wk03 - Hypothesis Testing - Hand Written Notes 170822

Basic Regression Analysis: Hypothesis Testing and
Model Speciifcation
Yiran Xie
School of Economics, University of Sydney
August 17, 2022
Yiran Xie (School of Economics, University of Sydney) Basic Regression Analysis August 17, 2022 1 / 32
Table of contents
1. Hypothesis Testing
Hypothesis test of single restriction: Review
Hypothesis test of multiple linear restrictions
2. Model Specification
Reference:
Chapter 7.2.1 and 4.7.4, Microecononmetrics: Methods and Applications,
Cameron and Trivedi (2005)
Chapter 3.4, Microecononmetrics Using Stata, Cameron and Trivedi (2009)
Hypothesis Testing
Hypothesis testing: Wald test
Consider test of a single restriction
H0 :β = β0
∕ β0
H1 :β =
A Wald test rejects H0 if β̂ differs greatly from β0 .

It is the commonly-used method to test H0 against H1
Post-estimation Wald test with β0 = 0:

a way to find out if explanatory variables in a model are significant.
”Significant” means that they add something to the model; variables that add
nothing can be deleted without affecting the model in any meaningful way.
Hypothesis Testing Hypothesis test of single restriction: Review
Hypothesis test of single restriction: Review
Suppose we want to test if our estimated β̂j (the coefficient of the j-th
regressor) is significantly different from a constant β0
Define σβ̂ to be the asymptotic standard deviation of β̂j . Then
a
β̂j ∼ N [β, σβ̂2 ] for unknown β
β̂j − β a
⇒ ∼ N [0, 1] standardizing
σβ̂
β̂j − β0 a
⇒ zj = ∼ N [0, 1] under H0 : β = β0
σβ̂
When β0 = 0, this test tells if the j-th regressor is significant
To implement this test, replace σβ̂ by sβ̂ , the standard error of β̂.
Because we do not know the true value of σβ̂
This makes no difference asymptotically (so still N [0, 1] if N is large; when N
is small, use t-distribution instead).
Test statistic: Wald z-statistic
β̂j − β0 a
zj = ∼ N [0, 1] under H0 : β = β0
sβ̂
Implementation by two equivalent methods

Test using p-values: reject H0 at level 0.05 if
p = Pr [|Z | > |zj |] < 0.05, where Z ∼ N [0, 1]
Test using critical values: reject H0 at level 0.05 if
|zj | > z.025 = 1.96
Hypothesis test of single restriction: t-distribution
Many packages such as Stata use T (N − K ) rather than N [0, 1]

More conservative (less likely to reject H0 )
Exact in unlikely special case that ui ∼ N[0, σ 2 ].
Better finite sample approximation
Confidence interval
A 100(1 − α)% confidence interval for β is
β̂ ± zα/2 × sβ̂
in particular a 95% confidence interval is β̂ ± 1.96sβ̂ .

can replace zα/2 by Tα/2 (N − K ) for better finite sample performance
Hypothesis Testing Hypothesis test of multiple linear restrictions
Joint Hypothesis?
Question: What is the difference between a Joint Hypothesis Testing and the
standard Single Hypothesis Testing?
Answer: Joint Hypothesis tests multiple conjectures
Joint Hypothesis contains multiple equal signs
Model Y = β0 + β1 x1 + β2 x2 + u
Examples of Single Hypothesis Testing
H0 : β1 = 0 versus H1 : β1 ∕= 0
H0 : β1 − β2 = 3 versus H1 : β1 − β2 ∕= 3
Examples of Joint Hypothesis Testing
H0 : β1 = 0 and β2 = 0 versus H1 : β1 ∕= 0 and/or β2 ∕= 0

H0 : β1 = β2 and β0 = 0 versus H1 : β1 ∕= β2 and/or β0 ∕= 0
Why Study Joint Hypothesis Testing?
Question: Does the quantity demanded of a product A depend on the prices

of substitute goods B, C (or only on its own price PriceA )?
DemandA = β0 + β1 PriceA + β2 PriceB + β3 PriceC + u
We seek to test the hypothesis whether the set of explanatory variables

