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You are on page 1of 34

**EC114 Introduction to Quantitative Economics
**

13. Non-Linear Models

Marcus Chambers

Department of Economics

University of Essex

31 January/01 February 2011

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

2/34

Outline

1

Transformations of Variables

2

Double Logarithm Functions

3

Other Transformations

Reference: R. L. Thomas, Using Statistics in Economics,

McGraw-Hill, 2005, sections 10.1–10.4.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 3/34

So far we have assumed that the relationship between our

two variables, X and Y, was linear.

In this case the population regression equation is of the

form

E(Y) = α + βX

rather than, for example,

E(Y) = α + βX

2

.

As a consequence the sample regression equation we

ﬁtted to a scatter of points was always a straight line:

ˆ

Y = a + bX

rather than, for example,

ˆ

Y = a + bX

2

.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 4/34

However many economic relationships are non-linear to a

lesser or greater extent, and we need to be able to take

this into account.

A very simple way of ﬁtting a curve to a scatter of points is

to apply the so-called transformation technique.

Consider the equation:

Y

∗

= α + βX

∗

,

where X

∗

= X

∗

(X) and Y

∗

= Y

∗

(Y) are simple functions (or

transformations) of the variables X and Y, respectively.

The choice of transformation depends on the nature of the

data under consideration and can partly be determined by

a scatter diagram plotting Y against X.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 5/34

Note that the equation Y

∗

= α + βX

∗

is linear in the

transformed variables Y

∗

and X

∗

(but not Y and X).

Hence we can apply regression techniques to the following

population regression equation:

E(Y

∗

) = α + βX

∗

.

The corresponding sample regression equation is therefore

ˆ

Y

∗

= a + bX

∗

where a and b are the OLS estimators of α and β.

The formulae determining a and b (and also R

2

) remain

unchanged but are now expressed in terms of Y

∗

and X

∗

rather than Y and X.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 6/34

The relevant formulae are therefore:

b =

x

∗

i

y

∗

i

x

∗2

i

;

a =

¯

Y

∗

−b

¯

X

∗

;

R

2

=

b

2

x

∗2

i

y

∗2

i

.

In the above:

x

∗

i

= X

∗

i

−

¯

X

∗

i

,

¯

X

∗

i

=

X

∗

i

n

,

y

∗

i

= Y

∗

i

−

¯

Y

∗

i

,

¯

Y

∗

i

=

Y

∗

i

n

.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 7/34

The formulae for computing sums involving deviations from

means remain valid for the transformed variables:

x

∗2

i

=

(X

∗

i

−

¯

X

∗

)

2

=

X

∗2

i

−

(

X

∗

i

)

2

n

,

x

∗

i

y

∗

i

=

(X

∗

i

−

¯

X

∗

)(Y

∗

i

−

¯

Y

∗

)

=

X

∗

i

Y

∗

i

−

X

∗

i

Y

∗

i

n

.

In view of this another common expression for b is:

b =

X

∗

i

Y

∗

i

−

X

∗

i

Y

∗

i

n

X

∗2

i

−

(

X

∗

i

)

2

n

.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 8/34

Example. The demand for carrots Y (in kilograms) and the

price of carrots X (in pence) are observed in a supermarket

over a period of 30 weeks.

Suppose we wish to estimate the price elasticity of the

demand for carrots and to predict the demand for carrots

when the price is 90p per kg.

The latter task is an out of sample prediction of the type

covered previously.

The sample data are represented in the following Table

(which is Table 10.1 of Thomas):

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 9/34

Demand for, and price of, carrots

i Y X i Y X

1 99 25 16 44 70

2 83 25 17 35 71

3 68 27 18 35 66

4 80 28 19 38 61

5 69 30 20 52 58

6 55 32 21 40 56

7 66 35 22 41 52

8 58 38 23 37 48

9 59 41 24 45 51

10 44 43 25 36 46

11 55 54 26 56 45

12 38 52 27 45 40

13 42 60 28 48 39

14 43 64 29 44 39

15 36 70 30 56 41

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 10/34

The scatter diagram suggests it would be unwise to ﬁt a

straight line to the data.

Some sort of curve would provide a better ﬁt.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 11/34

However, suppose we run a linear regression of Y on X; we

obtain

ˆ

Y = 92.9 −0.881X, R

2

= 0.61.

