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ECO 318
Instructor: Kanika Mahajan
Violation of Assumptions
Assumption on Xs
Multicollinearity
n
n _
i
_
^ ( X i X )u i / n V
i 1
( X X ) u i / n
V( 1 | X) V 1 i n1
_ 2
n _
(Xi X ) / n
i
2
( X X ) 2
/ n
i 1
i 1
Numerator in the previous expression :
n _
1 n _
Var ( X i X )u i / n | X 2 Var[( X i X )u i | X ]
i 1 n i 1
n 1 n _ _
2
2
n
Cov[( X
i 1 j i 1
i X )u i , ( X j X )u j | X ]
n _
1
2 E[( X i X ) 2 u i | X ]
2
n i 1
n _
1
2 [( X i X ) 2 E (u i | X )]
2
n i 1
1 n _
2 [( X i X ) 2 E (u i | X )]
2
n i 1
_
1 ^
2 i 1 [( X i X ) u i ]
n 2 2
n
Way out?: General case
1) Heteroscedasticity Robust Standard Errors (Huber, White, Eicker SE' s)
Yi 1 X 1i ... k X ki ui
^ ^
i 1 r ij u j
^ n 2 2
^
Var ( j ) 2
SSR j
where,
rij : i th residual obtained by regressing X j on all other independent
variables
SSR j : is the sum of squared residuals obtained from the above regression
( X j on all other independent variables)
STATA : regress y x, vce(robust)
Obtain H - Robust F - Stat and LM Tests : Wooldridg e
Way out?
2) Weighted Least Squares
Used when the functional form of heteroscedasticity is known.
Var(u | X) 2 h(X)
h(X) 0 since variance is always positive
for example : Savingsi Incomei ui
Let h(X) h(income) income. Then, Var(u|X) 2 Income
Idea : Give less weightage to observation which have a larger error variance
WLS
In general,
Yi 1 X 1i ... k X k i ui
Suppose the error is heteroscedastic, V( ui | X) 2 h(X i )
2
ui
Now conditonal on X, E 2 . So, what if we transform the model?
h
i
Yi X X ki u
1 1i ... k i
hi hi hi hi hi
Yi * 1 X 1i ... k X k i ui
* * * *
2) Feasible Generalized Least Squares
But do we know h(x)?
^
Use h i to do the estimation gives Feasible Generalized Least Squares (FGLS)
estimator.
Ho : Var(u | X) E (u 2 | X ) E (u 2 ) 2
1) Breusch - Pagan Test : Regress u 2 on X' s
u 2 0 1 X 1 ... k X k v
Suppose the error is heteroscedastic, V( ui | X) 2 h(X)
Ho : 1 .... k 0
Can test the above using F - Test or LM Test (asymptotically distributed)
Testing for Heteroscedasticity (1)
R^22 / k
F Stat : u
~ Fk ,n k 1
1 R 2 / n k 1
^2
u
LM Stat : nR^ 2 ~ k
2 2
u
Testing for Heteroscedasticity (2)
Consider the model below :
Y 1 X 1 2 X 2 3 X 3 u
1) Alternative specificat ion
^2
u 0 1 X 1 2 X 2 3 X 3 4 X 1 5 X 2 6 X 3
2 2 2
7 X1 X 2 8 X 2 X 3 9 X1 X 3 v
Ho : 1 2 0
Can test the above using F - Test or LM Test (asymptotically distributed)
Example
* OLS
regress cigs ln_income ln_cigpric educ age age_sq restaurn
u
1
satisfied for this model, then [E( u d | X) 0 md id ]
i 1
When the original model satisfies homoscedas ticity and errors not correlated
within individual s in a district
_
Var( u d | X) 2 /m d . Previously, h i 1/m d
Yi X 1i X ki ui
1 ... k
hi hi hi hi hi
WLS with weights equal to population
Example
Regress y x, [aw=wt]
In the above case, wt=district population