HETEROSCEDASTICITY

Heteroscedasticity refers to a situation when the variance of the error term in the model is not
constant. It is a violation of regression model assumptions. In the presence of
heteroscedasticity, we cannot use t and F-tests for hypothesis testing. Heterscedasticity may
arise due to many reasons, such as misspecification of the model, incorrect transformation of
data and outliers. Perhaps, the presence of outliers (i.e. extreme observations) is a common
reason for heteroscedaticity.
There are several approaches for detecting heteroscedasticity. The graphical approach may be
used. Alternatively, specialized heteroscedaticity tests may be used. After detecting
heteroscedasticity, we should apply some corrective measures so that the problem may be
alleviated.
Example
Use Table 2.8 to estimate the following regression model:
Foodexp = β1 + β2Totalexp + u
a. Use a scatterplot (or graphical approach) to detect heteroscedaticity.
b. Apply the Breusch-Pagan test to detect heteroscedasticity at the 5% level of
significance
c. Use a suitable corrective approach to alleviate the heteroscedasticity problem.
Solution:
a. We may generate a scatterplot in Stata using the graphics option. The scatterplot
indicates that there are some potential outliers in the data. Therefore, there is a
possibility that heteroscedasticity is present.
600
500
FOODEXP

400
300
200

400 500 600 700 800

TOTALEXP
 b. The Breusch Pagan test is a specialized statistical test for detecting heteroscedasticity.
The test was applied in Stata and the following results were generated. The null
hypothesis of the test is that there no heteroscedasticity. The alternative hypothesis is
that there is heteroscedasticity.

Breusch-Pagan / Cook-Weisberg test for heteroskedasticity

Ho: Constant variance
Variables: fitted values of foodexp

chi2(1) = 7.18
Prob > chi2 = 0.0074

The p-value of the test statistic is 0.0074, which is less than 0.05. Therefore, we can
reject the null hypothesis at the 5% level of significance. This implies that the
heteroscedasticity problem is present.

Note: To perform the Breusch Pagan test, we proceed in two steps. First, estimate the
original model. Second, go to Statistics, then postestimation and select reports and
statistics. Finally, select test of heteroscedasticity with the default option of Breusch
Pagan test and press OK.

c. As heteroscedasticity is present, we need to apply some corrective measure. One simple

approach that may resolve the problem is to estimate a double-log model instead of the
original model. After estimating the double-log model, we can reapply the Breusch
Pagan test to check if the problem has been resolved.

Breusch-Pagan / Cook-Weisberg test for heteroskedasticity

Ho: Constant variance
Variables: fitted values of lfoodexp

chi2(1) = 1.60
Prob > chi2 = 0.2052

Now the p-value of the test statistic is 0.2052, which is greater than 0.05. Therefore, we fail
to reject (or accept) the null hypothesis. Therefore, there is no heteroscedasticity problem
in the transformed double-log model.