Where can we use Dummy

Variables?
Cases where Dummy Variables are used as
proxies…
 To proxy Qualitative or Categorical Factors
– Like Rural and Urban, Young and Old.
 To proxy Numerical Factors
– Like Age Groups; Income Groups
 To proxy Shifts in Function over time –
Slope/Intercept
– Like before the introduction of derivatives
and after, boom vs recession period, normal
vs war period
 To proxy Seasonal Adjustments in a Time Series
– Like Month Effect, Festival Session Effect
 Do the
Dummy
Variables
hit us?
 Dummy Variable Trap

 When, say, two Dummy Variables relating to the same aspect are
included, such as Male and Female, it causes perfect collinearity
because Male + Female = 1.

 That’s it to say, when Di = 1, we face a problem of perfect

collinearity which does not allow us to determine the values of
coefficients. Such a case is called DUMMY VARIABLE TRAP.

 The Dummy Variable Trap can also occur when there are too many
dummy variables relative to the different number of observations.

 The solutions to avoid Dummy Variable Trap are – one, introduce

less number of dummy variables as compared to data points; and
second, define the dummy variables in such a manner that their sum
is not equal to 1.