PriceB , PriceC jointly cause the dependent variable DemandA .
Null Hypothesis: the coefficients of PriceB , PriceC are jointly equal to zero
H0 : β2 = 0 and β3 = 0
Alternative Hypothesis: at least one of the regression coefficients differs from

zero
H1 : β2 ∕= 0 and/or β3 ∕= 0
Hypothesis test of multiple linear restrictions

Consider test of several linear restrictions
e.g. Test H0 : β1 = 0, β2 = 0 against H1 : at least one ∕= 0.
In matrix algebra we test
H0 : Rβ = r against H1 : Rβ ∕= r
Example: Linear model y = X β + u

or yi = β0 + β1 x1i + β2 x2i + ... + βK xKi + ui for i = 1, ..., N.
Test H0 : β1 = 0, β2 = 0 against H1 : at least one ∕= 0.
We can rewrite H0 using matrix notations:
# &
β0
! " ! " $ β1 '
$
' ! "
β1 0 1 0 · · · 0 $ β2 ' 0
= $ '=
β2 0 0 1 ··· 0 $ . ' 0
% .. (
βK
or Rβ = r .
Quick practice:
yi = β0 + β1 x1i + β2 x2i + ... + βK xKi + ui for i = 1, ..., N
Test H0 : β0 = 0, 2β1 + 3β2 = 1 against H1 : β0 ∕= 0 or 2β1 + 3β2 ∕= 1
What are R and r ?
Quick practice:
What are R and r ?
Answers.
! "
1 0 0 0 ··· 0
R=
0 2 3 0 ··· 0
! "
0
r=
1
A Wald test rejects H0 : Rβ = r if R β̂ − r differs greatly from 0.

Now R β̂ − r is normal as linear combination of normals is normal
a
β̂ ∼ N [β, V [β̂]] for unknown β
a ′
⇒ R β̂ − r ∼ N [Rβ − r , RV [β̂]R ] linear transformation
a
⇒ R β̂ − r ∼ N [0, RV [β̂]R ′ ] under H0 : Rβ = r
′ −1/2 a
⇒ [RV [β̂]R ] (R β̂ − r ) ∼ N [0, Ih ] standardizing
where h is the number of restrictions.

a
⇒ (R β̂ − r )′ [RV [β̂]R ′ ]−1 (R β̂ − r ) ∼ χ2 (h) under H0
The last step converts to chi-square using the result
z ∼ N [0, IN ] ⇒ z ′ z ∼ χ2 (N)
To implement this test, replace V [β̂] by V̂ [β̂]

This makes no difference asymptotically.
Test statistic: Wald chi-squared statistic
a
W = (R β̂ − r )′ [R V̂ [β̂]R ′ ]−1 (R β̂ − r ) ∼ χ2 (h) under H0
Implementation by two equivalent methods

Test using p-values: reject H0 at level 0.05 if
p = Pr [χ2 (h) > W ] < 0.05.
Test using critical-values: reject H0 at level 0.05 if
W > χ2.05 (h)
The alternative Wald F-test statistic is

W
F = ∼ F (h, N − K ) under H0
h
Makes no difference asymptotically as F (h, N) → χ2 (h)/h as N → ∞.

More conservative (less likely to reject H0 )
Exact in unlikely special case that ui ∼ N [0, σ 2 ].
Better finite sample approximation
Quick practice (Continued):

Suppose β̂0 = 1, β̂1 = 1, β̂2 = −0.3,
)# & + # & # &
β̂0 V [β̂0 ] Cov [β̂0 , β̂1 ] Cov [β̂0 , β̂2 ] 1 0 0
V *%β̂1 (, = %Cov [β̂1 , β̂0 ] V [β̂1 ] Cov [β̂1 , β̂2 ]( = %0 1 0.5(
β̂2 Cov [β̂2 , β̂0 ] Cov [β̂2 , β̂1 ] V [β̂2 ] 0 0.5 1
What is the Wald chi-squared statistic?
Quick practice (Continued):

Suppose β̂0 = 1, β̂1 = 1, β̂2 = −0.3,
)# & + # & # &
β̂0 V [β̂0 ] Cov [β̂0 , β̂1 ] Cov [β̂0 , β̂2 ] 1 0 0
V *%β̂1 (, = %Cov [β̂1 , β̂0 ] V [β̂1 ] Cov [β̂1 , β̂2 ]( = %0 1 0.5(
β̂2 Cov [β̂2 , β̂0 ] Cov [β̂2 , β̂1 ] V [β̂2 ] 0 0.5 1
What is the Wald chi-squared statistic?

