Fundamental Econometrics

Assumption of OLS

MEB2476
LEE JEABOK

1. Linear in Parameters
In the population model, the dependent variable, y, is related to the independent variable x, and the
error (or disturbance), u, where B0 and B1 are the population intercept and slope parameters,
respectively.

If model is non-linear, we cannot fit the model, so we have to fix non-linear model to
be a linear model.

2. Random Sampling
We have a random sample of size n, {(xi,yi): i = 1, 2, ..., n}, following the population model in equation.

If the data are not random sample of the population, the errors may not
independent from one another, and this results in biased parameter estimates. To
solve this problem, we should make random sampling or look for correlation
between errors and another variable which is not in the model so that we can
include new variable.

3. Sample Variation in the Explanatory Variable

The sample outcomes on x, namely, {xi, i = 1, ..., n}, are not all the same value.

If x varies in the population, random samples on x will typically contain variation. If

not, this assumption fails and this may result in biased parameter estimates.

4. Zero Conditional Mean

The error u has an expected value of zero given any value of the explanatory variable.

E(ux) = 0
This means error term and independent variable are independent. Otherwise, error
term is set wrong, and we need to re-set independent variable to separate
independent variable from error term.

5. Homoskedasticity
The error u has the same variance given any value of the explanatory variable.

Var(ux) = 2

2 2
is the unconditional variance of u, and so is often called the error variance.

In contrast, when Var(ux) depends on x, the error term is said to exhibit heteroskedasticity. Because
Var(ux) = Var(yx), heteroskedasticity is present whenever Var((yx) is a function of x.

6. Normality
The population error u is independent of the explanatory variables x1, x2, , xk and is normally
2 2
distributed with zero mean and variance : u ~ Normal (0, )

The classical linear model assumption which states that the error (or dependent
variable) has a normal distribution, conditional on the explanatory variables.