Final Exam Suggested Solution Key

(10 points) False. Explain: P Because pi is randomly assigned, cov(pi, ui)=0 and b1 1 .

(10 points) True. Explain: Including relevant explanatory variables, such as prices of substitutes, the model can explain more variation in the quantity sold and reduce the residual sum of squares. This also means that the standard errors may be smaller and improve the precision of estimates. The predicted values may have smaller confidence intervals.

(10 points) True. Explain: Using the logarithm of the price and the logarithm of quantity in her linear regression, the manager is estimating a constant elasticity demand curve, where b1 measures the price elasticity of demand. Because as prices fall towards zero, quantity demanded will increase towards a large number (like infinity), and as prices rise to high values, quantity demanded will asymptotically get closer to zero, the nonlinear model will fit the extreme values better than a linear model. This will improve the precision of the estimates and give better prediction for extreme values of prices.

True; an OLS estimate will be inconsistent due to a simultaneity bias. As in the supply and demand example in class q determines p and p determines q ultimately resulting in a correlation between the right hand variable p and the error u. To see that the estimated slope will be biased towards zero it is best to use a graphical example. Looking at the graph below note that when both supply and demand shift we will observe points like A and B. Running an OLS regression based on these points will produce a regression line which will tend to be very flat. So the OLS estimate of (which started out negative) will tend to be too close to zero.

False, there is a way to consistently estimate

(see below).

Since some of the mangers stuck with the randomly assigned prices (p) exactly, and those that did not may have had their prices influenced by the randomly assigned prices, we can use the data from these managers as an instrument to consistently estimate . To be more precise, let Zi= Pi. We have now constructed an instrument Zi that is valid since COV[Ziui]=0 and is relevant since COV[Zi,Xi]>0. So we can use our IV estimator to consistently estimate .

The formula for our consistent estimator is.

(Z Z )q = (Z Z )( + X + u ) = (Z Z ) X + (Z Z )u (Z Z ) X (Z Z ) X (Z Z ) X (Z Z ) X (Z Z ) u = + (Z Z ) X Now ( Z Z ) u COV ( Z , u ) = 0 and ( Z Z ) X COV ( Z , X ) > 0

IV =
i i i 0 1 i i i i i i i i 1 i i i i i i 1 N i i 1 1 N i i 1 p N i i i i 1 p N i i i i

COV ( Z i , ui ) =0 COV ( Z i , X i ) Thus the IV estimator of is consistent. So

p IV 1

The variable Test_score is the midterm grade. num_classes is the number of classes attended through the midterm. GPA is the grade point average, as reported in the survey. reg Test_Score num_classes, robust Regression with robust standard errors Number of obs F( 1, 118) Prob > F R-squared Root MSE = = = = = 120 5.90 0.0166 0.0478 15.174

-----------------------------------------------------------------------------| Robust Test_Score | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------num_classes | 1.452607 .5980065 2.43 0.017 .2683911 2.636822 _cons | 64.09062 4.580781 13.99 0.000 55.01943 73.16181 -----------------------------------------------------------------------------. reg Test_Score num_classes GPA, robust Number of obs F( 2, 112) Prob > F R-squared Root MSE = = = = = 115 15.79 0.0000 0.2060 13.929

Regression with robust standard errors

-----------------------------------------------------------------------------| Robust Test_Score | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+--------------------------------------------------------------num_classes | .8330531 .6123387 1.36 0.176 -.3802176 2.046324 GPA | 13.67888 2.625461 5.21 0.000 8.476865 18.88089 _cons | 25.56469 8.855116 2.89 0.005 8.019418 43.10997 ------------------------------------------------------------------------------

University of California San Diego Econ 120B

Professor Eli Berman March 20, 2007

A 95% confidence interval is 1.453 +/- 1.96*0.598 or (0.281, 2.625).

Lets call whatever their GPA (and it is the same for both students A and B): g. or student A, who attended x + 10 classes, his predicted test score is Test_score_A = 25.56 + (x +10)*0.83 + (g)*13.68 For student B, who attended x classes, his predicted test score is Test_score_B = 25.56 + (x)*0.83 + (g)*13.68 There are still a lot of unknowns here, but fortunately we are only looking for the difference in their two predicted scores. Test_score_A Test_score_B = 0.83 * 10 = 8.3 We would predict that their midterms score will differ by 8.3 points.

Recall the omitted variable bias formula: b1short = b1long + b2long * b21 Where b1short refers to the coefficient in the first regression, and b1long and b2long refers to the coefficients in the second regression. Here we are looking for b21, which in words is the correlation between class attendance and GPA: b21 = (b1short - b1long ) /b2long b21 = (1.45 0.83)/13.68 = 0.045

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University of California San Diego Econ 120B

Professor Eli Berman March 20, 2007

A = p

6 36

=1 6 0.167

A)= se( p B )= se( p

A (1 p A ) N A = 0.167(0.833) 36 = 0.062 p B (1 p B ) N B = 0.2(0.8) 160 = 0.032 p

32 B = 160 p =1 5 = 0.2

Since both players have a sample with N>30 we can use a normal distribution to approximate the distribution of p. Z value for Pa > 0.25 = (0.25 0.167)/0.062 = 1.34 Z value for Pb > 0.25 = (0.25 0.20)/0.032 = 1.56 A is more likely to have p>0.25 because of the smaller Z value (more area in the right side tail of the normal distribution) Alternatively, if we construct confidence intervals for p, 95% CI for PA = 0.167 1.96*0.062 = (0.05, 0.29) 95% CI for PB = 0.20 1.96*0.032 = (0.14, 0.26) (While both players have p=0.25 in their 95% CI, the confidence interval for PA is wider, so it has more density to the right of 0.25.)
5. (10) If all the observations in the sample lie exactly on a vertical line (parallel to the Y axis), what will the value of the R2 be from a regression of Y on X?

The value of the R2 from a regression of Y on X will be 0 in this case. Intuitively, none of the variation in Y has been explained by variation in X.
Proof: Yi = B0 + B1 X i + u i

Since X i = X i ( X is a constant), we can write Yi = 0 + u i , where 0 = B0 + B1 X . = Y i . = Y . Hence, Y OLS will yield

ESS R = = TSS
2

(Y Y ) (Y Y )
i i

2 2

(Y Y ) = (Y Y )
i

2 2

=0 .

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