Functional form &

Functional Adequacy

MR. B.CHIZONDE
DEPARTMENT OF ECONOMICS, UNZA
©2016

“IF YOU WANT TO GO FAST, GO ALONE….

IF YOU WANT TO GO FAR, GO TOGETHER.”
AFRICAN PROVERB
 Outline

 1. Function Form-meaning
 2. Functional Form-Testing
 3. Functional Form-Solution
 1. Function Form-meaning

 Functional form refers to the mathematical nature of the

regression equation with regards to the natural
relationship indicated by the data.
 wrong functional form is synonymous to model
misspecification.
 WHY?
 This is because the omitting of relevant variables or
inclusion of irrelevant variables constitutes a wrong
functional form.
 If the correct functional form is a quadratic for example;
running a linear model is termed wrong functional form
and can also be viewed as model misspecification
because the quadratic part was omitted.
 1. Key Notes:
 The functional form which you choose should be
consistent with how the data are actually being
generated.
 Wrong functional form leads to poor or misleading
results.
 To correct functional form problem, we make some
transformations of the variables or add new
variables.
 4. Functional Form-Testing

 It is critical to find out whether there is model

misspecification or wrong functional form.
 The following can be used to analyze whether a
model is functionally adequate:
 (a) graphical Test
 (b) generalized R-square
 (c) Formal residual tests
 (a) graphical Test-Residual plots

 There are a number of formal test that one can use to

diagnose problems of specification, but researchers
often start by looking at the residual plots to get a
quick idea if the problem exits.
 If the assumptions of classical linear regression hold,
the residual should be normally distributed:
 use ch4sim1, clear
 hist e, normal bin(5)

If the residuals look like that, then the assumptions required for
Gauss-Markov theorem are satisfied.
 Example

 Let us plot the residuals of our simple linear

regression model.
 use food, clear
 reg food_exp income
 predict ehat, res
 hist ehat, normal bin(5)
 The residual appear to be normal and hence we
conclude that the model MAY BE correctly specified.
 (b) Generalized R-square

 A Slightly better method to test model fit is to consider

the same generalized R square of the model.
 The R-square gives the percentage of explaining ability
of the model and thus the closer it is to zero the poorer
the model fit.
 In our food expenditure example, R-sq=0.385002. this
is not very large.
 However, in cross sectional models, R-squares are
usually not large.
 This may thus still indicate no model misspecification
 (c) Formal tests

 There a number of formal econometric Normality

tests for model specification.
 Such formal tests include the following:
 1. skewness and Kurtosis Test
 2. Shapiro-Wilk W test
 3. Shapiro-Francia W Test
 Null Hypothesis: Residuals are normal
 *Thus failing to reject the null implies that the model
is correctly specified.
 These normality tests can be conducted as follows:
 sktest ehat
 swilk ehat
 sfrancia ehat
 * Based on the p-values, all tests indicated that the
residuals are normally distributed.
 There is therefore no model misspecification.
 The functional form is adequate.
 3. Functional Form-Solution

 If there we have a wrong functional form:

there is need to seek for another functional
form for the model.
1.Linear-Log Model
 consider the model:
 food_exp=α + β ln(income) + ε
 We can estimate the model and test for model
misspecification:
 gen l_income=ln(income)
 reg food_exp l_income
  predict ehat1, res
 hist ehat1, normal bin(5)

 sktest ehat1
 *The histogram appears to be normal and the formal
test gives a large p-value.
 We conclude that this is a correct functional form.
 There is no model misspecification.
 2. Log-Linear Model
Example 1: Consider the following equation:
 ln(food_exp)=α + β income + ε
 gen l_food_exp = ln(food_exp)
 reg l_food_exp income
 predict ehat2, residuals
 hist ehat2, normal bin(5)
 sktest ehat2
 *This Model is NOT correctly specified. This is a
wrong functional form.
 3. The Log-Log Model
 Consider the model:
 ln(food_exp)=α + β ln(income) + ε
 reg l_food_exp l_income
 predict ehat3, residuals
 hist ehat3, normal bin(5)
 sktest ehat3
 *This Model is NOT correctly specified. This is a
wrong functional form.
 CONCLUSION
 To Model the relationship between food_exp and
income, a linear model or a linear-log model
would be appropriate. This means taking the log of
the dependent variable is not required and
constitutes wrong functional form.
END
 Reference:
 Adkins L. (2014), Using stata for principles of Econometrics, 4th Edition: USA