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**Dummy Variables & Interaction Effects
**

1

**The Homogeneity Assumption
**

OLS assumes all cases in your data are comparable x’s are a sample drawn from a single population But we may analyze distinct groups of cases together in one analysis Mean value of y may differ by group

2

Qualitative Variables

These group effects remain as part of the error term If groups differ in their distribution of x’s, then we get a correlation between the X variables and the error term Violates assumption: cov(Xi, ui)=E(u)=0

**Omitted Variable Bias!
**

3

**Testing for Differences Across Groups (p. 249-252) Test: The Chow
**

2. The Chow Test Is only valid under homoskedasticity (the error variance for the two groups must be i.e. Testing for difference between males and females on equal). academic performance.

cases, we should allow dummy SSR1=Males only; SSR2=Females only variables and dummy interactions to allow us to SSRur=SSR1+SSR2 predict different slopes and intercepts for the two groups. SSRP=SSRr=Pooling across both groups

[ SSR p ( SSR SSR )] [n 2(k 1)] F * SSR4. This may be two restrictivein1these k 1 SSR2

3.

The null hypothesis is that there is no difference at all; either in the intercept or 1 2 the slope between the two groups.

4

**But if Democracies are more Example: Democracy & Tariffs
**

Percent Tariffs

likely to be in RTA’s, then 40 pooling RTA and non-RTA 35 Here we see that states biases the coefficient 30 25 democracies have 20 lower tariffs 15

10 5 0

Pooled Data

Here we see that states in Regional Trading Arrangements (RTA’s) have lower tariffs

Dictator

50 45 40 35 30 25 20 15 10 5 0 Dictator

Oligarch

Anocracy

Democracy

Percent Tariffs

RTA No RTA Pooled Data

Oligarch

Anocracy

Democracy

5

**Solution: The Qualitative Variable
**

Measure this group difference (RTA vs. Non-RTA) and specify it as an x This eliminates bias But we have no numerical scale to measure RTA’s Create a categorical variable that captures this group difference

6

**The Qualitative “Dummy”
**

Create a variable that equals 1 when a case is part of a group, 0 otherwise This variable creates a new intercept for the cases in the group marked by the dummy Specifically, how would we interpret:

**TARIFF 0 1 DEM 2 RTA u
**

7

**Democracy and Tariff Barriers
**

50 45 40 35 30 25 20 15 10 5 0 Dictator Oligarch Anocracy Democracy Percent Tariffs

RTA No RTA

**ˆ ˆ ˆ ˆ TARIFF 0 1 DEM 2 RTA u ˆ ˆ ˆ 50K and K 5K and K 10
**

0 1 2

8

**Graphical Depiction of a Dummy
**

y

ˆ ˆ ˆ ˆ y 0 1 x1 2 x2 if x2 1

ˆ ˆ ˆ y 0 1 x1

ˆ 1 ˆ 1

ˆ ˆ 0 2

ˆ ˆ 0

0

ˆ 1

ˆ ˆ ˆ ˆ y 0 1 x1 2 x2 if x2 0

x1 (could be continuous, categorical, or dichotomous)

9

**Multiple Category Dummies
**

Dummy variables are a very flexible way to assess categorical differences in the mean of y We can use dummies even for concepts with multiple categories Imagine we want to capture the impact of global region on tariffs

Regions:

**Americas, Europe, Asia, Africa
**

10

Warning!

Do not fall into the dummy variable trap! When you have entered both values of a dummy variable in the same regression. These two variables are linearly dependent. One will drop out.

11

**Multiple Category Dummies
**

Create 4 separate dummy variables - 1 for each region Include all except one of these dummies in the equation If you include all 4 dummies you get perfect collinearity with the constant. The fourth dummy will drop out. Americas+Europe+Asia+Africa=1

12

**Interpreting Multi-Category Dummies
**

Each coefficient compares the mean for that group to the mean in the excluded category Thus if: βhat2-βhat4 compare the mean tariff in each region to the mean in the Americas

**ˆ ˆ ˆ ˆ ˆ ˆ TARIFF 0 1 DEM 2 EUR 3 ASIA 4 AFR u
**

Mean in Americas is βhat0 An alternative strategy is to drop the constant and run all dummies, as discussed last week.

13

Dumb Dummies

Dummy variables are easy, flexible ways to measure categorical concepts They CAN be just labels for ignorance Try to use dummies to capture theoretical constructs not empirical observations If possible, measure the theoretical construct more directly

14

Interaction Effects

Dummy variables specify new intercepts Other slope coefficients in the equation do not change OLS assumes that the slopes of continuous variables are constant across all cases What if slopes are different for different groups in our sample?

15

**Interaction Effects: An Example
**

What if the effect of democracy on tariffs depends on whether the state is in an RTA?