Solutions.
W = (R β̂ − r )′ [R V̂ [β̂]R ′ ]−1 (R β̂ − r )
! "! "
- . 1 0 1
= 1 0.1 = 1.19
0 19 0.1
a
Since W ∼ χ2 (2) under H0 and W < χ20.05 (2) = 5.991, we cannot reject the null
hypothesis.
χ2 distribution table
Stata code for finding p-values and critical values
How do I have Stata report normal tail areas and inverse normal tail
areas?
To compute the left tail area for a given z value, use
display normal(z)
where z is the value of interest.
To compute the inverse tail area for an area equal to p, use
display invnormal(p)
Stata code for finding p-values and critical values
How do I use Stata to calculate tail areas and critical values for the t
distribution?
ttail(df,t): df is degrees of freedom and t is the test statistic.
display ttail(5,2) will return the upper tail area (to the right of 2) of a t
distribution with 5 degrees of freedom.
invttail(df,p): p is a right tail area from a t distribution with df degrees
of freedom.
display invttail(5,.05) will return the critical value from a t distribution
with 5 degrees of freedom such that the area to the right of the value is 0.05
Other distributions: chi2tail(df, c), invchi2tail(df, p),
Ftail(df1 ,df2 ,F), invFtail(df1 ,df2 ,p)
Stata example
In Week 1, we ran regressions using a medical expenditure dataset.

We can performed hypothesis test using Stata command test.
H0 :βprivate = 0, βchronic = 0
H1 : at least one of βprivate ∕= 0, βchronic ∕= 0
Stata post-estimation command test yields

. ∗ Wald t e s t o f r e s t r i c t i o n s
. q u i e t l y r e g r e s s d o c v i s p r i v a t e c h r o n i c f e m a l e income , v c e ( r o b u s t )
. t e s t ( p r i v a t e = 0) ( c h r o n i c = 0)
( 1) p r i v a t e = 0
( 2) c h r o n i c = 0
F (2 , 4407) = 165.11
Prob > F = 0 . 0 0 0 0
Reject H0 at level 0.05 since p < 0.05

or 165.11 > F.05 (2, 4407) = 3.00 using invFtail(2,4407,.05)
Model Specification
Model Specification in Multiple Regression Model
Model Specification
Questions Regarding Model Specification
First step of any econometric investigation is the choice of the model

Question: What are the considerations when choosing a model?
Answer: Use theory and economic rationale, think critically
Question: What are the consequences of choosing the wrong model?

Answer: Estimates are likely to be biased and misleading
Question: What constitute a wrong model?

Answer: Bad functional form or omission of important explanatory variables
Question: What happens when we omit important explanatory variables?

Answer: Generate Omitted Variable Bias
Model Specification
Omitted Variable Estimation
The dataset used is ”edu inc” from R package ”PoEdata”

Correct Model: FAMINC = β1 + β2 HEDUC + β3 WEDUC + e
FAMINC = Family income
HEDUC = Husband’s education
WEDUC = Wife’s education
Correct Estimation is given by:
! = −5, 534 + 3, 132HEDU + 4, 523WEDU

FAMINC
(se) (11,230) (803) (1,066)
Incorrect Estimation, we incorrectly omit wife’s education::
! = −26, 191 + 5, 155HEDU

FAMINC
(se) (8,541) (658)
Model Specification
! = −5, 534 + 3, 132HEDU + 4, 523WEDU

FAMINC
(se) (11,230) (803) (1,066)
! = −26, 191 + 5, 155HEDU

FAMINC
(se) (8,541) (658)
Omission of a relevant variable leads to a biased estimator

Omitted-variable bias induced by omitting a relevant variable
Question: What is the main consequence?

Answer: Misleading Interpretation
Omitting WEDU leads us to overstate the effect of an extra year of
education for the husband by about $2,000 !!!
The marginal effect of schooling for the husband is $3,000, not $5,000.
Omitted variable inflates the marginal effect by almost 70%
Model Specification
Formula for Omitted variable bias
Correct model is given by: yi = xi′ β + zi α + vi

(xi′ and zi are regressors, zi is a scalar for simplicity, vi is independent of xi′
and zi )
Correct regression yi = xi′ β̂ + zi α̂ + ei

Omitted Variable regression yi = xi′ β̂ ∗ + ei∗
Omitting zi is equivalent to imposing the restriction α = 0.

