Debre Tabor University

Faculty of Business and Economics

Department of Economics
Regular Master Program Year I Semester I

Econometrics and Software Applications (Econ7031) Assignment One

Name: Bantalem Sinishaw

ID NO. DTUR 13040

Submission Date: December 4, 2020

Submitted To: Doctor Yismaw Ayelign

1. Given the following Cobb-Douglas production function, state the interpretations of the coefficient
parameters (2 points)
, which could be transformed in to natural logarithm for as:
𝑙𝑛𝑌𝑖 = 𝛽𝑜 + 𝛽1𝑙𝑛𝑋1 + 𝛽2𝑙𝑛𝑋2 + 𝑢𝑖; Where 𝛽𝑜 = 𝑙𝑛𝐴
Yi = output in value added
X1 = labor input ui = stochastic disturbance term
X2 = capital input e = base of natural logarithm

 is interpreted as the elasticity of output with respect to X1 (labor input), holding X2 (capital input)
constant. That is, it gives the percentage change in output for a percentage change in the labor input,
given capital input remains unchanged. More specifically, if we change labor input by 1%, on average
the output will be changed by , holding the capital input constant.
 Similarly, gives the elasticity of output with respect to the X2 (capital input), holding X1 (labor
input) constant and gives the percentage change in output for a percentage change in the capital input,
keeping labor input fixed. If we change capital input by 1%, on average the output will be changed
by , holding the labor input constant.

2. What if the functional form of a different function is given as (1 point each):

a) 𝑙𝑛𝑌i = 𝛼𝑜 + 𝛼1𝑋1 + 𝛽2𝑋2 + 𝑢i
 In this model the slope coefficients measure the constant proportional or relative change in Y for a
given absolute change in the value of the repressors (X1 and X2), that is

 In above functional form can be interpreted as a one unit change in X1, holding X2 constant, causes
( ) change in Y. Example if the estimated coefficient means a one unit increase in
X1 will generate 5% increase in Y.
 is also interpreted as a unit change in X2, holding X1 constant, causes ( ) change in Y.
Example if the estimated coefficient means a one unit increase in X1 will generate
56.5% decrease in Y.
b) 𝑌i = 𝛼0 + 𝛼1𝑙𝑛𝑋1 + 𝛽2𝑙𝑛𝑋2 + 𝑢i
 In this model the slope coefficients measure the absolute change in Y for given relative changes in
the value of the regressors (X1 and X2), that is
And
⁄ ⁄
 From the functional form, is interpreted as a 1% change in X1 is associated with a 0.01 change
in Y, keeping X2 constant. For example if , the absolute change in Y=0.01(15)=0.15; that is if
X1 is increased by 1%, Y will increased by 0.15.
 Similarly is interpreted as a 1% change in X2 is associated with a 0.01 change in Y, keeping X1
constant. For example if , the absolute change in Y=0.01(300) =3.
3. Explain and demonstrate the nature, consequences, detection mechanisms and remedial measures
to be taken for the violation of the following assumptions of classical linear regression models (2
points each)

