1

INTRODUCTORY JJNPANEL DATA

JIBNIJBIJBBB
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CHAPTER 11: PANEL DATA

• What have we learned so far?

• Analyses based on…

1. Cross section data ✓

•It is time to depart from cross section and time series

econometrics and deal with…
2. Panel data
• We’re now ready for our final topic for this module.
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What is panel data?

1. Cross-sectional data - multiple observations of, say, individuals for,
say, a given year:
yi   0  1 x1i   2 x2i  ...   k xki  ui
▫ “i” refers to cross-sectional unit (e.g., individual).

2. Time-series data - say, multiple years of observations for, say, a given

country:
yt   0  1 x1t   2 x2t  ...   k xkt  ut
▫ “t” refers to time-series unit (e.g., year).

3. Panel data - observations on, say, multiple individuals at multiple

points in time:
yit   0  1 x1it   2 x2it  ...   k xkit  uit
▫ e.g., data on 500 individuals for 10 years.
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Panel data model - Example

• The simple panel data model looks like this:
yit     xit  uit

• where i = 1,…,N indexes individuals and t = 1,…,T indexes time periods.

• Example:
sleepit     total _ workit  uit
where sleep and total_work are sleeping and working measured by
hours per week.

• The data set covers 239 people in 1975 and 1981, i.e.,
▫ i = 1, 2,…., 239
▫ t = 1975 and 1981.
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Panel data model – cont.

• One way to use panel data is to view the unobserved factors affecting
the dependent variable as consisting of two types.
▫ Constant and time-varying:

yit    xit  d t  ai  uit


errors

where
• ai is called unobserved heterogeneity (a fixed effect) that captures all
unobserved, time-constant factors.
▫ Question: ai does not have t subscript. What does this mean?
▫ Answer:

• uit is called the idiosyncratic error (time-varying error) that

represents unobserved factors that change over time.
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Time dummies

yit    xit  d t  ai  uit

• We also normally include dt, a dummy variable(s) for the time period,
that captures time specific macro effects.
▫ Question: dt does not have i subscript. What does this mean?
▫ Answer:

• Q: Why bother including dt?

▫ We often think behavior changes over time due to natural evolutions
in economic variables.
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Unobserved heterogeneity

yit    xit  d t  ai  uit

• Q: What is ai (unobserved heterogeneity) capturing?

• We often think people are fundamentally different.

• We want to account for that by including ai.

▫ It measures tastes or costs that are (or might be) different for
each individual in the sample,
 that yield different choices of yit.
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Unobserved heterogeneity

• Q: Should you always account for unobserved heterogeneity?

• A: Depends on question being addressed…

• …but there almost always is a good reason to include it.

▫ Why?

• We will look at some examples!

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Example 1

• When analysing the impact of hours worked on hours of sleep, ai

could measure “how organised someone is”.

• People that are organised pay attention to how much sleep they get.

• We worry it’s also positively correlated with how much they choose
to work.

• Thus ignoring it could yield an upward biased estimate of the

effect of working on sleep.
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Example 2

• When analysing the impact of education on wages, ai could measure

“ability”.

• Highly “able” people are likely to have high wages.

• We worry it’s also positively correlated with their choice of education.

• Thus ignoring it could yield an upward biased estimate of the effect

of education on wages.
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Unobserved heterogeneity bias

• I’ve claimed that ignoring unobserved heterogeneity could yield bias.

• Why? This is easy!

• Surely you remember how to sign the bias in an OLS regression.

▫ (I say this in jest - I’m sure you do not.)

• It is worth a reminder, as this is an important skill.

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Unobserved heterogeneity bias – cont.

• How do you know there is bias from unobserved heterogeneity?

• Recall that ai is part of the error term in our regression:

yit    xit  d t  ai  uit




• Since ai is part of the error term, if it is also correlated with one of

our x’s...

• We’ve violated one of the CLRM assumptions: E(ηi |xi ) = 0

▫ This means the OLS estimator for β is biased.
▫ Sounds familiar? (It should!)
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Unobserved heterogeneity bias – cont.

• How do you measure the sign of the bias?
• Consider the true model:
y   0  1 x   2 z  u

while you omitted z and regressed:

y   0  1 x  u

• Remember the formula for omitted variable bias (Lecture Note 11,
p.16):
ˆ
E ( 1 )  1   2
 ( x  x )( z  z )
 1
2
( xx )

 
bias

▫ Note that θ is the slope from the regression of z on x.

 Think of θ as just measuring the correlation between z and x.
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Unobserved heterogeneity bias – cont.

ˆ
E ( 1 )  1   2
 ( x  x )( z  z )
 ( x  x )2

 
bias

• In a panel data setting, ai plays the role of the omitted z.

