Type author name/s here

Dougherty

Introduction to Econometrics,
5th edition
Chapter heading
Chapter 4: Nonlinear Models and
Transformations of Variables

© Christopher Dougherty, 2016. All rights reserved.

 ELASTICITIES AND LOGARITHMIC MODELS

Definition:
The elasticity of Y with respect to
X is the proportional change in
Y per proportional change in X. A
Y

dY Y
elasticity 
dX X Y
dY dX X
 O0 X
Y X 52

This sequence defines elasticities and shows how one may fit nonlinear models with
constant elasticities. First, the general definition of an elasticity.

1
 ELASTICITIES AND LOGARITHMIC MODELS

Definition:
The elasticity of Y with respect to
X is the proportional change in
Y per proportional change in X. A
Y

dY Y
elasticity 
dX X Y
dY dX X
 O0 X
Y X 52

slope of the tangent at A


slope of OA

Re-arranging the expression for the elasticity, we can obtain a graphical interpretation.

2
 ELASTICITIES AND LOGARITHMIC MODELS

Definition:
The elasticity of Y with respect to
X is the proportional change in
Y per proportional change in X. A
Y

dY Y
elasticity 
dX X Y
dY dX X
 O0 X
Y X 52

slope of the tangent at A


slope of OA

The elasticity at any point on the curve is the ratio of the slope of the tangent at that point
to the slope of the line joining the point to the origin.

3
 ELASTICITIES AND LOGARITHMIC MODELS

Definition:
elasticity < 1
The elasticity of Y with respect to
X is the proportional change in
Y per proportional change in X. A
Y

dY Y
elasticity 
dX X Y
dY dX X
 O0 X
Y X 52

slope of the tangent at A


slope of OA

In this case it is clear that the tangent at A is flatter than the line OA and so the elasticity
must be less than 1.

4
 ELASTICITIES AND LOGARITHMIC MODELS

Definition:
elasticity > 1
The elasticity of Y with respect to
X is the proportional change in
Y per proportional change in X.
A
dY Y Y
elasticity 
dX X
dY dX
 O0 X 52
Y X
slope of the tangent at A

slope of OA

In this case the tangent at A is steeper than OA and the elasticity is greater than 1.

5
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1   2 X Y

dY dX
elasticity 
Y X A
slope of the tangent at A

slope of OA
2

 1   2 X  X
O Xx
2

 1 X    2

In general the elasticity will be different at different points on the function relating Y to X.

6
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1   2 X Y

dY dX
elasticity 
Y X A
slope of the tangent at A

slope of OA
2

 1   2 X  X
O Xx
2

 1 X    2

In the example above, Y is a linear function of X.

7
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1   2 X Y

dY dX
elasticity 
Y X A
slope of the tangent at A

slope of OA
2

 1   2 X  X
O Xx
2

 1 X    2

The tangent at any point is coincidental with the line itself, so in this case its slope is
always b2. The elasticity depends on the slope of the line joining the point to the origin.

8
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1   2 X Y

dY dX B
elasticity 
Y X A
slope of the tangent at A

slope of OA
2

 1   2 X  X
O Xx
2

 1 X    2

OB is flatter than OA, so the elasticity is greater at B than at A. (This ties in with the
mathematical expression: (b1 / X) + b2 is smaller at B than at A, assuming that b1 is
positive.)
9
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

However, a function of the type shown above has the same elasticity for all values of X.

10
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

dY
  1  2 X  2 1
dX

For the numerator of the elasticity expression, we need the derivative of Y with respect to X.

11
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

dY
  1  2 X  2 1
dX

Y 1 X 2
   1 X  2 1
X X

For the denominator, we need Y/X.

12
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

dY
  1  2 X  2 1
dX

Y 1 X 2
   1 X  2 1
X X

dY dX  1  2 X  2 1
elasticity    2 1   2
Y X 1 X

Hence we obtain the expression for the elasticity. This simplifies to b2 and is therefore
constant.

13
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  0.25

By way of illustration, the function will be plotted for a range of values of b2. We will start
with a very low value, 0.25.

14
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  0.50

We will increase b2 in steps of 0.25 and see how the shape of the function changes.

15
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  0.75

b2 = 0.75.

16
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  1.00

When b2 is equal to 1, the curve becomes a straight line through the origin.

17
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  1.25

b2 = 1.25.

18
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  1.50

b2 = 1.50.

19
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  1.75

b2 = 1.75. Note that the curvature can be quite gentle over wide ranges of X.

20
 ELASTICITIES AND LOGARITHMIC MODELS

Y
Y  1 X 2
 2  1.75

This means that even if the true model is of the constant elasticity form, a linear model may
be a good approximation over a limited range.

21
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

log Y  log  1 X  2
 log  1  log X  2
 log  1   2 log X

It is easy to fit a constant elasticity function using a sample of observations. You can
linearize the model by taking the logarithms of both sides.

22
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

log Y  log  1 X  2
 log  1  log X  2
 log  1   2 log X

Y '   1'   2 X ' where Y '  log Y ,

X '  log X
 1'  log  1

You thus obtain a linear relationship between Y' and X', as defined. All serious regression
applications allow you to generate logarithmic variables from existing ones.