i. Heteroscedasticity ii. Serial correlation iii. Perfect multicollinearity

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 i. Heteroscedasticity
Nature
Heteroscedasticity violates the classical linear regression assumption of constant variance of the error terms
(ui). In other words, this problem exists when, given the values of Xi (explanatory variables), the variance of each
error term is different. It encounters cross sectional data.
Consequences
a. Heteroscedasticity does not alter the unbiasedness and consistency properties of OLS estimators.
b. But OLS estimators ( ̂ i) are no longer of minimum variance or efficient. That is, they are not best
linear unbiased estimators (BLUE); they are simply linear unbiased estimators (LUE).
c. As a result, the t and F tests based under the standard assumptions of CLRM may not be reliable,
resulting in erroneous conclusions regarding the statistical significance of the estimated regression
coefficients.
Detection mechanisms
There are several detection mechanisms of heteroscedasticity. Among them:
a. The Goldfeld-Quandt test
Step 1: Arrange the data from small to large values of the independent variable Xj
Step 2: Run two separate regressions, one for small values of Xj and one for large values of Xj, omitting d
middle observations (app. 20%), and record the residual sum of squares RSS for each regression: RSS1 for
small values of Xj and RSS2 for large Xj’s.
Step 3: Calculate the ratio F = RSS2/RSS1, which has an F distribution with d.f. = [n – d – 2(k+1)]/2 both in
the numerator and the denominator, where n is the total number of observations, d is the number of omitted
observations, and k is the number of explanatory variables.
Step 4: Reject H0: All the variances σi2 are equal (i.e., homoscedastic) if F > Fcr, where Fcr is found in the
table of the F distribution for [n-d-2(k+1)]/2 d.f. and for a predetermined level of significance α, typically
5%.
b. Breusch-Pagan (BP) test : Lagrange Multiplier (LM) tests (for large n>30)
Step 1: Run the regression of ûii2 on all the explanatory variables. If there is only one explanatory variable,
X1, the model for the OLS estimation has the form: ûii2 = α0 + α1X1i +… α1Xki+vi
Step 2: Keep the R2 from this regression. Let’s call it R2 ûii2 calculate either
F = [(R2 ûii2 /k)]/ [(1- R2 ûii2)/(n-(k+1)], where k is the number of explanatory variables; the F
statistic has an F distribution with d.f. = [k-1, n-k]. Then reject H0: All the variances σi2 are equal
(i.e., homoscedastic) if F >Fcr. Or
 LM = nR2 ûii2, where LM is called the Lagrangian Multiplier (LM) statistic and has an asymptotic
chi-square (χ2) distribution with d.f. = k Reject H0: All the variances σi2 are equal (i.e.,
homoscedastic) if LM> χcr.
Remedial measures
Assume the model: Yi=β1+β2X2i+ β3X3i +ui has heteroscedastic variance. Then can solve it as follow.
 Method of Generalized Least Squares (GLS)
If we can know the true heteroscedastic variances, , though they are rarely observed. If we could observe
them, then we could obtain BLUE estimators by dividing each observation by the (true heteroscedastic)
and estimate the transformed model by OLS. The method is dividing each observation by as follow:
Yi/ =β1/ +β2 [X2i / ] + β3[X3i/ ]+ui/ . Then estimating this equation using OLS will correct the
heteroscedasticity problem. But to be sure it needs to be detected for heteroscedasticity by the mechanisms
discussed above.

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In the case of true heteroscedastic variances, is unknown, we make educated guess about true
heteroscedasticity variance and transform our data accordingly to remove heteroscedasticity. There
numbers of ways doing so.
 If we guess that the true error variance is proportional to the square of one of the regressors say X2i, we
can divide both sides of Yi=β1+β2X2i+ β3X3i by X2i and run the transformed regression.
 If the true error variance is proportional to one of the regressors, we can use the so-called square
transformation, that is, we divide both sides Yi=β1+β2X2i+ β3X3i+ui by the square root of the chosen
regressor and run regression of the result.
White's heteroscedasticity-consistent standard errors or robust standard errors19
If the sample size is large, White has suggested a procedure to obtain heteroscedasticity-corrected standard
errors. These are known as robust standard errors. The procedure does not alter the values of the
coefficients, but corrects the standard errors to allow for resolving heteroscedasticity.