• Thus we infer the sign of…

▫ β2 by the impact of positive changes in ai is likely to have on the
dependent variable.
▫ θ by the correlation between ai and and xi.

• Here’s some examples..

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Example 1 (revisited)
E ( ˆ1 )  1   2

bias

• In the sleep-work example, we worry ai captures “how organised

someone is”.

• Higher organisation is likely to have a positive impact on the amount

of sleep someone gets.

• We further worry that highly organised people also work more.

• Therefore… E ( ˆworking )   working  

2 

bias

• Meaning that we think their may be positive bias on our estimate of

the impact of working on sleep.
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Example 2 (revisited)
E ( ˆ1 )  1  
 2
bias

• In the wages-education example, we worry ai captures ability.

• Higher ability is likely to have a positive impact on wages.

• We further worry that highly-able people get more education.

• Therefore,
E ( ˆeduc )   educ  
2 

bias

• Meaning that we think their may be positive bias on our estimate of

the impact of education on wages.
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Final thoughts: Thinking about bias

• Thinking about possible sources of bias, such as unobserved

heterogeneity, and its impact on your regression coefficients…

• ...is a major part of contemporary econometric practice.

• It is the thing that separates

▫ “Careful Econometricians” from
▫ “Regression Runners”.

• Please be one of the former, not one of the latter!

• Now let’s see how to handle problems of unobserved heterogeneity.

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Panel data analysis

• How to estimate the parameters in a panel data model?

• Consider the most common representation. Let’s begin by assuming

our data only have 2 time periods.
▫ This corresponds nicely to our sleep dataset.
yit    xit  d t  ai  uit
where i = 1, . . . ,N and t = 0, 1.

▫ Therefore we have only a single time dummy, dt, where dt = 1 in

period 1 and dt = 0 in period 0.
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Estimation methods
• I’ll introduce four common ways to estimate panel data models.

1. Pooled OLS

• In this case, we ignore concerns of unobserved heterogeneity and

simply use OLS to estimate:

Pooled OLS: yit     xit  d t  a

i  uit

 it

where ai + uit is a composite error term, ηit, that includes any

unobserved heterogeneity.
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Estimation methods – cont.

2. First-Differences:

• In this case, we account for unobserved heterogeneity by estimating

in first-differences:

First-Differences: yi     xi  ui

where yi  yi 2  yi1 , xi  xi 2  xi1 , ui  ui 2  ui1

• Taking first-differences eliminates unobserved heterogeneity.

• This is the simplest way to correct for unobserved heterogeneity.

▫ though you loose one period by taking differences.
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Estimation methods – cont.

3. Fixed Effects:

• In this case, we account for unobserved heterogeneity by estimating

the fixed effects model:

Fixed Effects: yit  yi   ( xit  xi )   ( d t  d )  (uit  ui )

1 T 1 T 1 T 1 T
where yi   yit , xi   xit , d   d t , ui   uit
T t 1 T t 1 T t 1 T t 1

• Taking mean deviations eliminates unobserved heterogeneity.

• This is the most common panel data estimation method.

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Estimation methods – cont.

4. Random Effects:

• In this case, we assume that any unobserved heterogeneity, ai, is

uncorrelated with the x’s and estimate the random effects model:

Random Effects: yit  yi   (1   )   ( xit  xi )   (d t  d )  (uit  ui )

1 T 1 T 1 T 1 T
where yi   yit , xi   xit , d   d t , ui   uit
T t 1 T t 1 T t 1 T t 1

 u2
and   1 
 u2  T a2
• This is like Pooled OLS accounting for the “serial correlation” in the
composite error term, ai + uit, due to ai.
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Estimation method 1: Pooled OLS

• Our estimating equation for Pooled OLS is:
yit     xit  d t  ai  uit

 it

where ai + uit is a composite error term that includes any unobserved

heterogeneity.

• As you can see, we are ignoring the unobserved heterogeneity, ai.

▫ It is just part of the composite error, ηit = ai + uit.

• To estimate, we run a simple OLS regression.

• When we do this for our example, what do we get for ̂ ?

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Pooled OLS – cont.

yit     xit  d t  ai  uit (1)

• What do we get for (expectation of) ˆ ?

E ( ˆ )      
where
▫ ρ = the impact of positive changes in ai is likely to have on the dependent
variable.
▫ θ = the correlation between ai and and xit.

• Thus the OLS estimator is biased, unless

1. ρ = 0 in which case ai does not appear in equation (1).
2. θ = 0, that is, unobserved heterogeneity ai is unrelated to the
variable xit.
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Estimation method 2: First Differences

• We need to derive our estimating equation for the First Difference
estimation.

