Introduction To Econometrics, 5 Edition

Type author name/s here
Dougherty
Introduction to Econometrics,
5th edition
Chapter heading
Chapter 14: Introduction to Panel
Data Models
© Christopher Dougherty, 2016. All rights reserved.

FIXED EFFECTS OR RANDOM EFFECTS?
NLSY 1980–1996
Dependent variable LGEARN
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
When should you use fixed effects estimation rather than random effects estimation, or
vice versa?
1
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
In principle random effects is more attractive because observed characteristics that remain
constant for each individual are retained in the regression model. In fixed effects
estimation, they have to be dropped.
2
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
Also with random effects estimation we do not lose n degrees of freedom, as is the case
with fixed effects.
3
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
However if either of the preconditions for using random effects is violated, we should use
fixed effects instead.
4
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
One precondition is that the observations can be described as being drawn randomly from
a given population. This is a reasonable assumption in the case of the NLSY because it
was designed to be a random sample.
5
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
By contrast, it would not be a reasonable assumption if the units of observation in the panel
data set were countries and the sample consisted of those countries that are members of
the Organization for Economic Cooperation and Development (OECD).
6
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
These countries certainly cannot be considered to represent a random sample of the 200-
odd sovereign states in the world.
7
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
The other precondition is that the unobserved effect be distributed independently of the Xj
variables. How can we tell if this is the case?
8
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
The standard procedure is yet another implementation of the Durbin–Wu–Hausman test

used to help us choose between OLS and IV estimation in models where there is suspected
measurement error or simultaneous equations endogeneity.
9
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
The null hypothesis is that the ai are distributed independently of the Xj.
10
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
If this is correct, both random effects and fixed effects are consistent, but fixed effects will
be inefficient because, looking at it in its LSDV form, it involves estimating an unnecessary
set of dummy variable coefficients.
11
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
If the null hypothesis is false, the random effects estimates will be subject to unobserved
heterogeneity bias and will therefore differ systematically from the fixed effects estimates.
12
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
As in its other applications, the DWH test determines whether the estimates of the
coefficients, taken as a group, are significantly different in the two regressions.
13
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
If any variables are dropped in the fixed effects regression, they are excluded from the test.
Under the null hypothesis the test statistic has a chi-squared distribution.
14
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
In principle this should have degrees of freedom equal to the number of slope coefficients
being compared, but for technical reasons that require matrix algebra for an explanation,
the actual number may be lower.
15
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
A regression application that implements the test, such as Stata, should determine the
actual number of degrees of freedom.
16
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
We will perform the test for the marriage-effect-on-earnings example. The fixed effects
estimates, using the within-groups approach, of the coefficients of married men and soon-
to-be married men are 0.106 and 0.045, respectively.
17
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
The corresponding random effects estimates are considerably higher, 0.134 and 0.060,
inviting the suspicion that they may be inflated by unobserved heterogeneity.
18
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
The DWH test involves the comparison of 13 coefficients (those of MARRIED, SOONMARR,
and 11 controls). The test statistic is 306.2.
19
NLSY 1980–1996
OLS Fixed Random

effects effects
MARRIED 0.184 0.106 0.134

(0.007) (0.012) (0.010)
SOONMARR 0.096 0.045 0.060
(0.009) (0.010) (0.009)
  13 crit, 0.1%  34.5
2
SINGLE — — —
R2 0.358 0.268 0.346
DWH test — — 306.2
n 20,343 20.343 20.343
With 13 degrees of freedom the critical value of chi-squared at the 0.1 percent level is 34.5,
so we definitely conclude that we should be using fixed effects estimation.
20
Random effects estimation

k s
Yit   1    j X jit    p Z pi   t   it
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
  1    j X jit   t  uit uit   i   it
j2
Suppose that the DWH test indicates that we can use random effects rather than fixed
effects.
21

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
We should then consider whether there are any unobserved effects at all. It is just possible
that the model has been so well specified that the disturbance term u consists of only the
purely random component eit and there is no individual-specific ai term.
22

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS
k
Yit   1    j X jit   t   it if  i  0
j2
In this situation we should use pooled OLS, with two advantages. There is a gain in
efficiency because we are not attempting to allow for non-existent within-groups
autocorrelation.
23

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS
k
Yit   1    j X jit   t   it if  i  0
j2
In addition we will be able to take advantage of the finite-sample properties of OLS, instead
of having to rely on the asymptotic properties of random effects.
24

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS
k
Yit   1    j X jit   t   it if  i  0
j2
Various tests have been developed to detect the presence of random effects.
25

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS
k
Yit   1    j X jit   t   it if  i  0
j2
The most common, implemented in some regression applications, is the Breusch–Pagan

lagrange multiplier test, the test statistic having a chi-squared distribution with one degree
of freedom under the null hypothesis of no random effects.
26

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS Breusch–Pagan statistic (c2(1) under H0) = 20,007

k
Yit   1    j X jit   t   it if  i  0
j2
In the case of the marriage effect example the statistic is very high indeed, 20,007, but in
this case it is meaningless because are not able to use random effects estimation.
27

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS
k
Yit   1    j X jit   t   it if  i  0
j2
A note on the random effects and fixed effects terminology. It is generally agreed that
random effects/fixed effects terminology can be misleading, but that it is too late to change
it now.
28

k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS
k
Yit   1    j X jit   t   it if  i  0
j2
It is natural to think that random effects estimation should be used when the unobserved
effect can be characterized as being drawn randomly from a given population and that fixed
effects should be used when the unobserved effect is non-random.
29
k s
j2 p 1
k
Yit   1    j X jit   i   t   it
j2
k
j2
OLS
k
Yit   1    j X jit   t   it if  i  0
j2
The second part of that statement is correct. However the first part is correct only if the
unobserved effect is distributed independently of the Xj variables. If it is not, fixed effects
should be used instead to avoid the problem of unobserved heterogeneity bias.
30
Can the observations be described as being a

random sample from a given population?
Yes No
Perform both fixed Use fixed effects

effects and random
effects regressions.
Does a DWH test indicate No Provisionally choose random

significant differences in effects. Does a test indicate the
the coefficients? presence of random effects?
Yes Yes No
Use fixed effects Use random Use pooled
effects OLS
The diagram summarizes the decision-making procedure. Make sure that you understand
the reasons for making the choices.
31
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 14.3 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
http://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
20 Elements of Econometrics
www.londoninternational.ac.uk/lse.
2016.05.28

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OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

The standard procedure is yet another implementation of the Durbin–Wu–Hausman test

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

OLS Fixed Random

MARRIED 0.184 0.106 0.134

Random effects estimation

Random effects estimation

Random effects estimation

Random effects estimation

Random effects estimation

Random effects estimation

The most common, implemented in some regression applications, is the Breusch–Pagan

Random effects estimation

OLS Breusch–Pagan statistic (c2(1) under H0) = 20,007

Random effects estimation

Random effects estimation

Can the observations be described as being a

Perform both fixed Use fixed effects

Does a DWH test indicate No Provisionally choose random

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

The content of this slideshow comes from Section 14.3 of C. Dougherty,

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