Econometrics II

BSC III Section A

Spring 2014
Problem Set 2 (Revision)
8
th
January, 2014

Question 1:
(Linear Restrictions) Consider the CobbDouglas production function:

where Y = output, X2 = labor input, and X3 = capital input. Written in log form, the equation becomes

a) If there are constant returns to scale (equiproportional change in output for an equiproportional
change in the inputs), what restriction would the economic theory suggest?











b) Show mathematically how imposing the restriction suggested in part (a) is the same as estimating the
equation:

where (Yi/X2i) = output/labor ratio and (X3i/X2i) = capital labor ratio, quantities of great
economic importance



















Attempting to fit the CobbDouglas production function to the Mexican Economy for years 1955 to
1974 gives us the following results:


c) Interpret the coefficients given in the regression.









d) Are the coefficients significant? Explain.











e) Adding up the coefficients gives us a value of _________. What is the value suggesting?














f) In order to test the restriction of constant returns to scale, equation given in part (b) is estimated
which gives the following results:

Using appropriate test, explain whether the production function of the Mexican Economy exhibits
constant returns to scale or not?













Question 2:
(Specification Issues) In this question we will look at the relation between the logarithm of weekly earnings
and years of education. Using data from the National longitudinal study of youth, we find the following
results for a regression of log weekly wage on years of education, experience, experience squared and an
intercept:

a) Construct a 95% confidence interval for the effect of years of education on log weekly earnings. (t
critical = 1.96)














b) Consider an individual with 10 years of experience. What would you expect to be the return to an
additional year of experience for such an individual (the effect on log weekly earnings)?









Labor economists studying the relation between education and earnings are often concerned about
what they call ability bias." Suppose that individuals differ in ability, and that the correct
specification of the regression function is one that includes ability:

c) In this regression, what do you expect the sign of 4 (the coefficient on ability) to be? What do you
think is the sign of the correlation between ability and years of education?











d) If we estimate the regression function with ability included, do you think that the estimated value of
1 will be greater or less than what it was in the regression without ability? Explain.