Introduction to Econometrics

Lecture 5
Extensions to the multiple regression model

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Lecture plan
logarithmic transformations - log-linear

(constant elasticity) models

dummy variables for qualitative factors
simple dynamic models with lagged variables the partial adjustment mechanism
an application to illustrate the above - A study
of cigarette consumption in Greece by Vasilios
Stavrinos (Applied Economics, 1987 pp 323329)
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Guy Judge March 2007

Log-linear regression models (1)

In many cases relationships between
economic variables may be non-linear.
However we can distinguish between
functional forms that are intrinsically nonlinear (and will need to be estimated by
some kind of iterative non-linear least
squares method) and those that can be
transformed into an equation to which we
can apply ordinary least squares
techniques.
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Guy Judge March 2007

Log-linear regression models (2)

Of those non-linear equations that can be
transformed, the best known is the
multiplicative power function form
(sometimes called the Cobb-Douglas
functional form), which is transformed into
a linear format by taking logarithms.

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Log-linear regression models (3)

Production functions
For example, suppose we have cross-section
data on firms in a particular industry with
observations both on the output (Q) of each firm
and on the inputs of labour (L) and capital (K).
Consider the following functional form

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Log-linear regression models (4)

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Log-linear regression models (5)

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Log-linear regression models (6)

The parameters and can be estimated directly from a

regression of the variable lnQ on lnL and lnK

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Log-linear regression models (7)

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Log-linear regression models (8)

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Dummy variables (1)

Dummy variables (sometimes called dichotomous variables) are variables that are
created to allow for qualitative effects in a regression model.
A dummy variable will take the value 1 or 0 according to whether or not the
condition is present or absent for a particular observation.
For example suppose we are investigating the relationship between the wage (Y)
and the number of years of experience (X) of workers in a particular industry.
Our initial model is
Y=a+bX+u
However we are concerned that the wages of female workers may be below that of
male workers with similar experience. To test for this we can introduce a dummy
variable to distinguish between the observations for male and female workers in
the regression.
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Dummy variables (2)

Define D = 1 for male workers and 0 for female workers.
The overall equation becomes
Y = a + b X + cD + u
where c will measure the differential between male and female
workers, having taken account of differences in experience. We can
run a normal multiple regression with X and D as explanatory
variables. Assuming that c is positive it means that the regression
line for male workers lies above that for female workers - c
measures the extent of the upward shift. We can use its t value to
test whether these differences are statistically significant.
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Guy Judge March 2007

Dummy variables (3)

Ramu Ramanathan (1998) includes a data set compiled by Susan Wong relating to
49 professionals in an industry (23 are for females and 26 for males).
The results show a large and significant difference in wages (which range between
981 and 3833 with a mean of 1820).

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Guy Judge March 2007

Dummy variables (4) Testing for differences in intercept.

Yi = 1 + 2 Xi+ 3 Di + ui
Y

wage
rate

For men: Di= 1.

Yi = (1+ 3) + 2 Xi + ut

Men
Women
For women: Di = 0.

Yi = 1 + 2 Xi + ui
1 + 3
1
0
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years of experience

Guy Judge March 2007

Interactive dummies: Testing for differences in intercept and slope

Yi = 1 + 2 Xi + 3 Di + 4 Di Xi + ui
Y
wage
rate

Yi = (1 + 3) + (2 + 4) Xi + ui
Men

+ 4

Women
Yi = 1 + 2 Xi + ui

1
1 + 3
0
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years of experience
Guy Judge March 2007

Dummy variables and time series data

With time series data we can have
impulse dummies just affecting a particular period
step dummies affect remains on for a number of periods
We might also have seasonal dummies
e.g. lnQt = b0 + b1 lnYt + b2lnPt + d1D1t + d2D2t + d3 D3t + ut
D1 = 1 for quarter 1 observations, 0 otherwise
D2 = 1 for quarter 2 observations, 0 otherwise
D3 = 1 for quarter 3 observations, 0 otherwise

Beware of the dummy variable trap

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Partial adjustment mechanisms (1)

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Partial adjustment mechanisms (2)

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Illustration: cigarette consumption in Greece

(see Stavrinos, Applied Economics, 1987 19, pp323-329)

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Stavrinos results

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