Summer 2021 Exam

EC221
Principles of Econometrics

Suitable for all candidates

Instructions to candidates
This paper contains FOUR questions, divided into two sections. Section A contains ONE question
related to Michaelmas Term and Section B contains THREE questions related to Lent Term. You
should answer ALL questions from Section A and ALL questions from Section B.
If at any point in this exam you feel that anything is unclear, please make additional assumptions that
you feel are necessary and state them clearly.
For Section A: Please type your answer in a Word-processing software on a computer (e.g. Word).
You could combine the typed document with scanned or photographed hand-drawn diagrams and
computations. The maximum word count is 1500 words, beyond which nothing will be marked. There
is no minimum word count and concise answers will be rewarded.
For Section B: Please use pen and paper and scan (or photograph) your answers. You could also use
an iPad or a tablet. There is no maximum word count for Section B. Please annotate your answers
clearly.
The answers must then be converted to pdf and uploaded to Moodle as ONE individual file together
with the Coversheet. Please make sure every single scanned page is legible and properly ordered.
The file will be run through Turnitin to ensure academic integrity.

Time Allowed Submit PDF with answers within 24 hours after official start of the exam

Expected effort Reading Time: 15 minutes

Answering Time: 3 hours

You are supplied with: Lindley & Scott Cambridge Statistical Tables
Table A5 Durbin-Watson d-statistic
You may also use: Open book examination

Calculators: Calculators are allowed in this exam

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 Section A
(Answer all questions.)

Question 1
[33.34 marks]
A blowout of the BP Deepwater Horizon oil-well in April 2010 led to the largest marine oil spill in history,
lasting until July of that year. Researchers would like to analyse whether consumers reacted to the
disaster by reducing their consumption of BP branded petrol during the oil spill. They collected data
on the prices and quantities sold at BP-branded and non-BP petrol stations across zip codes (postal
codes; small local areas) in the US. Either a zip code contains BP stations, in which case the average
price and average number of gallons sold for each of these BP stations is recorded (and the indicator
variable BP = 1), or a zip code contains no BP station, in which case the price and quantity at these
non-BP stations is recorded (and BP = 0). An observation is a particular petrol station. Non-BP
stations in BP zip codes are not used in the sample.
Prices and quantities are the averages either for the period January 2009 to March 2010 (before the
oil spill) in columns (1) and (2) or for April 2010 to July 2010 (during the oil spill) in columns (3) to (6)
of the table below. Prices are in US Dollars per gallon and coded as P rice. Quantities are in logarithm
and coded as ln(sales). The researchers also constructed a variable called Green Index, which is
supposed to measure the environmental orientation of consumers in the zip code. The Green Index
is constructed by combining the share of hybrid vehicle registrations, per capita membership in the
Sierra Club, an environmental organisation, and per capita contributions to Green Party election funds
in the zip code, all measured prior to 2010. The Green Index is then standardised to have mean 0
and standard deviation 1. Using either P rice or ln(sales) as the dependent variable, the researchers
obtain the following results.

Jan 2009 - Mar 2010 Apr 2010 - Jul 2010

Price ln(sales) Price ln(sales) Price ln(sales)
(1) (2) (3) (4) (5) (6)
0.003 -0.004 -0.043 -0.036 -0.041 -0.033
BP
(0.002) (0.007) (0.002) (0.009) (0.002) (0.009)
0.006 -0.002
Green Index
(0.001) (0.002)
-0.006 0.013
BP × Green Index
(0.002) (0.008)
Notes: All regressions also contain a constant. Robust standard errors are
in parentheses. The regressions have 5,686 observations

(a) Define the treatment, the outcome, and the counterfactuals implicit in the regression in column
(3)? What do the researchers use as the control group in this regression?
[3.34 marks]
(b) Why do the researchers run the regressions in columns (1) and (2) for the period before the oil
spill? What do you conclude from this exercise?
[6 marks]
(c) What is the average effect of the oil spill on BP prices in column (3)? Discuss whether this is
likely a causal effect.
[6 marks]

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(d) The researchers also have a variable available which measures the advertising expenditures by
BP in a particular zip code from April to July 2010. Would this variable be useful for the analysis?
Explain either how it could be used productively or why you think it is not useful.
[4 marks]
(e) What is the interpretation of the coefficient on the interaction term BP x Green Index in Column
(5)? How much lower is the BP price at a station in a zip code which is 2 standard deviations
above the mean in the Green Index compared to a similarly green control counties? Carefully
explain your answer.
[6 marks]
(f) The average BP price during the sample period (2009-2010) is US$2.70. Use the estimates in
columns (3) and (4) to construct a price elasticity for BP-branded petrol. Is this a demand or
supply elasticity or neither? Carefully explain your answer.
[8 marks]

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 Section B
(Answer all questions.)

