Chapter IV

Tranformations and Dummy Variables

Pr Dr Hédi ESSID
 Topics to be Covered

 Logarithmic transformations - log-linear (constant

elasticity) models .

 Dummy variables for qualitative factors.

 An application to illustrate the above.

Econometrics 2
 Log-linear Regression Models

 In many cases relationships between economic

variables may be non-linear. However we can
distinguish between functional forms that are
intrinsically non-linear (and will need to be estimated by
some kind of iterative non-linear least squares method)
and those that can be transformed into an equation to
which we can apply ordinary least squares techniques.

 Of those non-linear equations that can be transformed,

the best known is the multiplicative power function form
(sometimes called the Cobb-Douglas functional form),
which is transformed into a linear format by taking
logarithms.

Econometrics 3
 Log-linear Regression Models

Production functions
 For example, suppose we have cross-section data on
firms in a particular industry with observations both on
the output (Q) of each firm and on the inputs of Labour
(L) and Capital (K).

 Consider the following functional form

Q  AL K  1

Econometrics 4
 Log-linear Regression Models

 Equation [1] means that the impact on Q of a change in

L (K held constant) will not be constant but will different
according to the values of L and K.

 In mathematical terms Q/L (the derivative of Q with

respect to L) is not a constant.

 Differentiating [1] we can see that Q/L=AL-1Kβ

 Note that this can also be written as Q/L=(Q/L) ; and

= (Q/Q)/(L/L) = LogQ/LogL

Econometrics 5
 Log-linear Regression Models

 In term of economics Q/L is the Marginal Product of

Labour (MPL).

 Note: If we differentiate again with respect to L we can

see that if 0<<1 the MPL will be positive but declining
function of L.

 = LogQ/LogL is the elasticity of Q with respect to L.

This elasticity is defined to be the proportional change
in Q for a given proportional change in L.

 Similarly MPK=Q/K=β(Q/K) ; and

β= LogQ/LogK is the elasticity of Q with respect to K.
Econometrics 6
Log-linear Regression Models

Further, if

 α + β = 1, the production function has constant returns

to scales, meaning that doubling the usage of capital
K and labor L will also double output Q. If

 α + β < 1, returns to scale are decreasing, and if

 α + β > 1, returns to scale are increasing.

Econometrics 7
Log-linear Regression Models

 Now lets see what happens when we take logarithms of

both sides of [1]

LogQ=LogA + LogL +βLogK [2]

 The logarithmic transformation has converted the

equation to one which is linear in the logarithms.

Econometrics 8
Log-linear Regression Models

 Of course up until now have neglected to incorporate an

error term into the equation. For it, to be additive in
equation [2] it must have been multiplicative in equation [1]

i.e. Q=ALKβeu [1*]

 Becomes LogQ= LogA +LogL +βLogK +u [2*]

 The parameters  and  can be estimated directly from a

regression of the variable LogQ on LogL and LogK.

Econometrics 9
Log-linear Regression Models
Demande functions

Similary we might find if it necessary to use a multiplicative function

form when studying demand.

e.g. Q  AP 1Y  2 R  3 eU

or LogQ   0   1LogP   2LogY   3 LogR  U

where here Q =quantity demanded of a comodity

P =the price of a comomdity
Y=consumer's income
R =the price of the related comodity
and we write  0 for log A
Econometrics 10
Log-linear Regression Models

 This functional from would be consistent with curves

which are convex to the origin. It also has the advantage
that the regression parameters can be interpreted as the
elasticities.

 For example the (own) price elasticity = (Q/P)*(P/Q)=1

[Prove this as an exercise]. Of course this is expected to
be negative.

 Similarly the income elasticity of demand will be 2 and

the cross-price elasticity of demand is 3 (>0 if our
commodity is a substitute for the related commodity, <0 if
the goods are complements).

Econometrics 11
Logarithms in Regression :

 Logarithms can be used to transform the dependent

variable Y, an independent variable X, or both (but the
variable being transformed must be positive).

 The following table summarizes three cases and the

interpretation of the regression coefficient 1. In each
case, 1 can be estimated by applying OLS after taking
the logarithm of the dependant variable and/or
independent variable.

Econometrics 12
Logarithms in Regression :

Case Regression Specification Interpretation of α1

A 1% change in X is associated with

I Yi = α0+α1logXi+ui
a change in Y of 0.01α1

II A change in X by one unit (ΔX=1)

logYi = α0+α1Xi+ui is associated with a 100α1% change
in Y.
III A 1% change in X is associated with
logYi = α0+α1 logXi+ui a α1 % change in Y, so α1 is the
elasticity of Y with respect to X.

Econometrics 13
Dummy Variables

 Dummy variables (sometimes called dichotomous

variables) are variables that are created to allow for
qualitative effects in a regression model.

 A dummy variable will take the value 1 or 0 according

to whether or not the condition is present or absent for
a particular observation.

 For example suppose we are investigating the

relationship between the wage (Wage) and the number
of years of education (Education) in the textile sector.

Econometrics 14
Dummy Variables

 Our initial model is

Y = β1 + β2 X + u

 However, we are concerned that the wages of female

workers may be below that of male workers with
similar experience.

 To test for this we can introduce a dummy variable to

distinguish between the observations for male and
female workers in the regression.

Econometrics 15
 Dummy Variables
 Define D = 1 for male workers and 0 for female workers.

 The overall equation becomes

Y = β0 + β1 X + D + u

 where  will measure the differential between male and female

workers, having taken account of differences in experience. We can
run a normal multiple regression with X and D as explanatory
variables.

 Assuming that  is positive it means that the regression line for male
workers lies above that for female workers -  measures the extent
of the upward shift.

 We can use its t-value to test whether these differences are

statistically significant.

Econometrics 16
Dummy Variables
Example : A wage-discrimination model

 Our dataset includes wage as dependent variable, education and

dummy variables for gender and race as independent variables.

 Let us consider the model in the above equation:

Wage = 1+2Educ + 1Black + 2Female + 3(black*female) + U

1. Is there a difference between wages of male and female workers with

similar experience ?

2. What are the expected wages for different categories ?

- White/male.
- Black/male.
- White/female.
- Black/female.

3. Given the same education, calculate the difference between black

female and white male. Econometrics 17