Econometrics

Chapter 8 -- Functional Form I : Linearity

Linearity

Linear in variables:

Yi = bo + b1 X1i + b2 X2i ++ bk Xki +ui

the dependent variable is written as a linear combination of the independent variables.

Linear in parameters:

A model that is linear in parameters may be transformed into a model that is linear in variables by defining new variables, Zi =fi(X1i , , Xki)

Yi = bo + b1 f1(X1i , , Xki) + b2 f2(X1i , , Xki) + + bk f2(X1i , , Xki) +ui

Yi = bo + b1 Z1i + b2 Z2i ++ bk Zki +ui

Polynomial transformations

Y= bo + b1 X + b2 X2++ bk Xk Zi = Xi Y= bo + b1 Z1 + b2 Z2++ bk Zk
Common forms:

Linear: Y= bo + b1 X Quadratic: Y= bo + b1 X + b2 X2 Cubic: Y= bo + b1 X + b2 X2+ b3 X3

Linear model

Quadratic model

Cubic model

Common applications

Quadratic model:

age-earnings or experience-earnings profiles ATC, AVC, MC, AP, and MP curves TC and TP curves

Cubic model

Reciprocal transformation

Yi = bo + b1 (1/Xi )+ui Let Zi = 1/Xi Yi = bo + b1 Zi +ui

Log-transformations

Log-log model (double-log model)

or:

Elasticity and log-log model

Each slope coefficients equals the elasticity of the dependent variable with respect to that independent variable.

Log-log model

Example: Cobb-Douglas production function

Constant returns to scale: b1 + b2 = 1 Increasing returns to scale: b1 + b2 > 1 Decreasing returns to scale: b1 + b2 < 1

Semi-log models

Linear-log model:

Yi = bo + b1 ln(X1i )+ b2 ln(X2i )+ + bk ln(Xki) +ui

ln(Yi) = bo + b1 X1i + b2 X2i ++ bk Xki +ui

Log-linear model:

Linear-log model

Linear-log model

Yi = bo + b1 ln(X1i )+ b2 ln(X2i )+ + bk ln(Xki) +ui

Log-linear model

Log-linear model
Yt = Aert ln(Yt )= ln(A)+rt

adding an error term:

ln(Yt )= bo + b1 t +ut

Estimated value of b1 is an estimate of the growth rate of Yt

Example: health-care expenditures

Health-care expenditures

Log transformations and zero values

Do not use the log transformation if the variable to be transformed is less than or equal to zero.

Marginal effects and elasticities

See Table 8.1 in the text

Selecting a functional form

Use economic theory, prior studies, and knowledge of institutional features to guide model specification. For example:

Assignment

pp. 308-14, #1, 10, 16