Question 2
[22.33 marks]
Consider the linear regression model under the Gauss Markov assumptions

y = Xβ + ε,

where X has full column rank k and ε|X ∼ N (0, σ 2 I).

We are interested in testing the joint linear restrictions

H0 : Rβ = c against H1 : Rβ 6= c,

where R is a J × k matrix of known constants with full row rank (no redundant restrictions) and c is
a J × 1 vector of known constants.

Lagrange multipliers play an important role in constrained optimisation. In lectures we showed how,
with the help of the Lagrangean

L = (y − Xb)0 (y − Xb) − 2λ0 (Rb − c), (2.1)

where λ is the J × 1 vector of Lagrange multipliers associated with our J restrictions, we could obtain
the constrained OLS estimator for β. Specifically, we showed

β ∗ = β̂ − (X 0 X)−1 R0 (R(X 0 X)−1 R0 )−1 (c − Rβ̂), (2.2)

where β̂ is the usual OLS estimator β̂ = (X 0 X)−1 X 0 y . The estimator for the Lagrange multipliers
was shown to equal

λ∗ = (R(X 0 X)−1 R0 )−1 (c − Rβ̂). (2.3)

(a) The Lagrange multiplier test is based on testing H0 : λ = 0 against H1 : λ 6= 0. Explain

intuitively why this is an appropriate null to use to test the hypothesis H0 : Rβ = c, referring
explicitly to the interpretation of the Lagrange multipliers.
[4 marks]
(b) Show that the sampling distribution of λ∗ conditional on X is given by:

λ∗ |X ∼ N (R(X 0 X)−1 R0 )−1 (c − Rβ), σ 2 (R(X 0 X)−1 R0 )−1 .

Hint: You are allowed to make use of the well-known sampling distribution of β̂|X (no need to
derive).
[4 marks]
(c) Suppose σ 2 is known. Based on the sampling distribution of λ∗ in (b), propose a test statistic
to test for H0 : λ = 0 against H1 : λ 6= 0. Clearly state the sampling distribution of your test
statistic and discuss how to carry out the test.

Hint: You may, without loss of generality, assume X to be non-stochastic.

[5.33 marks]

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(d) When σ 2 is unknown, your test in part (c) is infeasible. Using the unbiased estimator for σ 2 ,
s2 = (y − X β̂)0 (y − X β̂)/(n − k), propose a feasible test statistic to test for H0 : λ = 0
against H1 : λ 6= 0. Clearly state the sampling distribution of this LM test statistic and discuss
how to carry out the test.

Hint: You are allowed to make use of the well-known sampling distribution of the suitably nor-
malised estimator s2 (no need to derive).
[5 marks]

(e) Show that the LM test statistic in (d) is equivalent to the more familiar Wald test statistic.
[4 marks]

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Question 3
[22.33 marks]
Let us consider the linear regression model

y = Xβ + ε, where E(ε|X) 6= 0,

where y is an (n×1) vector of the dependent variable and X is a full column rank (n×k) dimensional
matrix that contains exogenous and endogenous regressors. Let Z be an (n × L) dimensional matrix
that contains instruments, L ≥ k.
n
We assume that {(yi , xi , zi )}i=1 forms a random sample.
(a) Provide and discuss the requirements on our instruments that are needed for identification and
will permit us to obtain a consistent estimator for β. Distinguish in your discussion the concepts
of underidentification, just identified and overidentification.
[3 marks]
(b) Suppose our equation is just identified. Derive the IV estimator for β, β̂IV .
[3 marks]
(c) Suppose our equation is overidentified.

(i) For this setting, we considered the 2SLS estimator for β, β̂2SLS . Consider the following
estimation method: 1) regress y on Z and collect the fitted values ỹ; 2) regress each column
of X on Z and collect fitted values X̃; 3) regress ỹ on X̃. Show that the resulting estimator
from 3) is the same as the 2SLS estimator.
[3 marks]
We are advised that there is evidence of heteroskedasticity such that V ar(εi |zi ) = σ 2 ωi2 , where
ωi2 = h(zi ) for some known function h(·). In matrix form, V ar (ε|Z) = σ 2 Ω, where Ωii = ωi2
and Ωij = 0 for i 6= j.