ii. Serial correlation

Nature
Common problem in regression analysis involving time series data is autocorrelation. Recall that one of the
assumptions of the classical linear regression model (CLRM) is that the error terms, Ut, are uncorrelated
that is the error term at time t is not correlated with the error term at time (t - 1) or any other error term in
the past.
If the error terms are correlated, the following consequences follow:
a. The OLS estimators are still unbiased and consistent.
b. They are still normally distributed in large samples.
c. But they are no longer efficient. That is, they are no longer BLUE (best linear unbiased estimator). In
most cases OLS standard errors are underestimated, which means the estimated t values are inflated,
giving the appearance that a coefficient is more significant than it actually may be.
d. As a result, as in the case of heteroscedasticity, the hypothesis-testing procedure becomes suspect, since
the estimated standard errors may not be reliable, even asymptotically (Le. in large samples). In
consequence, the usual t and F-tests may not be valid.
Detection mechanism
Durbin-Watson d- test
It was developed by statisticians Durbin and Watson, and is popularly known as the Durbin-Watson d
∑( ̂ ̂ )
statistic, which is defined as: ∑̂
which lies between 0 and 4.
Assumptions
 The regression model includes an intercept term.
 The explanatory variables, or regressors, are fixed in repeated sampling.
 The error term Ut follows the first-order autoregressive (ARl) scheme: ut= ut-1+vt. Where (rho) is the
coefficient of autocorrelation and it lies in the range 1. It is called first-order AR because it
involves only the current and one-period lagged error term. Vt is a random error term.
 The error term Ut is normally distributed.
 The regressors do not include the lagged value(s) of the dependent variable, Yt, that is, regressors do not
include Yt-1, Yt-2 and other lagged terms of Y.
Decision rules
 If d < dv there probably is evidence of positive autocorrelation.
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  If d > du, there probably is no evidence of positive autocorrelation.
 If dL < d < dU, no definite conclusion about positive autocorrelation may be made.
 If dU < d < 4-du, there is probably no evidence of positive or negative autocorrelation.
 If 4-du < d < 4-dL, no definite conclusion about negative autocorrelation may be made.
 If 4-dL < d < 4 there probably is evidence of negative autocorrelation.
Where dL= 0 and dU=4
Remedial measure
Consider the model: Yt = β1+β2X2t+β3X3t+β4X4t+…+βkXkt+ut where ut=ρ1ut-1+vt. Then we will assume two
cases:
Case 1: when ρ is known
Step 1: Write the model of t-1: Yt-1=β1+β2X2t-1+β3X3t-1+β4X4t-1+…+βkXkt-1+ut-1
Step 2: Multiply both sides by ρ to get: ρYt-1= ρβ1+ ρβ2X2t-1+ ρβ3X3t-1+ ρβ4X4t-1 +…+ ρ βkXkt-1+ ρut-1
Step 3: Subtract those two equations:
Yt-ρYt-1= (1-ρ)β1+ β2(X2t-ρX2t-1)+ β3(X3t-ρX3t-1)+ +…+ βk(Xkt -ρXkt-1)+(ut-ρut-1) or
Y*t= β*1+ β*2X*2t+ β*3X*3t+…+ β*kX*kt+vt. Where now the problem of autocorrelation is resolved
because vt is no longer autocorrelated.
Case 2: when ρ is unknown
The Cochrane-Orcutt iterative procedure
Step 1: Estimate the regression and obtain residuals
Step 2: Estimate ρ from regressing the residuals to its lagged terms ̂ t= 𝑢̂t-1+vt
Step 3: Transform the original variables using the obtained from step 2.
Step 4: Run the regression again with the transformed variables and obtain residuals.
Step 5 and on: Continue repeating steps 2 to 4 for several rounds until (stopping rule) the estimates of
from two successive iterations differ by no more than some preselected small value, such as 0.001.
iii. Perfect multicollinearity
Nature
When the explanatory variables are very highly correlated with each other or if there is one more exact
relationship between explanatory variables, then the problem of perfect multicollinearity occurs. For
example assume the model 𝑌 𝛽 𝛽𝑋 𝛽𝑋 , if X1 =2X2, there is exact relationship between X1
and X2 and hence perfect multicollinearity.
Consequences
If collinearity is not perfect, but high, several consequences ensure:
 The OLS estimators are still BLUE,
 But one or more regression coefficients have large standard errors relative to the values of the
coefficients, thereby making the t ratios small.
 Even though some regression coefficients are statistically insignificant, the R2 value may be very
high.
 Therefore, one may conclude (misleadingly) that the true values of these coefficients are not
different from zero.
 Also, the regression coefficients may be very sensitive to small changes in the data, especially if the
sample is relatively small.

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Detection mechanisms
If one or more of the following is existed in regression, multicollinearity will occur
 High R2 but few significant t ratios.
 High pair-wise correlations among explanatory variables or regressors.
 High partial correlation coefficients.
 Significant F test for auxiliary regressions (regressions of each regressor on the remaining regressors).
 High Variance Inflation Factor (VIF) – particularly exceeding 10 in value – and low Tolerance Factor
(TOL, the inverse of VIF). where is the correlation coefficient between two
explanatory variables
Remedial measures
 Dropping one of the collinear variables is the remedy for multicollinearity.
4. Taking a dummy explanatory economic variable, illustrate diagrammatically the cases as (1 point
each):
a) Slope indicators: Let us have the following regression model: Yi=β1+β2X2i+β3Di+ui, Where Yi =
annual salary, X2i= working years of experience, Di is dummy variable i =1 for male workers and 0 for
female workers. Graphically
If β3 >0 and D=1
Annual salary (Yi)
β3 =0 if D=0

If β3 <0 and D=1

β1+ β3

β1

β1+β3

Years of experience (Xi)

Figure: intercept indicator dummy variable
From the above equation the intercept indicator is the coefficient of the dummy variable (Di). That is if the
worker is female (D=0) the intercept will be at Yi= β1 on the above graph and if the worker is male the
intercrecept moves either up or down depending on the value of β3. If β3>0, the intercept moves up and if
β3<0, it moves down. Mathematically, we have two cases
D=0 Yi=β1+β2X2i+ β3(0) +ui
Yi=β1+β2X2i+ui……………………the intercept is β1

And

D=1 Yi=β1+β2X2i+β3(1)+ui
Yi=(β1+β3) +β2X2i+ui……………………… the intercept is β1+β3

b) Slope indicator (interaction with a quantitative variable): sometimes dummy variables may also
affect the slope of the regression line. Let us consider simple Keynesian consumption model:
Yt=β1+β2X2t+ui

