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Stock Watson 3U Exercise Solutions Chapter 11 Instructors

Econometria (Universidad Carlos III de Madrid)

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Introduction to Econometrics
rd
(3 Updated Edition, Global Edition)

by

James H. Stock and Mark W. Watson

Solutions to End-of-Chapter Exercises: Chapter 11*

(This version August 17, 2014)

*Limited distribution: For Instructors Only. Answers to all odd-numbered questions

are provided to students on the textbook website. If you find errors in the solutions,
please pass them along to us at mwatson@princeton.edu.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 1

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11.1. (a) The t-statistic for the coefficient on Schooling is 0.272/.029 = 9.38, which is
significant at the 1% level.

(b) zMatthew  4.107  0.272  (16)  0.245; (0.245)  0.597

(c) zChristopher  4.107  0.272  (12)  0.843;  (0.843)  0.200

(d) zJed  4.107  0.272  (24)  2.421; (2.421)  0.992, this is unlikely to be

accurate because the sample did not include anyone with more than 24 years of
schooling.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 2

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11.2. (a) The t-statistic for the coefficient on Schooling is 0.551/0.062 = 8.89, which is
significant at the 1% level.

1 1
Prob Matthew   ( 8.146  0.551  16)
  0.662
1 e 1  e 0.67
1 1
ProbChristopher   ( 8.146  0 .551  12)
  0.18
1 e 1  e1.534

(b)

The shape of the regression functions is similar but the logit regression lies
above the probit function for years of schooling above 14 years, and below the
probit function for years of schooling between 8 and 14 years.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 3

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11.3. (a) The t-statistic for the coefficient on Schooling is 0.035/0.003 = 11.67, which is
significant at the 1% level.

ZMatthew  –0.172  0.035  (16)  0.388; Φ(0.388) = 0.651

ZChristopher  –0.172  0.035  (12) = 0.248; Φ(0.248) = 0.599

(b)

The probabilities are very different and for years of schooling below 5 years, the
LPM model produces non-sensical results (negative probabilities).

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 4

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11.4.(a)

Group Probit Logit LPM

Men (1.027  0.242)  0.102 1 0.102
 ( 1.717  0.455)
 0.102
1 e
Women (1.027)  0.152 1 0.152
 ( 1.717)
 0.152
1 e

(b) Because there is only regressor and it is binary (Male), estimates for each model
show the fraction on males and females passing the test. Thus, the results are
identical for all models.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 5

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11.5. (a) (–7.702 + 4.352  1 + 0.548  10 – 0.344  10  1) = 0.095

(b) (–7.702 + 4.352  0 + 0.548  12 – 0.344  12  0) = 0.130

(c) The t-statistic for the coefficient on the interaction term is −0.344/0.096 =
−3.58, which is significant at the 1% level, suggesting that years of schooling
influence whether a person is employed by government differently by gender.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 6

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11.6. (a) For a black applicant having a P/I ratio of 0.35, the probability that the
application will be denied is (2.26  2.74  0.35  0.71)  (0.59) 
27.76%.

(b) With the P/I ratio reduced to 0.30, the probability of being denied is (2.26 
2.74 0.30  0.71)  (0.73)  23.27%. The difference in denial probabilities
compared to (a) is 4.4 percentage points lower.
(c) For a white applicant having a P/I ratio of 0.35, the probability that the
application will be denied is (2.26  2.74  0.35)  9.7%. If the P/I ratio is
reduced to 0.30, the probability of being denied is (2.26  2.74  0.30) 
7.5%. The difference in denial probabilities is 2.2 percentage points lower.
(d) From the results in parts (a)–(c), we can see that the marginal effect of the P/I
ratio on the probability of mortgage denial depends on race. In the probit
regression functional form, the marginal effect depends on the level of
probability which in turn depends on the race of the applicant. The coefficient
on black is statistically significant at the 1% level.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 7

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11.7. (a) For a black applicant having a P/I ratio of 0.35, the probability that the
1
application will be denied is F (4.13  5.37  0.35 1.27)   27.28%.
1  e0.9805

(b) With the P/I ratio reduced to 0.30, the probability of being denied is
1
F (4.13  5.37  0.30  1.27)   22.29%. The difference in denial
1  e1.249
probabilities compared to (a) is 4.99 percentage points lower.