(ii) Derive the V ar(Z 0 ε|Z).

[2 marks]
(iii) An optimal IV estimator, which recognizes the heteroskedasticity, solves the following cri-
terion

min(y − Xb)0 Z(Z 0 ΩZ)−1 Z 0 (y − Xb).

b

Give an intuitive explanation for the form of the criterion using (c.ii).
[3 marks]
(iv) Derive the optimal IV estimator for β.
[3.33 marks]
(v) Show that the optimal IV estimator for β equals β̂2SLS , when we do not have heteroskedas-
ticity.
[2 marks]
(d) Suppose our equation is just identified, show that the optimal IV estimator for β that recognizes
the presence of heteroskedasticity equals the β̂IV estimator derived in (b). Interpret this finding.

[3 marks]

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Question 4
[22 marks]
Let us consider the linear probability model

y = x1 α1 + X2 α2 + ε,

where y is a binary variable. In particular, let y = 1 if the application for a mortgage was denied, and
y = 0 if an application for a mortgage was successful.

The matrix X = [x1 : X2 ] is full column rank and E(ε|X) = 0. We obtain a random sample
{(yi , xi1 , x0i2 ) , i = 1, .., n}.

The parameter of interest is α1 , where in our example x1 is an indicator of the individual belongs
to an ethnic minority group and X2 are other characteristics that a loan officer might legally con-
sider when deciding on a mortgage application. We will restrict our attention to the variables: pirat
(ratio of total monthly debt payment to total monthly income), lvrat_med and lvrat_high (dummy
variables indicating whether the loan-to-value ratio is intermediate or high, with the excluded dummy
being low), and a consumer credit score, chist (which ranges from 1 to 5, where 5 is the worst rating),
and hschool (dummy indicating completion of high school). We have a random sample of 2,380 ob-
servations. There are 285 denied applications, the average of pirat equals 0.33, and the average of
chist equals 2.12.
(a) Discuss how we can obtain the OLS estimator for α1 using a residual based regression. Clearly
define any notation you introduce and provide a clear interpretation of α1 in this model.
[5 marks]
(b) The linear probability is known to exhibit heteroskedasticity. Prove that the estimator derived in
(a) for α1 remains consistent in the presence of heteroskedasticity.
Hint: you are expected to use the formula for α1 provided in (a) in your answer to this question.
[5 marks]
(c) You want to test the hypothesis H0 : α1 = 0 against H1 : α1 > 0. Discuss how you can test
this hypothesis. In your answer indicate how you can obtain the standard error for α1 .
[5 marks]
The loan officer considers a behavioural model underlying the riskiness associated with each mort-
gage application. In particular, he considers the model

y ∗ = x1 δ0 + X2 δ1 + u,

where y ∗ represents the risk associated with the mortgage application. The loan officer will decide to
deny the application (y = 1) if

y ∗ > 0.

The loan officer is concerned about the presence of heteroskedasticity in the errors, and proceeds
to estimate a probit model that permits heteroskedasticity, such that V ar(ui |xi ) = exp(x0i2 γ)2 . The
log-likelihood is given by
n
( ! " !#)
X xi1 δ0 + x0i2 δ1 xi1 δ0 + x0i2 δ1
log L (δ0 , δ1 , γ) = yi log Φ + (1 − yi ) log 1 − Φ .
exp x0i2 γ exp x0i2 γ



i=1

Ignoring the presence of heteroskedasticity is serious here, as the usual probit parameter estimator for
(δ0 , δ1 ) will be inconsistent in the presence of heteroskedasticity. In Stata we can use the command
hetprobit to estimate the above model.

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(d) Use the regression results provided to test for the presence of heteroskedasticity. Clearly indi-
cate the null and alternative hypothesis, the test statistic with its distribution under the null, and
interpret the outcome of your test.
[3 marks]
(e) Obtain the partial effect of being a minority on the mortgage denial rate using the standard probit
model, given an intermediate loan-to-value ratio, with no high school completion and evaluating
the other explanatory variables at their mean. Briefly indicate whether you expect this effect to
be significant (no formal test expected), and should we expect this effect to be the same given
a high loan-to-value ratio?
[4 marks]

END OF PAPER

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