The regression line slopes downwards (the slope is

−0.881) and 61% of the variation in Y can be attributed to

X.

The out-of-sample prediction, obtained when X = 90, is

ˆ

Y = 92.9 −0.881(90) = 13.6.

Looking at the scatter diagram, it suggests that the

demand for carrots is likely to be considerably higher than

13.6 kg when the price is 90p.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 12/34

Turning to the price elasticity, this is given by

η =

dY

dX

X

Y

;

(note that Thomas inserts a minus in front of the

right-hand-side).

We estimate dY/dX by b and calculate the elasticity

evaluated at the sample means of X and Y,

¯

X = 46.9 and

¯

Y = 51.6.

The estimated elasticity is thus

η = (−0.881)(46.9/51.6) = −0.801,

meaning that a 1% rise in price leads to a fall of 0.8% in

the demand for carrots (so carrots are price inelastic).

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Transformations of Variables 13/34

Neither the out-of-sample prediction nor the elasticity

estimate are likely to be very accurate in view of the linear

model being a poor representation of the data.

It is likely that better estimates can be obtained from a

non-linear model that provides a better ﬁt to the data.

There are many relationships that give rise to curves of

varying degrees of non-linearity, and we will consider some

important examples.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 14/34

Consider the nonlinear function:

Y = AX

β

, A > 0, A and β constant.

The diagram on the next slide presents the possible

shapes for this function for different values of the

parameter β, these being:

(a) β > 1;

(b) 0 < β < 1; and

(c) β < 0.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 15/34

Notice how the value of β affects the shape of the curve.

It would appear that the function in part (c) might be a

suitable candidate for our data.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 16/34

If we are going to use a function of the form

Y = AX

β

then how do we estimate A and β? Is it possible to use

OLS?

Obviously OLS cannot be applied directly to this function

because it is not linear in the variables.

However, the function has the convenient property that it

can be made linear by taking (natural) logarithms.

We shall need the following rules:

ln(uv) = ln(u) + ln(v) and ln(p

q

) = q ln(p),

which we apply with u = A, v = X

β

, p = X and q = β.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 17/34

Taking logarithms therefore yields

ln(Y) = ln(A) + β ln(X)

which can be written in the form

ln(Y) = α + β ln(X)

where α = ln(A).

Hence ln(Y) is a linear function of ln(X) or

Y

∗

= α + βX

∗

where Y

∗

= ln(Y) and X

∗

= ln(X).

Can we use this equation as a basis for estimating α and β

by OLS?

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 18/34

As it stands, the equation Y

∗

= α + βX

∗

is deterministic

i.e. non-random, but we can use it to deﬁne the population

regression equation in the form

E(Y

∗

) = α + βX

∗

.

Furthermore, introducing a random disturbance

∗

, Y

∗

satisﬁes

Y

∗

= α + βX

∗

+

∗

.

We can apply OLS to this equation and estimate α and β

by a and b giving the sample regression equation

ˆ

Y

∗

= a + bX

∗

.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 19/34

The usual calculations for computing the OLS estimates

are therefore performed on the transformed variables

Y

∗

= ln(Y) and X

∗

= ln(X).

Recall that

a =

¯

Y

∗

−b

¯

X

∗

and b =

x

∗

i

y

∗

i

x

∗2

i

.

Table 10.2 of Thomas shows that

X

∗

i

= 114.059,

X

∗2

i

= 436.524,

X

∗

i

Y

∗

i

= 443.056,

Y

∗

i

= 117.096,

Y

∗2

i

= 459.289.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 20/34

The sample means are therefore

¯

X

∗

=

114.059

30

= 3.802 and

¯

Y

∗

=

117.096

30

= 3.903.

Furthermore,

x

∗2

i

=

X

∗2

i

−

(

X

∗

i

)

2

n

= 436.524 −

(114.059)

2

30

= 2.875;

x

∗

i

y

∗

i

=

X

∗

i

Y

∗

i

−

X

∗

i

Y

∗

i

n

= 443.056 −

114.059 ×117.096

30

= −2.140.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 21/34

We ﬁnd that

b =

−2.140

2.875

= −0.744 and a = 3.903−(−0.744)3.802 = 6.73.