23
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

log Y  log  1 X  2
 log  1  log X  2
 log  1   2 log X

Y '   1'   2 X ' where Y '  log Y ,

X '  log X
 1'  log  1

The coefficient of X' will be a direct estimate of the elasticity, b2.

24
 ELASTICITIES AND LOGARITHMIC MODELS

Y  1 X 2

log Y  log  1 X  2
 log  1  log X  2
 log  1   2 log X

Y '   1'   2 X ' where Y '  log Y ,

X '  log X
 1'  log  1

The constant term will be an estimate of log b1. To obtain an estimate of b1, you calculate
exp( ̂ 1 ), where ̂ 1 is the estimate of  1 . (This assumes that you have used natural
' ' '

logarithms, that is, logarithms to base e, to transform the model.)

25
 ELASTICITIES AND LOGARITHMIC MODELS

FDHO

7000

6000

5000

4000

3000

2000

1000

0
0 10000 20000 30000 40000 50000 EXP

Here is a scatter diagram showing annual household expenditure on FDHO, food eaten at
home, and EXP, total annual household expenditure, both measured in dollars, for 1995 for
a sample of 869 households in the United States (Consumer Expenditure Survey data).
26
 ELASTICITIES AND LOGARITHMIC MODELS

. reg FDHO EXP

----------------------------------------------------------------------------
Source | SS df MS Number of obs = 6334
-----------+------------------------------ F( 1, 6332) = 3431.01
Model | 972602566 1 972602566 Prob > F = 0.0000
Residual | 1.7950e+09 6332 283474.003 R-squared = 0.3514
-----------+------------------------------ Adj R-squared = 0.3513
Total | 2.7676e+09 6333 437006.15 Root MSE = 532.42
----------------------------------------------------------------------------
FDHO | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
EXP | .0627099 .0010706 58.57 0.000 .0606112 .0648086
_cons | 369.4418 10.65718 34.67 0.000 348.5501 390.3334
----------------------------------------------------------------------------

Here is a regression of FDHO on EXP. It is usual to relate types of consumer expenditure to

total expenditure, rather than income, when using household data. Household income data
tend to be relatively erratic.
27
 ELASTICITIES AND LOGARITHMIC MODELS

. reg FDHO EXP

----------------------------------------------------------------------------
Source | SS df MS Number of obs = 6334
-----------+------------------------------ F( 1, 6332) = 3431.01
Model | 972602566 1 972602566 Prob > F = 0.0000
Residual | 1.7950e+09 6332 283474.003 R-squared = 0.3514
-----------+------------------------------ Adj R-squared = 0.3513
Total | 2.7676e+09 6333 437006.15 Root MSE = 532.42
----------------------------------------------------------------------------
FDHO | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
EXP | .0627099 .0010706 58.57 0.000 .0606112 .0648086
_cons | 369.4418 10.65718 34.67 0.000 348.5501 390.3334
----------------------------------------------------------------------------

The regression implies that, at the margin, 6.3 cents out of each dollar of expenditure is
spent on food at home. Does this seem plausible? Probably, though possibly a little low.

28
 ELASTICITIES AND LOGARITHMIC MODELS

. reg FDHO EXP

----------------------------------------------------------------------------
Source | SS df MS Number of obs = 6334
-----------+------------------------------ F( 1, 6332) = 3431.01
Model | 972602566 1 972602566 Prob > F = 0.0000
Residual | 1.7950e+09 6332 283474.003 R-squared = 0.3514
-----------+------------------------------ Adj R-squared = 0.3513
Total | 2.7676e+09 6333 437006.15 Root MSE = 532.42
----------------------------------------------------------------------------
FDHO | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
EXP | .0627099 .0010706 58.57 0.000 .0606112 .0648086
_cons | 369.4418 10.65718 34.67 0.000 348.5501 390.3334
----------------------------------------------------------------------------

It also suggests that $369 would be spent on food at home if total expenditure were zero.
Obviously this is impossible. It might be possible to interpret it somehow as baseline
expenditure, but we would need to take into account family size and composition.
29
 ELASTICITIES AND LOGARITHMIC MODELS

FDHO

7000

6000

5000

4000

3000

2000

1000

0
0 10000 20000 30000 40000 50000 EXP

Here is the regression line plotted on the scatter diagram

30
 ELASTICITIES AND LOGARITHMIC MODELS

LGFDHO
10

1
6 7 8 9 10 11 LGEXP

We will now fit a constant elasticity function using the same data. The scatter diagram
shows the logarithm of FDHO plotted against the logarithm of EXP.