**ˆ ˆ ˆ ˆ TARIFF 0 1DEM 2 RTA u
**

ˆ ˆ ˆ 1 0 1 RTA

16

**Interaction Effects: An Illustration
**

(Notice that democracy has been converted to a dummy as well for illustration purposes)

35 Percent Tariffs 30 25 20 15 10 5 0 Non-Dem Democracy RTA No RTA

**ˆ ˆ ˆ TARIFF 0 1 DEM 2 RTA u ˆ 5K if K RTA 0
**

1

ˆ 1 6K if K RTA 1

17

**How Do We Estimate This Set of Relationships?
**

We begin with:

**ˆ ˆ ˆ ˆ TARIFF 0 1 DEM 2 RTA u
**

ˆ ˆ ˆ 1 0 1 RTA

Substituting for Βhat1, hat Β 1 we get:

**ˆ ˆ ˆ ˆ ˆ TARIFF 0 ( 0 1 RTA) DEM 2 RTA u ˆ ˆ ˆ ˆ ˆ TARIFF DEM RTA * DEM RTA u
**

0 0 1 2

18

In STATA, they will Βhat2 appear as regular coefficients

Βhat3

**What Do These Coefficients Mean?
**

ˆ ˆ ˆ ˆ ˆ TARIFF 0 0 DEM 1RTA * DEM 2 RTA u ˆ 0 is the intercept for DEM when RTA=0

ˆ ˆ 0 2 is the new intercept for DEM when RTA=1 0 is the slope of DEM when RTA=0 1 is the impact of RTA on the coefficient for DEM

**So if RTA=1, the slope of DEM is 0 + 1
**

19

**Interpreting the Interaction
**

Recall that:

**ˆ ˆ ˆ ˆ TARIFF 0 1 DEM 2 RTA u
**

ˆ ˆ ˆ 1 0 1 RTA

**ˆ ˆ ˆ ˆ ˆ TARIFF 0 ( 0 1 RTA) DEM 2 RTA u ˆ ˆ ˆ ˆ ˆ TARIFF DEM RTA * DEM RTA u
**

0 0 1 2

RTA is a dummy variable taking on the values 0 or 1

ˆ ˆ Thus if RTA=0, then 1 = 0 ˆ ˆ ˆ But if RTA=1, then 1 = 0 + 1

20

**An Illustration of the Coefficients
**

Imagine we estimate:

TARIFF 30 5( DEM ) 1( RTA * DEM ) 10( RTA)

35 Percent Tariffs 30 25 20 15 10 5 0 Non-Dem Democracy

21

RTA No RTA

**Substantive Effects of Dummy Interactions
**

No RTA RTA

NonDemocracy Democracy

Βhat0 =

Βhat0 + Βhat3 =

30

Βhat0 + Βhat1 =

20

Βhat0 + Βhat1 + Βhat2 + Βhat3 = 14

22

25

**Interactions with Continuous Variables
**

The exact same logic about interactions applies if Βhat1 depends on a continuous variable

ˆ ˆ ˆ ˆ y 0 1x1 2 x 2 u ˆ ˆ ˆ x

1 0 1 2

ˆ 0 is the impact of x1 when x 2 =0

**ˆ ˆ 1 is the change in 1 for each one unit increase in x 2 ˆ 2 is the impact of x 2 when x1 =0
**

23

**Example: Democracy, Tariffs & Unemployment
**

Tariff Rate 30 40 10 Dictator 20 50

Oligarch

Democracy 1-4

Anocrat

Demo

yhat_, Unemployment == 0 yhat_, Unemployment == 4

yh at_, Unemplo ym ent == 2 yh at_, Unemplo ym ent == 6

**TARIFF 28 2( DEM ) 1( DEM *UNEMP) 5(UNEMP)
**

24

**Graphical Depiction of a Dummy/Continuous Interaction
**

y

ˆ y ˆ0 0 x1 1 ( x1 * x2 ) ˆ3 x2 if x2 1

ˆ1 0 1

ˆ 1

ˆ y ˆ0 ˆ1 x1 ˆ2 x2 if x2 1

ˆ 0

ˆ 0

ˆ ˆ ˆ ˆ y 0 0 x1 1 ( x1 * x2 ) 3 x2 if x2 0 1 0

ˆ ˆ 0 3

x1 (could be continuous, categorical, or dichotomous)

25

**What if a Variable Interacts with Itself?
**

What if Βhat1 depends on the value of x1?

ˆ ˆ ˆ ˆ y 0 1x1 2 x 2 u ˆ ˆ ˆ 1 0 1x1

**Then we substitute in as before: ˆ ˆ ˆ ˆ ˆ y 0 ( 0 1x1 )x1 2 x 2 u ˆ ˆ ˆ ˆ ˆ y x x 2 x u
**

0 0 1 1 1 2 2

Curvilinear (Quadratic) effect is a type of interaction

26

**More Complex Interactions
**

We can use this method to specify the functional form of βhat1 in any way we choose Simply substitute the function in for βhat1 , multiply out the terms and estimate Only limitations are theories of interaction and levels of collinearity

27

Examples of interaction effects from my own research

28

**Governance and Economic Welfare
**

2 004 G DP per capita (in M illions of Con stant 199 4 VN D)

**Figure 4: PCI Performance and Economic Welfare
**

15

0

5

10

“The Governance Premium” Better governed (high PCI) provinces are able to generate higher living standards from the same level of development

0

Structura l E n dowments (Infrastructure, H uma n C a pital, Proxim ity to M arkets)

20

40

60

80

10 0

Low PC I

H igh PCI

29

**Predicted Number of Loans by Legal Status among Vietnamese Private Firms
**

Land Use Rights Certificate Registered at DPI

No Yes None 0.83 2.73 Partial 0.99 3.27 Full 1.2 3.98

30

(By State Sector Output with Number of Cabinet Officials)

Predicted Probablity of Provincial Division .4 .5 .6 .7 .8

Predicted Probability of Provincial Division in Vietnam

0

.2

.4 .6 State Contribution to Provincial Output

.8

1

**No Cabinet Members 2+ Cabinet Members
**

Contribution of covariates at 75th percentile

1 Cabinet Member

31

32

33

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