The sample regression equation is therefore

ˆ

Y

∗

= 6.73 −0.744X

∗

or, substituting for Y

∗

and X

∗

,

ln(Y) = 6.73 −0.744 ln(X).

If we want to convert these estimates back into the original

non-linear relationship between X and Y we can take take

the exponential function of each side of the equation.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 22/34

The following rules are useful:

e

u+v

= e

u

e

v

and e

p ln(q)

= q

p

,

which we apply with u = 6.73, v = −0.744 ln(X), p = −0.744

and q = X.

We therefore obtain

ˆ

Y = 837.1X

−0.744

.

This equation is plotted on the next slide in terms of the

untransformed variables X and Y:

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 23/34

The curve appears to ﬁt the data much better than any

straight line could.

The next diagram plots the sample linear regression line in

terms of X

∗

and Y

∗

:

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 24/34

The straight line appears to ﬁt the transformed data much

better than any curve could.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 25/34

The coefﬁcient of determination is equal to

R

2

=

b

2

x

∗2

i

y

∗2

i

=

(−0.744)

2

2.875

2.239

= 0.71

meaning that 71% of the variation in Y

∗

= ln(Y) can be

attributed to X

∗

= ln(X).

Note that the R

2

is in terms of the transformed variables.

It cannot, therefore, be compared with the R

2

of 0.61 for

the regression in the untransformed variables.

This is because one measures the percentage of variation

in Y

∗

attributable to X

∗

while the other measures the

percentage of variation in Y attributable to X, which are

different quantities.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Double Logarithm Functions 26/34

As for the price elasticity, recall that

η =

dY

dX

X

Y

.

Differentiating Y = AX

β

with respect to X gives

dY

dX

= βAX

β−1

and so

η = βAX

β−1

X

AX

β

= β.

Hence our estimate of the price elasticity of demand for

carrots is given by b = −0.744 which is our estimate of β.

Note that the elasticity does not depend on the value of X

or Y; hence the elasticity is the same for all values of X and

Y.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Other Transformations 27/34

A number of other types of transformation are also

commonly employed in regression analysis.

We shall take a look at the properties of three such

transformations:

(a) semi-logarithmic;

(b) exponential; and

(c) reciprocal.

The semi-logarithmic function has the form

Y = α + β ln(X)

and is depicted for β > 0 and β < 0 on the next slide:

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Other Transformations 28/34

The function is linear in Y and ln(X) and so in this case

Y

∗

= Y and X

∗

= ln(X).

The elasticity of Y with respect to X can be shown to be

η =

β

Y

.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Other Transformations 29/34

The exponential function is of the form

Y = Ae

βX

, A > 0.

It can be made linear by taking (natural) logarithms of both

sides:

ln(Y) = ln(A) + βX

and so Y

∗

= ln(Y) and X

∗

= X.

The elasticity of Y with respect to X can be shown to be

η = βX.

The shape of the function for β > 0 and β < 0 is as follows:

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Other Transformations 30/34

Note that the intercept on the Y-axis is equal to A and the

slope is positive if β > 0 and negative of β < 0.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Other Transformations 31/34

Finally, the reciprocal function is given by

Y = α + β

1

X

**and is linear in Y and 1/X, so that Y
**

∗

= Y and X

∗

= 1/X.

The elasticity of Y with respect to X can be shown to be

η = −

β

XY

.

The shape of the function for β > 0 and β < 0 is as follows:

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Other Transformations 32/34

Note that the slope is negative if β > 0 and positive if β < 0

and the function tends towards α as X increases.

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Other Transformations 33/34

All four transformations we have considered are based on

the linear regression

Y

∗

= α + βX

∗

+

∗

,

with the estimated version being

ˆ

Y

∗

= a + bX

∗

.

They can be summarised as follows:

Double-log Semi-log Exponential Reciprocal

Y

∗

ln(Y) Y ln(Y) Y

X

∗

ln(X) ln(X) X 1/X

η β β/Y βX −β/(XY)

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

Summary 34/34

Summary

Transformations

Double-log, semi-log, exponential and reciprocal.

Next week:

Properties of estimators and the Classical two-variable

regression model

EC114 Introduction to Quantitative Economics 13. Non-Linear Models

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