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.

 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

2
Y  1  u
X

1
Z
X

Y  1   2 Z  u

Thus far, nothing has been said about the disturbance term in nonlinear regression models.

1
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

2
Y  1  u
X

1
Z
X

Y  1   2 Z  u

For the regression results in a linearized model to have the desired properties, the
disturbance term in the transformed model should be additive and it should satisfy the
regression model conditions.
2
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

2
Y  1  u
X

1
Z
X

Y  1   2 Z  u

To be able to perform the usual tests, it should be normally distributed in the transformed
model.

3
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

2
Y  1  u
X

1
Z
X

Y  1   2 Z  u

In the case of the first example of a nonlinear model, there was no problem. If the
disturbance term had the required properties in the original model, it would have them in
the regression model. It has not been affected by the transformation.
4
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2 e u  1 X 2 v

log Y  log  1   2 log X  u

In the discussion of the logarithmic model, the disturbance term was omitted altogether.

5
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2 e u  1 X 2 v

log Y  log  1   2 log X  u

However, implicitly it was being assumed that there was an additive disturbance term in the
transformed model.

6
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2 e u  1 X 2 v

log Y  log  1   2 log X  u

For this to be possible, the random component in the original model must be a
multiplicative term, eu.

7
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2 e u  1 X 2 v

log Y  log  1   2 log X  u

We will denote this multiplicative term v.

8
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2 e u  1 X 2 v

log Y  log  1   2 log X  u

When u is equal to 0, not modifying the value of log Y, v is equal to 1, likewise not
modifying the value of Y.

9
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2 e u  1 X 2 v

log Y  log  1   2 log X  u

Positive values of u correspond to values of v greater than 1, the random factor having a
positive effect on Y and log Y. Likewise negative values of u correspond to values of v
between 0 and 1, the random factor having a negative effect on Y and log Y.
10
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

f(v)
0.45

0.40 Y  1 X 2 e u  1 X 2 v
0.35
log Y  log  1   2 log X  u
0.30

0.25

0.20

0.15

0.10

0.05

0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 v
16

Besides satisfying the regression model conditions, we need u to be normally distributed if

we are to perform t tests and F tests.

11
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

f(v)
0.45

0.40 Y  1 X 2 e u  1 X 2 v
0.35
log Y  log  1   2 log X  u
0.30

0.25

0.20

0.15

0.10

0.05

0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 v
16

This will be the case if v has a lognormal distribution, shown above.

12
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

f(v)
0.45

0.40 Y  1 X 2 e u  1 X 2 v
0.35
log Y  log  1   2 log X  u
0.30

0.25

0.20

0.15

0.10

0.05

0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 v
16

The mode of the distribution is located at v = 1, where u = 0.

13
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

f(v)
0.45

0.40 Y   1e  2 X e u   1e  2 X v
0.35
log Y  log  1   2 X  u
0.30

0.25

0.20

0.15

0.10

0.05

0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 v
16

The same multiplicative disturbance term is needed in the semilogarithmic model.

14
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

f(v)
0.45

0.40 Y   1e  2 X e u   1e  2 X v
0.35
log Y  log  1   2 X  u
0.30

0.25

0.20

0.15

0.10

0.05

0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 v
16

Note that, with this distribution, one should expect a small proportion of observations to be
subject to large positive random effects.

15
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

120

100
Hourly earnings ($)

80

60

40

20

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years of schooling (highest grade completed)

Here is the scatter diagram for earnings and schooling using Data Set 21. You can see that
there are several outliers, with the three most extreme highlighted.

16
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

4
Logarithm of hourly earnings

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years of schooling (highest grade completed)

Here is the scatter diagram for the semilogarithmic model, with its regression line. The
same three observations remain outliers, but they do not appear to be so extreme.

17
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

160

140

120

100

80

60

40

20

0–3 –2 –1 0 1 2 3
-2.75 to -2.25 -2.25 to 1.75 -1.75 to -1.25 -1.25 to -0.75 -0.75 to -0.25 -0.25 to 0.25 0.25 to 0.75 0.75 to 1.25 1.25 to 1.75 1.75 to 2.25 2.25 to 2.75

Residuals (linear) Residuals (semilogarithmic)

The histogram above compares the distributions of the residuals from the linear and semi-
logarithmic regressions. The distributions have been standardized, that is, scaled so that
they have standard deviation equal to 1, to make them comparable.
18
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

160

140

120

100

80

60

40

20

0–3 –2 –1 0 1 2 3
-2.75 to -2.25 -2.25 to 1.75 -1.75 to -1.25 -1.25 to -0.75 -0.75 to -0.25 -0.25 to 0.25 0.25 to 0.75 0.75 to 1.25 1.25 to 1.75 1.75 to 2.25 2.25 to 2.75

Residuals (linear) Residuals (semilogarithmic)

It can be shown that if the disturbance term in a regression model has a normal
distribution, so will the residuals.

19
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

160

140

120

100

80

60

40

20

0–3 –2 –1 0 1 2 3
-2.75 to -2.25 -2.25 to 1.75 -1.75 to -1.25 -1.25 to -0.75 -0.75 to -0.25 -0.25 to 0.25 0.25 to 0.75 0.75 to 1.25 1.25 to 1.75 1.75 to 2.25 2.25 to 2.75

Residuals (linear) Residuals (semilogarithmic)

It is obvious that the residuals from the semilogarithmic regression are approximately
normal, but those from the linear regression are not. This is evidence that the semi-
logarithmic model is the better specification.
20
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2  u

What would happen if the disturbance term in the logarithmic or semilogarithmic model
were additive, rather than multiplicative?

21
 THE DISTURBANCE TERM IN LOGARITHMIC MODELS

Y  1 X 2  u

log Y  log   1 X  2  u 

If this were the case, we would not be able to linearize the model by taking logarithms.
There is no way of simplifying log   1 X 2  u  . We should have to use some nonlinear


regression technique.
22
Copyright Christopher Dougherty 2016.

These slideshows may be downloaded by anyone, anywhere for personal use.

Subject to respect for copyright and, where appropriate, attribution, they may be
used as a resource for teaching an econometrics course. There is no need to
refer to the author.

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

Introduction to Econometrics, fifth edition 2016, Oxford University Press.
Additional (free) resources for both students and instructors may be
downloaded from the OUP Online Resource Centre
www.oxfordtextbooks.co.uk/orc/dougherty5e/.

Individuals studying econometrics on their own who feel that they might benefit
from participation in a formal course should consider the London School of
Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
EC2020 Elements of Econometrics
www.londoninternational.ac.uk/lse.

2016.05.02