Random effects

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Random Effects

Random effects

© All Rights Reserved

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The Random Effects Model

Original equation

yit = β 0 + β1 x1it + β 2 x2it + ... + β k xkit + λi + uit

are representative of a sample rather than the whole

population. Generally attractive argument.

2

The Variance Structure in Random Effects

In random effects, we assume the λi are part of the

composite error term εit. To construct an efficient estimator

we have to evaluate the structure of the error and then apply

an appropriate generalised least squares estimator to find

an efficient estimator. The assumptions must hold if the

estimator is to be efficient. These are:

E (λi2 ) = σ λ2 ; E (uit λi ) = 0 for all i, t

E (ε it2 ) = σ u2 + σ λ2 t = s; E (ε it ε is ) = σ λ2 , t ≠ s;

and

E ( xkit λi ) = 0 for all k , t , i

It is necessary for the consistency of the RE model,

3

but not for FE. It can be tested with the Hausman test.

The Variance Structure in Random Effects

Derive the T by T matrix that describes the variance structure of the εit

for individual i. Because the randomly drawn λi is present each

period, there is a correlation between each pair of periods for

this individual.

σ u2 + σ λ2 σ λ2 σ λ2 σ λ2

σλ σu +σλ σλ

2 2 2 2

= σ 2

I + σ λ ee ' = Ω

2

σi 2

.. ..

u

2

σ λ σλ .. σ u + σ λ

2 2 2

4

Random Effects (GLS Estimation)

The Random Effects estimator has the standard

generalised least squares form summed over all

individuals in the dataset i.e.

-1

βˆ RE = ∑ ( X i Ω X i )

' −1

∑ i yi

X '

Ω −1

i =1 i =1

−1 / 2 1 θ σu

Ω = I T − ee ' where θ = 1 -

σu T T σ λ2 + σ u2

5

Fixed Effects (GLS Estimation)

which brings out its relationship to the RE estimator.

It is given by:

-1 T

T

1

βˆ FE = ∑ ( X i MX i )

'

∑ X My i where M = I T − ee '

i

'

i =1 i =1 T

constructing a new matrix, X* say, comprised of deviations

from individual means. (This is a more elegant way

mathematically to carry out the operation we described previously)

The FE estimator uses M as its weighting matrix rather than Ω.

6

Relationship between Random

and Fixed Effects

The random effects estimator is a weighted combination of the

“within” and “between” estimators. The “between” estimator is

formed from:

βˆ RE = Ψ βˆ Between + ( I K − Ψ ) βˆWithin

Ψ depends on θ in such a way that if θ → 1 then the

RE and FE estimators coincide. This occurs when the variability of

the individual effects is large relative to the random errors.

θ → 0 correspond s to OLS (because the individual effects are small

relative to the random error).

7

Random or Fixed Effects?

For random effects:

•Random effects are efficient

•Assumption one set of unobservables fixed and the other

random?

•Sample information more common than from the entire

population?

•Can deal with regressors that are fixed across individuals

Likely to be correlation between the unobserved effects and

the explanatory variables. These assumed to be zero in

random effects model, but in many cases would be them to be

non-zero. This implies inconsistency due to omitted variables in

the RE model. Fixed effects is inefficient, but consistent.

8

The Hausman Test

If there is no correlation between regressors and effects, then

FE and RE are both consistent, but FE is inefficient.

If there is correlation, FE is consistent and RE is inconsistent.

differences between the estimators. To carry out the Hausman

test

Calculate βˆ RE − βˆ FE and its covariance

9

The Hausman Test

Is a test for the independence of the λi and the xkit.

an inefficient estimator should be zero. Under the null

hypothesis we test:

−1

W = ( β RE − β FE )' Σ ( β RE − β FE ) ~ χ ( k )

ˆ 2

estimator.

10

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