pertinent to mention here that changes in the units of measurement of the dependent
and independent variable would have no impact on the slope so the slope remains the
same, but the intercept changes( See Wooldridge, chapter 2 )

The table below gives the summary of four combinations of functional forms

Model Dependant Independent Interpreting Summary

variable variable 𝜷1

Level – Level Y X ∆𝑦 = 𝛽∆𝑥 Linear Model

Level – log Y Log (x) 𝛽
∆𝑦 = (100) % Less often in
practice
∆𝑥
Log – level Log(y) X 100
%∆𝑦 = ( 𝛽1 ) ∆𝑥 Semi Elasticity
Log – log Log(y) Log (x) %∆𝑦 = 𝛽1%∆𝑥 Elasticity