Units of Measurement and Functional Form

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-Two important econometric issues are:
1) Changing measurement
-When does scaling variables have an effect on
OLS estimates?
-When does scaling variables have no effect on
OLS estimates?
2) Functional Forms
-How do natural logs affect linear regressions?
-How do functional forms impact elasticity?
• When the dependent variable is
multiplied (divided) by a constant:-
 Multiply (divide) the OLS intercept
and slope by the same constant.
 That is, if you change the y,
change OLS intercept and slope the
same way.
When the independent variable is
multiplied (divided) by a constant:-
Divide (multiply) the OLS slope
(not intercept) by the same
constant.
That is if you change the x,
change OLS slope the opposite
way.
• How does r2 (goodness of fit) change when a
variable is scaled?
 It doesn’t
 r2 calculates how much of the
variation in y is explained by x
 this doesn’t depend on scaling
 a similar “best fit line” is drawn
through data points, regardless of
scaling
 Functional Form
• Lin-Lin Model
y  1   2 x  u

Linear relationships assume that the first x

has the same impact on y as the last x
 Linear relationships don’t capture all of the
possible interaction between variables
 changing impacts can be captured through
the use of NATURAL LOGARITHMS

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• Log-Lin Model
log( y )  1   2 x  u

• Lin-Log Model
y  1   2 log( x)  u

• Log-Log Model
log( y )  1   2 log(x)  u

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Functional Forms are Summarized as Follows:
Model Function Interpretation of B2
Lin-Lin y=f(x) ∆y= B2∆x
Lin-Log y=f(log(x)) ∆y= (B2/100)%∆x

Log-Lin Log(y)=f(x) %∆y= 100B2∆x

also call semi-elasticity
Log-Log Log(y)=f(log(x)) %∆y= B2%∆x
also call elasticity
 Other functional forms
• Quadratic: Y= 1+2x +3x2 + u ( +2 x)
2 3

• Cubic: Y=1+2x+3x2 + 4x3+u

• Kth degree polynomial: Y=1+2x+3x2+4x3+…+ 4xk+u
• Inverse: Y= 1+21/x etc
• Interactions: Y=1+2x1+3x2+ 3(x1*x2)+ u

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