Nonlinear econometric models

Production function
Lecture 5

Reading assignments
J. Wooldridge, Introductory Econometrics. A
Modern Approach, South-Western, 2009
[chapters 2.4 and 6.2 on different functional
forms of variables]
For the next class:
J. Wooldridge, [ch. 7 on linear probability model
and qualitative variables, ch. 17 on logit, probit,
and tobit models, excluding section 17.3]
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What models are nonlinear?

Nonlinear models

Nonlinear models

Nonlinear models

Even more general form:

g ( y ) = 0 + 1 f1 ( x ) + 1 f1 ( x ) + ... + p f p ( x ) +

Nonlinear models

can be transformed to:

y = 0 + 1 x1 + 2 x2 +
where 0 exp( 0 ) 1 cos(1 ) 1 ( 2 )

Nonlinear models
Easier to deal with models linear in
parameters:
estimation with OLS method allowed
parameters interpreted as marginal effects
[of what?]

OLS estimates of parameters in models

nonlinear in parameters are usually
biased, but can be consistent
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Examples of linearized models

Models often can be linearized,
i.e. transformed into the linear form
Example (power function):

y=e x z
ln( y ) = + ln( x) + ln( z ) + ln( )
Note the multiplicative error term

Examples of linearized models

Exponential function (log-level model):

y = exp( + x + z + )
ln( y ) = + x + z +
S-curve model:

y = exp( + x + )
1
ln( y ) = + +
x

Strictly nonlinear models

Some models cannot be transformed to the
linear form
Logistic function

y=
+
x
1+ e

lim y =

x +

lim y = 0

Box-Cox model

x 1
+
y = +

y = + x+

for 1

y = + ln( x) +

for 1

Nonlinear least squares method

Find parameter values that minimize SSR:

yi = h ( x i , ) + i
) ) min
(
y

h
(
x
,

gradient methods used to find optimal

parameter values

Testing linear vs. nonlinear

Ramseys RESET test
H0: linear model correct
H1: nonlinear model better
y = 0 + 1 x1 + ... + k xk +
y = 0 + 1 x1 + ... + k xk
2
3

y = 0 + 1 x1 + ... + k xk + k +1 y + k + 2 y + ... +

H 0 : k +1 = k + 2 = ... = 0

( F test can be used )

Example
RESET test

Interpreting nonlinear models

Useful approximation (percentage change,
rate of growth): xt xt 1
xt 1

ln( xt ) ln( xt 1 ) = ln( xt )

Marginal effect of y with respect to x

marginal change in x causes change in y

y
xi

y x
Elasticity of y with respect to x El ( y x) =

x y
one percent change in x causes percentage change in y

Interpreting nonlinear models

Marginal
effect y

Elasticity Interpretation
El ( y x)

Level-level

x
y

if x increases by 1
then y increases by

y = + x+

Level-log

if x increases by 1%

y = + ln(x) +

then y increases by 100

Log-level
ln( y) = + x +

Log-log
ln( y ) = + ln( x ) +

+ x

e x

if x increases by 1
then y increases by 100 %

if x increases by 1%
then y increases by %

Production function
Econometric production function
y = f ( x1 , x2 ,..., xk , )
Production factors: capital (K), labor (L)
y = f ( K , L)

Production function
Characteristics of the production function
Marginal productivity of factors positive
f
= fK > 0
K

f
= fL > 0
L

Marginal productivity of each factor falling with

respect to the value of this factor
2 f
= f KK < 0
2
K

2 f
= f LL < 0
2
L

Marginal productivity of each factor increasing

with respect to the values of other factors
2 f
= f KL > 0
KL

2 f
= f LK > 0
LK

Production function
Characteristics of the production function
Homogeneous production function with
increasing/constant/falling returns to scale

f (K , L) = n f ( K , L)
n >1
n =1
n <1
Factors are substitutable

dK
fL
MRS =
=
dL
fK
Isoquant = all input combinations that produce exactly
the same output (units of output)

Examples of production functions

Cobb-Douglas

y = aK b Lc
ln y = ln a + b ln K + c ln L + ln

Marginal productivities
f KK

f K = abK b 1 Lc > 0 f L = acK b Lc 1 > 0

= ab(b 1) K b 2 Lc < 0 f LL = ac(c 1) K b Lc 2 < 0
f KL = f LK = abcK b 1 Lc 1 > 0

f (K , L) = b + c f ( K , L) n = b + c

Homogeneous
Substitution MRS = c K
b L

El ( y K ) =

ln y
ln y
= b El ( y L) =
=c
ln K
ln L

Examples of production functions

CES function constant elasticity of substitution
y = [K + (1 ) L ] v /
ES

( K / L) MRS
1

=
MRS K / L 1 +

Zellner-Revankar function (changing returns to

scale) y e d y = aK b Lc
Translog (transcendental logarithmic) function
(changing elasticities)
ln y = a1 + a2 ln K + a3 ln L + a4 ln K ln K + a5 ln L ln L + a6 ln K ln L +