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Where Yt is consumption expenditure, X2t is disposable income of a consumer and β2 is marginal
propensity to consume. Assume that we have time-series observations for total consumer expenditure and
disposable income from 2000 to 2012 for Ethiopian economy. Assume, further, that we think that a change
in the marginal propensity to consume (β2) occurred in 2007 due to drought that generally affected
Ethiopian economy. In order to test this, we need to insert a dummy variable (Dt) to the above model. For
the year 2000-2006; D=0 and for 2007-2012; D=1. This dummy variable, because we assume that it
affected the slope parameter, must be included in the model in the following multiplicative way:
Yt=β1+β2X2t+ β3 DtX2t +ui, Now we have the following two cases:
Di=0 Yi=β1+β2X2i+β3(0)X2i+ui
Yi=β1+β2X2i+ui………………… for the year 2000-2006, the slope is β2
Di=1 Yi=β1+β2X2i+β3(1)X2i+ui
Yi=β1+(β2+β3)X2i+ui…………… for the year 2007-2012, the slope is β2+β3.
The two cases above have the same intercept but different slopes. Graphically
Consumption expenditure
Slope: β2+β3

Slope: β2

β1

Disposable income
Figure: slope indicator dummy variable
So, before 2007 the marginal propensity to consume is given by β2 and after 2007 it is given by β2+β3
(higher slope assuming β3>0). In other words, the dummy variable cause the slope coefficient to change
from β2 to β2+β3.
c) Both slope as well as intercept indicator: let us see what the outcome will be when using a dummy
variable that is allowed to affect both the intercept and the slope coefficients. Reconsider the model in b
above: Yt=β1+β2X2t+ui and let us assume we have the dummy variable defined as: D=0 for t=1,..,s and
D=1 for t= s+1,..,T. Then using the dummy variable to examine its effect on both intercept and slope
coefficient we will have: Yt=β1+β2X2t+ β3 Dt + β4 DtX2t +ui. Doing the same procedure as b above, we
have the following two case
D=0 Yt=β1+β2X2t+ β3(0) + β4 (0)X2t +ui
Yt= β1+β2X2t+ ui................................................................. (1)
D=1 Yt=β1+β2X2t+ β3(1) + β4 (1)X2t +ui
Yt=(β1+ β3)+( β2+ β4) X2t+ ui………….…………………...(2)
In this case, the dummy variable causes the intercept to increase from β1 to β1+ β3 and at same time it
causes the slope to increase from β2 to β2+ β4 (here, we assume that β3, β4>0). This is the case when the
dummy variable is allowed to affect both the slope coefficient and intercept.
If we draw a graph for (1) and (2) as follow, we can observe the effects of the dummy variable on both
slopes as well as intercept indicator.

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 Consumption expenditure Slope= β2+ β4, β4>0
D=1

Slope=β2
D=0
β1 + β3

β1

Disposable income
Figure: intercept and slope indicator dummy variable

5. In hypothesis testing (statistical inference) economists/statisticians use either two tail test or one
tail test for their respective research. Given: 𝛽𝑖 = 0, what conditions should guide the researcher
to make the alternative hypothesis ( ) either two tail or one tail test. Support your answer with
example (2 points)

As we know, econometrics presupposes economic theories. That is the first step in the methodology of
econometrics is Statement of theory or hypothesis. And again the first step in hypothesis testing is stating
the null and alternative hypotheses. Economist sate alternative hypothesis in ether two or on tailed test
depending on their theoretical expectations. In short, economic theory guides economists to take alternative
hypothesis either two or on tailed test.

If economic theory is not strong enough to enable economists to specify the value (s) of 𝛽i, they will use
two tailed test. Inability to specify the value (s) 𝛽i implies that the theory does not tell them about whether
the independent variables affect the dependent variable negatively or positively. For example, demand
theory states that quantity demanded is a function of own price and income. Own price affects quantity
demanded negatively but income affects it positively if the good is normal and negatively if the good is
inferior. The theory can be presented as: Yi=β1+β2X2i+ β3X3i+ ui, where Yi is quantity demanded, X2i is
price of the good and X3i is income of the consumer. Thus, for β3 economists will use two tailed test
because they don’t know about the good either it is normal or inferior good.

On the other hand if economic theory is strong enough to specify the value (s) of 𝛽i they can use on tailed
test. From the above example we have said that own price affect quantity demanded negatively. That is β2
is negative. Therefore, it is the case one tailed test about β2 (left sided test).

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