PANEL DATA ANALYSIS

Panel data consist of observations on the same cross-sectional, or individual, units over
several time periods.
Advantages of panel data
(1) They increase the sample size considerably.
(2) By studying repeated cross-section observations, panel data are better suited to study the
dynamics of change.
(3) Panel data enable us to study more complicated behavioral models.
Problems with panel data
Since such data involve both cross-section and time dimensions, problems that plague crosssectional data (e.g., heteroscedasticity) and time series data (e.g., autocorrelation) need to
addressed. There are also some additional problems, such as cross-correlation in individual
units at the same point in time.
Estimation techniques
The two most prominent are (1) the fixed effects model (FEM) and (2) the random effects
model (REM) or equivalently the error components model (ECM).
FEM
In FEM the intercept in the regression model is allowed to differ among individuals in
recognition of the fact each individual, or cross-sectional, unit may have some special
characteristics of its own. To take into account the differing intercepts, one can use dummy
variables. The FEM using dummy variables is known as the least-squares dummy variable
(LSDV) model. FEM is appropriate in situations where the individual-specific intercept may
be correlated with one or more regressors. A disadvantage of LSDV is that it consumes a lot
of degrees of freedom when the number of cross-sectional units, N, is very large, in which
case we will have to introduce N dummies (but suppress the common intercept term).
-Fixed Effects are generally used when there is a correlation between the individual intercepts
and the independent variables.
-Generally used when N is relatvely small and T is relatively large.
REM (ECM)
In REM it is assumed that the intercept of an individual unit is a random drawing from a
much larger population with a constant mean value. The individual intercept is then expressed
as a deviation from this constant mean value. One advantage of REM over FEM is that it is
economical in degrees of freedom, as we do not have to estimate N cross-sectional
intercepts.We need only to estimate the mean value of the intercept and its variance. REM is
appropriate in situations where the (random) intercept of each cross-sectional unit is
uncorrelated with the regressors.
-Random Effects models assume that the intercept of an individual unit is a random drawing
from a much larger population with a constant mean value.
-If N is large and T is small (and if the assumptions underlying RE hold) the RE are more
efficient estimators.

-Use Fixed Effects if the errors and the observations are correlated (e.g. countries).
Hausman test
The Hausman test can be used to decide between FEM and ECM.
-The Hausman (1978) test is distributed Chi-squared asymptotic around the null hypothesis
that Random Effects is appropriate.
-The null hypothesis is that the FE and the RE do not differ substantially.
-The test is distributed asymptotically chi-squared.
-FE is consistent under both the null and the alternative
-RE is consistent under both the null and inconsistent under the alternative.
Other reasons to use panel data analysis
With panel data we can control for factors that:
-vary across entities (e.g. states) but do not vary over time.
-could cause omitted variable bias if they are omitted
-are unobserved or unmeasured - and therefore cannot be included in the regression using
multiple regression.
The key idea: If an omitted variable does not change over time, then any changes in Y over
time cannot be caused by the omitted variable.
Panel data lets us eliminate omitted variable bias when the omitted variables are constant over
time within a given entity (e.g. a state).

http://www.powershow.com/view/e4cf7NWQyO/Applied_Econometrics_Panel_Lecture_powerpoint_ppt_presentation