(c) For a white applicant having a P/I ratio of 0.35, the probability that the
1
application will be denied is F (4.13  5.37  0.35)   9.53%. If the
1  e2.2505
P/I ratio is reduced to 0.30, the probability of being denied is
1
F (4.13  5.37  0.30)   7.45%. The difference in denial
1  e2.519
probabilities is 2.08 percentage points lower.

(d) From the results in parts (a)–(c), we can see that the marginal effect of the P/I
ratio on the probability of mortgage denial depends on race. In the logit
regression functional form, the marginal effect depends on the level of
probability which in turn depends on the race of the applicant. The coefficient
on black is statistically significant at the 1% level. The logit and probit results
are similar.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 8

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11. 8. (a) Since Yi is binary variable, we know E(Yi |Xi)  1  Pr(Yi  1|Xi)  0  Pr(Yi 
0|Xi) Pr(Yi  1|Xi)  0  1Xi. Thus

E (ui | X i )  E[Yi  (0  1 X i )| X i ]

 E (Yi|X i )  ( 0  1 X i )  0

(b) Using Equation (2.7), we have

var(Yi | X i )  Pr(Yi  1| X i )[1  Pr(Yi  1| X i )]

 ( 0  1 X i )[1  ( 0  1 X i )].

Thus

var(ui | X i )  var[Yi  ( 0  1 X i )i | X i ]
 var(Yi | X i )  (0  1 X i )[1  ( 0  1 X i )].

(c) var(ui |Xi) depends on the value of Xi, so ui is heteroskedastic.

(d) The probability that Yi  1 conditional on Xi is pi  0  1Xi. The conditional

probability distribution for the ith observation is Pr(Yi  yi | X i )  piyi (1  pi )1 yi .

Assuming that (Xi, Yi) are i.i.d., i  1,, n, the joint probability distribution of
Y1,, Yn conditional on the Xs is
n
Pr(Y1  y1 ,  , Yn  yn | X 1 ,  , X n )   Pr(Yi  yi |X i )
i 1
n
  piyi (1  pi )1 yi
i 1
n
  (  0  1 X i ) yi [1  (  0  1 X i )]1 yi .
i 1

The likelihood function is the above joint probability distribution treated as a

function of the unknown coefficients (0 and 1).

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 9

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11.9. (a) The coefficient on Self-employed is 0.060, indicating an estimated denial

probability that is 6% points higher for the self-employed candidate.

(b) The 95% confidence interval is 0.06 ± 1.96 × 0.021 = [0.019, 0.101].

(c) The answer in (a) will be biased if there are omitted variables, which are related
to whether an individual is self-employed as well as have an impact on
mortgage denial. Such variables would have to be related with race and standard
measures of default probability (past credit history and loan-related
information). They are included in the regressions shown in Table 9.2, so these
omitted variables are unlikely to bias the answer in (a). Other variables such as
education, marital status, and unemployment may also be related to the
probability of default, and these variables are omitted from the regression in
column. Adding these variables [see columns (4)–(6)] have a substantial effect
on the estimated effect of self-employed on the probability of mortgage denial.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 10

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11.10. (a) Let n1   (Y  1), the number of observations on the random variable Y which
equals 1; and n2   (Y  2). Then (Y  3)  n  n1  n2. The joint probability
distribution of Y1,, Yn is

n
Pr(Y1  y1 ,, Yn  yn )   Pr(Yi  yi )  p n1 q n2 (1 p  q) nn1n2 .
i1

The likelihood function is the above joint probability distribution treated as a

function of the unknown coefficients (p and q).

(b) The MLEs of p and q maximize the likelihood function. Let’s use the log-
likelihood function

L  ln[Pr(Y1  y1 , , Yn  yn )]
 n1 ln p  n2 ln q  (n  n1  n2 ) ln(1  p  q).

Using calculus, the partial derivatives of L are

L n1 n  n1  n2
  , and
p p 1  p  q
L n2 n  n1  n2
  .
q q 1  p  q

Setting these two equations equal to zero and solving the resulting equations yield
the MLE of p and q:

n1 n
pˆ  , qˆ  2 .
n n

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 11 11

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11. 11. (a) Censored or truncated regression model (note the dependent variable might
be 0).

(b) This is an ordered response model.

(c) This is a discrete choice (or multiple choice) model.

(d) This is a model with count data.

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