• For a cross-sectional observation i, write the two years as

yi 2  (   )  xi 2  ai  ui 2 for t = 2.
yi1     xi1  ai  ui1 for t = 1.

• Subtracting the second equation from the first, we obtain:

( yi 2  yi1 )     ( xi 2  xi1 )  (ui 2  ui1 ) (2)
or
yi    xi  ui (2)’
where yi  yi 2  yi1 , xi  xi 2  xi1 , ui  ui 2  ui1 .
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First Differences – cont.

yi    xi  ui (2)’

• Equation (2)’ is called the first-differenced equation.

• Using OLS to estimate (2)’ yields the first-differenced (FD) estimator.

• The first-differenced estimator is unbiased...

▫ as long as uit is uncorrelated with x in both time periods;
▫ even if ai is correlated with x because ai is differenced away.

• Note that any explanatory variable that is constant over time gets
swept away by first-differencing.
▫ Thus, we cannot estimate the effect of such variable on y.
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Estimation method 3: Fixed Effects

• We need to derive our estimating equation for the Fixed Effects
estimation. Consider a model:
yit    xit  d t  ai  uit (3)
• Now, for each i, average this equation over time:
yi    xi  d  ai  ui (4)
1 T
where yi   yit and so on.
T t 1
▫ Note that α and ai are fixed over time.

• If we subtract (4) from (3) (called the within transformation), we obtain

yit  yi   ( xit  xi )   (d t  d )  (uit  ui ) (5)
or
~ ~
yit  ~xit  d t  u~it (5)’

where ~
yit  yit  yi is the mean deviation of y and so on.
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Fixed Effects – cont.

~ ~
yit  ~
xit  d t  u~it (5)’

• Using OLS to estimate (5)’ yields the fixed effects (FE) estimator.
▫ It is also called the within estimator.
 because we use the time variation in y, x and d within each cross-
sectional observation.

• The fixed effects estimator is unbiased...

 as long as uit is uncorrelated with x across all time periods;
▫ even if ai is correlated with x because ai is dropped by the within
transformation.

• Note that any explanatory variable that is constant over time gets
swept away by the within transformation.
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Estimation method 4: Random Effects

• The Random Effects estimator assumes that any unobserved
heterogeneity, ai, is uncorrelated with the x’s.
▫ OK, why not then just run OLS?

• You can, but the fact that ai is constant over time means that there is
serial correlation within each i.

• The composite error term is  it  ai  uit .

• Assume t = 0, 1. The correlation of the composite errors across time

is: Cov(i 0 ,i1 )
 Cov(ai  ui 0 , ai  ui1 )
 Cov(ai , ai )
 Var (ai )  0
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Random Effects – cont.

• You can fix the correlation caused by ai by modelling the correlation.
▫ This is what the Random Effects estimator does.

• For a general panel dataset, you can show (but we won’t)...

• ...that the correlation between any ηis and ηit (for a given i) is:
 a2
Corr (is ,it )  2
 a   u2
where it  ai  uit ,  a2  Var (ai ) and  u2  Var (ui ) .

• Note that the pooled OLS ignores this serial correlation.

▫ Therefore, the usual standard errors from the pooled OLS are incorrect.
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Random Effects – cont.

• The random effects estimator exploits this correlation to create a

transformed equation.
▫ whose error term does not have any serial correlation within i.

• To do so, let
 u2
  1
 u2  T a2

• Then the Random Effects model is:

yit  yi   (1   )   ( xit  xi )   (d t  d )  (it  i ) (6)

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Random Effects – cont.

yit  yi   (1   )   ( xit  xi )   (d t  d )  (it  i ) (6)

• Equation (6) involves quasi-mean deviations of each variable.

• In practice, we never know λ. Instead, use its estimate ̂ .

• The OLS estimator of equation (6), using ̂ in place of λ, is called the

Random Effects (RE) estimator.

• Equation (6) allows for x that are constant over time.

▫ This is an advantage of RE over FE or FD.
▫ This is possible because RE assumes ai is uncorrelated with all x’s.
 though the assumption is quite unlikely to hold in reality…
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Relationships among estimators

yit  yi   (1   )   ( xit  xi )   ( d t  d )  ( it   i ) (6)
where it  ai  uit .
• In order to relate RE to OLS and FE, recall that:

 u2
  1
 u2  T a2
▫ when λ = 0, we get the estimating equation of pooled OLS.
▫ when λ = 1, we get the estimating equation of FE.

• In practice, ̂ is between 0 and 1.