The estimator β̂ ∗ is biased. But what is the formula for the bias?
Model Specification
Stacking all observations yi = xi′ β + zi α + vi gives the d.g.p.
y = X β + zα + v
When z is omitted, the estimated model is
y = X β + (zα + v )
The biased OLS estimator β̂ ∗ = (X ′ X )−1 X ′ y . Substitute y with the model

yields
β̂ ∗ = (X ′ X )−1 X ′ (X β + zα + v )
= β + (X ′ X )−1 X ′ zα + (X ′ X )−1 X ′ v
= β + (N −1 X ′ X )−1 (N −1 X ′ z)α + (N −1 X ′ X )−1 (N −1 X ′ v )
Model Specification
N −1 X ′ X converge in probability to some finite and invertible matrix

! p
N −1 X ′ X = N1 i xi xi′ → E [xi xi′ ]
(the first equality comes from X = [x1 , x2 , ..., xN ]′ , xi is a K × 1 column vector)
N −1 X ′ v converge in probability to 0
! p
N −1 X ′ v = 1
N i xi vi → E [xi vi ] = 0 because xi and vi are independent
/ p
N −1 X ′ z = 1
N i xi zi → E [xi zi ] it is not 0 if xi and zi are correlated
⇒ plim β̂ ∗ = β + δα
where
δ = plim[(N −1 X ′ X )−1 (N −1 X ′ z)] = E [xi xi′ ]−1 E [xi zi′ ]
Model Specification
Understanding the Omitted variable bias
The Omitted Variable Bias is given by:
bias(β̂ ∗ ) = E (β̂ ∗ ) − β = E [xi xi′ ]−1 E [xi zi′ ] · α = δα
Main Properties
The sign of the bias depends two factors: α and δ
α > 0 because wife’s education has a positive effect on family income
δ = Cov (HEDU, WEDU)/Var (HEDU) > 0 because husband/wife education is
positively correlated
(Assortative Matching: couples often have similar schooling levels)
We conclude that the bias is positive
If correlation/covariance were 0: Cov (xi , zi ) = 0 No Bias!

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Basic Regression Analysis: Hypothesis Testing and

School of Economics, University of Sydney

August 17, 2022

Hypothesis testing: Wald test

Consider test of a single restriction

A Wald test rejects H0 if β̂ diﬀers greatly from β0 .

Post-estimation Wald test with β0 = 0:

Hypothesis test of single restriction: Review

When β0 = 0, this test tells if the j-th regressor is significant

Implementation by two equivalent methods

p = Pr [|Z | > |zj |] < 0.05, where Z ∼ N [0, 1]

Test using critical values: reject H0 at level 0.05 if

|zj | > z.025 = 1.96

Hypothesis test of single restriction: t-distribution

Many packages such as Stata use T (N − K ) rather than N [0, 1]

A 100(1 − α)% confidence interval for β is

in particular a 95% confidence interval is β̂ ± 1.96sβ̂ .

Examples of Joint Hypothesis Testing

H0 : β1 = 0 and β2 = 0 versus H1 : β1 ∕= 0 and/or β2 ∕= 0

Why Study Joint Hypothesis Testing?

Question: Does the quantity demanded of a product A depend on the prices

DemandA = β0 + β1 PriceA + β2 PriceB + β3 PriceC + u

We seek to test the hypothesis whether the set of explanatory variables

Alternative Hypothesis: at least one of the regression coeﬃcients diﬀers from

Hypothesis test of multiple linear restrictions

Example: Linear model y = X β + u

A Wald test rejects H0 : Rβ = r if R β̂ − r diﬀers greatly from 0.

where h is the number of restrictions.

The last step converts to chi-square using the result

To implement this test, replace V [β̂] by V̂ [β̂]

Implementation by two equivalent methods

p = Pr [χ2 (h) > W ] < 0.05.

Test using critical-values: reject H0 at level 0.05 if

W > χ2.05 (h)

The alternative Wald F-test statistic is

Makes no diﬀerence asymptotically as F (h, N) → χ2 (h)/h as N → ∞.

Quick practice (Continued):

What is the Wald chi-squared statistic?

Quick practice (Continued):

What is the Wald chi-squared statistic?

Stata code for finding p-values and critical values

Stata code for finding p-values and critical values

In Week 1, we ran regressions using a medical expenditure dataset.

Stata post-estimation command test yields

Reject H0 at level 0.05 since p < 0.05

Model Specification in Multiple Regression Model

Questions Regarding Model Specification

First step of any econometric investigation is the choice of the model

Question: What are the consequences of choosing the wrong model?

Question: What constitute a wrong model?

Question: What happens when we omit important explanatory variables?

Omitted Variable Estimation

The dataset used is ”edu inc” from R package ”PoEdata”

! = −5, 534 + 3, 132HEDU + 4, 523WEDU

Incorrect Estimation, we incorrectly omit wife’s education::

! = −26, 191 + 5, 155HEDU

! = −5, 534 + 3, 132HEDU + 4, 523WEDU

! = −26, 191 + 5, 155HEDU

Omission of a relevant variable leads to a biased estimator

Question: What is the main consequence?

Formula for Omitted variable bias

Correct model is given by: yi = xi′ β + zi α + vi