31
 ELASTICITIES AND LOGARITHMIC MODELS

. g LGFDHO = ln(FDHO)
. g LGEXP = ln(EXP)
. reg LGFDHO LGEXP
----------------------------------------------------------------------------
Source | SS df MS Number of obs = 6334
-----------+------------------------------ F( 1, 6332) = 4719.99
Model | 1642.9356 1 1642.9356 Prob > F = 0.0000
Residual | 2204.04385 6332 .348080204 R-squared = 0.4271
-----------+------------------------------ Adj R-squared = 0.4270
Total | 3846.97946 6333 .60744978 Root MSE = .58998
----------------------------------------------------------------------------
LGFDHO | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
LGEXP | .6657858 .0096909 68.70 0.000 .6467883 .6847832
_cons | .7009498 .0843607 8.31 0.000 .5355741 .8663254
----------------------------------------------------------------------------

Here is the result of regressing LGFDHO on LGEXP. The first two commands generate the
logarithmic variables.

32
 ELASTICITIES AND LOGARITHMIC MODELS

. g LGFDHO = ln(FDHO)
. g LGEXP = ln(EXP)
. reg LGFDHO LGEXP
----------------------------------------------------------------------------
Source | SS df MS Number of obs = 6334
-----------+------------------------------ F( 1, 6332) = 4719.99
Model | 1642.9356 1 1642.9356 Prob > F = 0.0000
Residual | 2204.04385 6332 .348080204 R-squared = 0.4271
-----------+------------------------------ Adj R-squared = 0.4270
Total | 3846.97946 6333 .60744978 Root MSE = .58998
----------------------------------------------------------------------------
LGFDHO | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
LGEXP | .6657858 .0096909 68.70 0.000 .6467883 .6847832
_cons | .7009498 .0843607 8.31 0.000 .5355741 .8663254
----------------------------------------------------------------------------

The estimate of the elasticity is 0.67. Does this seem plausible?

33
 ELASTICITIES AND LOGARITHMIC MODELS

. g LGFDHO = ln(FDHO)
. g LGEXP = ln(EXP)
. reg LGFDHO LGEXP
----------------------------------------------------------------------------
Source | SS df MS Number of obs = 6334
-----------+------------------------------ F( 1, 6332) = 4719.99
Model | 1642.9356 1 1642.9356 Prob > F = 0.0000
Residual | 2204.04385 6332 .348080204 R-squared = 0.4271
-----------+------------------------------ Adj R-squared = 0.4270
Total | 3846.97946 6333 .60744978 Root MSE = .58998
----------------------------------------------------------------------------
LGFDHO | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
LGEXP | .6657858 .0096909 68.70 0.000 .6467883 .6847832
_cons | .7009498 .0843607 8.31 0.000 .5355741 .8663254
----------------------------------------------------------------------------

Yes, definitely. Food is a normal good, so its elasticity should be positive, but it is a basic
necessity. Expenditure on it should grow less rapidly than expenditure generally, so its
elasticity should be less than 1.
34
 ELASTICITIES AND LOGARITHMIC MODELS

. g LGFDHO = ln(FDHO)
. g LGEXP = ln(EXP)
. reg LGFDHO LGEXP
----------------------------------------------------------------------------
Source | SS df MS Number of obs = 6334
-----------+------------------------------ F( 1, 6332) = 4719.99
Model | 1642.9356 1 1642.9356 Prob > F = 0.0000
Residual | 2204.04385 6332 .348080204 R-squared = 0.4271
-----------+------------------------------ Adj R-squared = 0.4270
Total | 3846.97946 6333 .60744978 Root MSE = .58998
----------------------------------------------------------------------------
LGFDHO | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
LGEXP | .6657858 .0096909 68.70 0.000 .6467883 .6847832
_cons | .7009498 .0843607 8.31 0.000 .5355741 .8663254
----------------------------------------------------------------------------

ˆ
LGFDHO ˆ  2.02 EXP 0.666
 0.701  0.666 LGEXP  FDHO

The intercept has no substantive meaning. To obtain an estimate of b1, we calculate e0.701,
which is 2.02.

35
 ELASTICITIES AND LOGARITHMIC MODELS

LGFDHO
10

1
6 7 8 9 10 11 LGEXP

Here is the scatter diagram with the regression line plotted.

36
 ELASTICITIES AND LOGARITHMIC MODELS

FDHO

7000

6000

5000

4000

3000

2000

1000

0
0 10000 20000 30000 40000 50000 EXP

Here is the regression line from the logarithmic regression plotted in the original scatter
diagram, together with the linear regression line for comparison.

37
 ELASTICITIES AND LOGARITHMIC MODELS

FDHO

7000

6000

5000

4000

3000

2000

1000

0
0 10000 20000 30000 40000 50000 EXP

You can see that the logarithmic regression line gives a somewhat better fit, especially at
low levels of expenditure.

38
 ELASTICITIES AND LOGARITHMIC MODELS

FDHO

7000

6000

5000

4000

3000

2000

1000

0
0 10000 20000 30000 40000 50000 EXP

However, the difference in the fit is not dramatic. The main reason for preferring the
constant elasticity model is that it makes more sense theoretically. It also has a technical
advantage that we will come to later on, when we discuss heteroskedasticity.
39
Copyright Christopher Dougherty 2016.

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The content of this slideshow comes from Section 4.2 of C. Dougherty,

Introduction to Econometrics, fifth edition 2016, Oxford University Press.
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Individuals studying econometrics on their own who feel that they might benefit
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Economics summer school course
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http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
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2016.05.01