▫ when λ is close to 0, the RE estimates will be close to the pooled OLS
estimates.
▫ when λ is close to 1, the RE estimates will be close to the FE estimates.
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Example
• Let’s consider a wage equation for men:

ln( wageit )   0  1educi   2 blacki   3 hispanici

  4 exp erit   5 exp erit2   6 married it   7unionit  ai  uit

where…
educ: years of schooling;
black: a dummy =1 if black, = 0 otherwise;
hispanic : a dummy =1 if hispanic, = 0 otherwise;
exper: years of labour market experience;
exper^2: squared exper;
married: a dummy =1 if married, = 0 otherwise;
union: a dummy =1 if in union, = 0 otherwise.

• Estimate the wage equation using observations on 545 males for the
years 1980-1987 in the US.
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• We use 4 methods:
Pooled OLS, Random Effects, Fixed Effects and First Differences.
(1) (2) (3) (4)
VARIABLES pooled OLS RE FE FD

educ 0.0994*** 0.101*** - -

(0.00468) (0.00891)
black -0.144*** -0.144*** - -
(0.0236) (0.0476)
hisp 0.0157 0.0202 - -
(0.0208) (0.0426)
exper 0.0892*** 0.112*** 0.117*** -
(0.0101) (0.00826) (0.00842)
expersq -0.00285*** -0.00407*** -0.00430*** -0.00388***
(0.000707) (0.000592) (0.000605) (0.00139)
married 0.108*** 0.0628*** 0.0453** 0.0381*
(0.0157) (0.0168) (0.0183) (0.0229)
union 0.180*** 0.107*** 0.0821*** 0.0428**
(0.0171) (0.0178) (0.0193) (0.0197)

Observations 4,360 4,360 4,360 3,815

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Interpretation of the quadratic term

• The estimation results show that the quadratic term, exper^2 is
significant.
Diagram:
• What does this mean? Effects of experience on wage
• Answer:

• Using FE estimates, we can compute

years of experience that maximise (log of)
wage:
ln( wage)  1.065  0.117 exp er  0.0043 exp er 2  ....
 ln( wage)
 0.117  2  0.0043 exp er  0
 exp er
0.117
exp er   13.604651
2  0.0043
 37

Estimation methods: Which to use?

• OK, I just showed you a bunch of different estimation methods. The
next question is..

Which one should you use?

• There is a tradeoff:

▫ If ai is uncorrelated with all the x’s,

 the Random Effect estimator is the best.
 because it is efficient.

▫ If instead ai is correlated with at least one of the x’s,

 the Random Effects estimator is biased and inconsistent!
 and the Fixed Effects estimator is the best.
 because ai gets swept away by within transformation.
 38

Which one to use? – cont.

• That’s great but it still doesn’t tell you which one to use!

• What you need is a test of the correlation between ai and the x’s.

• Fortunately, there is a way to test it, called the Hausman test.

• The basic idea of the Hausman test:

1. Compare the difference in the estimates between the FE and the RE
estimators.
2. If they are similar, then the assumption underlying the RE estimator,
 i.e., ai is uncorrelated with all the x’s
is not a bad one.
3. Thus use the RE estimator if the RE and FE estimates are “close
enough” and use the FE estimator otherwise.

• Let’s see it concretely..

 39

Hausman test

• Consider the model:

yit    xit  ai  uit
• The null hypothesis to be tested is:

H0: ai and xit are not correlated

H1: otherwise

• The RE estimator is
▫ unbiased under H0.
▫ biased under H1.

• The FE estimator is
▫ unbiased both under H0 and H1.
 40

Hausman test – cont.

• Using the difference ( ˆFE  ˆRE ) , the Hausman test statistic is:

Hausman  ( ˆFE  ˆRE )'[Vˆ{ˆFE }  Vˆ{ˆRE }]1 ( ˆFE  ˆRE )

2
• Hausman is asymptotically distributed as  with degrees of
freedom (k+1), where k is the number of explanatory variables in
the model.

• Remember: an important reason why the two estimators would be

different is the existence of correlation between ai and xit.

• Decision rule:
▫ Use the RE estimator if H0 is not rejected.
▫ Use the FE estimator if H0 is rejected.
 41

Example
• Consider again the wage equation for men:
ln( wageit )   0  1educi   2 blacki   3 hispanici
  4 exp erit   5 exp erit2   6 married it   7unionit  ai  uit
• Estimating the equation by the RE and FE estimators yields ˆRE and ˆFE :

• The Hausman test statistic is:

 42

Example – cont.
• The Hausman test statistic is:

• Do we reject the null hypothesis?

• Answer:

• Which estimator should we use then?

 43

Summary
1. What is panel data?
▫ time dummies, unobserved heterogeneity

2. What is unobserved heterogeneity bias?

3. How to estimate the parameters in a panel data model?

▫ Pooled OLS
▫ First Differences
▫ Fixed Effects
▫ Random Effects

4. Which estimation methods to use?

▫ Hausman test