Multicollinearity

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Multicollinearity

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Multicollinearity

All rights reserved.

Washington and Lee University

The next three chapters deal with violations of the Classical

Assumptions and remedies for those violations

This chapter addresses multicollinearity; the next two chapters are

on serial correlation and heteroskedasticity

For each of these three problems, we will attempt to answer the

following questions:

1. What is the nature of the problem?

2. What are the consequences of the problem?

3. How is the problem diagnosed?

4. What remedies for the problem are available?

8-2

Perfect Multicollinearity

no explanatory variable is a perfect linear function of any other explanatory variables

The word perfect in this context implies that the variation in one explanatory

variable can be completely explained by movements in another explanatory

variable

A special case is that of a dominant variable: an explanatory variable is definitionally

related to the dependent variable

X1i = 0 + 1X2i

(8.1)

where the s are constants and the Xs are independent variables in:

Yi = 0 + 1X1i + 2X2i + i

(8.2)

8-3

Figure 8.1

Perfect Multicollinearity

8-4

Perfect Multicollinearity

(cont.)

perfect multicollinearity?

OLS is incapable of generating estimates of the regression coefficients

most OLS computer programs will print out an error message in such a situation

because the perfectly collinear variables cannot be distinguished from each

other:

You cannot hold all the other independent variables in the equation constant if

every time one variable changes, another changes in an identical manner!

Solution: one of the collinear variables must be dropped (they are essentially

identical, anyway)

8-5

Imperfect Multicollinearity

Imperfect multicollinearity occurs when two (or

more) explanatory variables are imperfectly

linearly related, as in:

X1i = 0 + 1X2i + ui

(8.7)

Notice that Equation 8.7 includes ui, a stochastic error

term

2011 Pearson Addison-Wesley. All

8-6

Figure 8.2

Imperfect Multicollinearity

8-7

The Consequences of

Multicollinearity

There are five major consequences of multicollinearity:

1.

2.

will increase:

a. Harder to distinguish the effect of one variable from the

effect of another, so much more likely to make large

errors in estimating the s than without multicollinearity

b. As a result, the estimated coefficients, although still

unbiased, now come from distributions with much larger

variances and, therefore, larger standard errors (this

point is illustrated in Figure 8.3)

8-8

Increases the Variances of the s

8-9

The Consequences of

Multicollinearity (cont.)

3. The computed t-scores will fall:

a. Recalling Equation 5.2, this is a direct consequence of 2. above

a.

will often cause major changes in the values of the s when significant

multicollinearity exists

b.

For example, if you drop a variable, even one that appears to be statistically

insignificant, the coefficients of the remaining variables in the equation

sometimes will change dramatically

c.

effect of one variable from the effect of another

5. The overall fit of the equation and the estimation of the coefficients of

nonmulticollinear variables will be largely unaffected

8-10

The Detection of

Multicollinearity

First realize that that some multicollinearity exists in every equation:

all variables are correlated to some degree (even if completely at

random)

So its really a question of how much multicollinearity exists in an

equation, rather than whether any multicollinearity exists

There are basically two characteristics that help detect the degree of

multicollinearity for a given application:

1. High simple correlation coefficients

2. High Variance Inflation Factors (VIFs)

We will now go through each of these in turn:

8-11

Coefficients

variables is high in absolute value, these two particular Xs are highly

correlated and multicollinearity is a potential problem

Some researchers pick an arbitrary number, such as 0.80

A better answer might be that r is high if it causes unacceptably large

variances in the coefficient estimates in which were interested.

Groups of independent variables, acting together, may cause

multicollinearity without any single simple correlation coefficient being high

enough to indicate that multicollinearity is present

As a result, simple correlation coefficients must be considered to be

sufficient but not necessary tests for multicollinearity

8-12

Factors (VIFs)

The variance inflation factor (VIF) is calculated from two steps:

1.

explanatory variables in the equationFor i = 1, this equation would

be:

X 1 = 1 + 2X 2 + 3X 3 + + KX K + v

(8.15)

(8.16)

where

is the unadjusted

8-13

Factors (VIFs) (cont.)

From Equation 8.16, the higher the VIF, the more severe the effects of

mulitcollinearity

While there is no table of formal critical VIF values, a common rule of thumb is

that if a given VIF is greater than 5, the multicollinearity is severe

this number slightly

Note that the authors replace the VIF with its reciprocal,

tolerance, or TOL

, called

There can still be severe multicollinearity even with small VIFs

VIF is a sufficient, not necessary, test for multicollinearity

8-14

Remedies for

Multicollinearity

Essentially three remedies for multicollinearity:

1. Do nothing:

a. Multicollinearity will not necessarily reduce the t-scores

enough to make them statistically insignificant and/or

change the estimated coefficients to make them differ

from expectations

b. the deletion of a multicollinear variable that belongs in

an equation will cause specification bias

2. Drop a redundant variable:

a. Viable strategy when two variables measure essentially

the same thing

b. Always use theory as the basis for this decision!

8-15

Remedies for

Multicollinearity (cont.)

3. Increase the sample size:

a. This is frequently impossible but a useful alternative

to be considered if feasible

b. The idea is that the larger sample normally will

reduce the variance of the estimated coefficients,

diminishing the impact of the multicollinearity

8-16

Table 8.1a

8-17

Table 8.1a

8-18

Table 8.2a

8-19

Table 8.2b

8-20

Table 8.2c

8-21

Table 8.2d

8-22

Table 8.3a

8-23

Table 8.3b

8-24

Perfect multicollinearity

Severe imperfect multicollinearity

Dominant variable

Auxiliary (or secondary) equation

Variance inflation factor

Redundant variable

8-25

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