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Maximilian Kasy
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Functional form
Roadmap, Part I
2 / 15
Functional form
Functional forms:
I Quadratic: decreasing or increasing returns
I Interactions: returns vary with covariates
I Discrete regressors, dummy variables, and saturated regressions
I Polynomial
I Linear in logarithms: elasticities
I Justification via Mincer model
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Functional form
I Quadratic polynomial:
I Y = earnings, Z = experience; X1 = Z , X2 = Z 2
E ∗ (Y | 1, X1 , X2 ) = β0 + β1 X1 + β2 X2
E ∗ (Y | 1, X1 , X2 , X3 ) = β0 + β1 X1 + β2 X2 + β3 X3
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Functional form
5 / 15
Functional form
min E [Y − g (Z )]2
g
r (z ) = E (Y | Z = z ).
U = Y − r (Z ).
E ∗ (Y |r (Z ), h(Z )) = β1 r (Z ) + β2 h(Z ) = r (Z ).
E (Y |X = x ) = E ∗ (Y |X = x ).
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Functional form
Discrete regressors
I Assume
Z1 ∈ {λ1 , . . . , λJ }, Z2 ∈ {δ1 , . . . , δK }.
I Dummy Variables:
(
1, ifZ1 = λj , Z2 = δk
Xjk =
0, otherwise
= 1(Z1 = λj , Z2 = δk ).
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Functional form
Solution:
I Any function g (Z1 , Z2 ) can be written as
J K
g (Z1 , Z2 ) = ∑ ∑ γjk Xjk
j =1 k =1
where
βjk = E (Y | Z1 = λj , Z2 = δk ).
I Since E (Y |X = x ) is linear in x, we get
E (Y | Z1 , Z2 ) = E (Y |X ) = E ∗ (Y |X ).
8 / 15
Functional form
Sample Analog
I Data: (yi , zi1 , zi2 ), i = 1, . . . , n.
I Dummy Variables: xi ,jk = 1(zi1 = λj , zi2 = δk ),
y1 x1,jk
.. ..
y = . , xjk = . .
yn xn,jk
I Least Squares:
n
J K
2
min ∑ yi − ∑ ∑ bjk xi ,jk
b
i =1 j =1 k =1
I This gives:
∑ni=1 yi xi ,jk
bjk = = ȳ | λj , δk .
∑ni=1 xi ,jk
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Functional form
Polynomial regressors
I Assume
∼ β0 + β1 s + β2 s2 + β3 t · s + β4 t + β5 t 2 .
E (Y |Z1 = s, Z2 = t ) =
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Functional form
Predictive Effect
I Returns to college:
11 / 15
Functional form
12 / 15
Functional form
E (log W | Z ) = β0 + β1 Z .
I Define U = log W − β0 − β1 Z , so E (U | Z ) = 0.
I
W = β0 + β1 Z + U
⇒ W = exp(β0 + β1 Z ) · exp(U ).
I If U and Z are independent, E [exp(U ) | Z ] = E [exp(U )] and
E (W | Z = d ) ∼ β1 (d − c ) + 1,
= exp[β1 (d − c )] =
E (W | Z = c )
E (W | Z = d ) ∼ 100β1 (d − c ).
100 −1 =
E (W | Z = c )
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Functional form
Mincer model
I Compound Interest (4 = fraction of one year):
E ∗ (Y | 1, S ) = γ0 + (r + γ1 )S ,
E ∗ (A | 1, S ) = γ0 + γ1 S .
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