FUNDAMENTALS OF

ECONOMETRICS
DR ABDUL WAHEED
PhD Econometrics
FUNDAMENTALS OF
ECONOMETRICS
Week 4
Lecture 7
 Functional Forms of
Regression Models
OLS method assume that regression models are linear in
parameters.
Regression models may or may not be linear in
variables.
There are several models that are linear in parameters
but are not necessarily so in the variables.
 Functional Forms of
Regression Models
Consider the following models, which are frequently used in empirical analysis.
1. Log-linear or double-log models (where the regressand as well as the
regressors are all in logarithmic form).
2. Log-lin models (where the regressand is logarithmic but the regressors can
be in log or linear form).
3. Lin-log models (where the regressand is in linear form, but one or more
regressors are in log form).
4. Reciprocal models (where the regressors are in inverse form).
5. Standardized variable regression models
 Production Function
A production function gives the technological relation between
the quantities of physical inputs and quantities of outputs of
goods.
The production function is one of the key concepts of
mainstream neoclassical theories and used to define marginal
product and to distinguish allocative efficiency, a key focus of
economics.
One of the popular production function used by neoclassical
theories such as Robert Solow is Cobb-Douglas production
function…..that assume constant returns to scale.
 Returns to scale
It explains the behavior of the rate of increasing in output
(production) relative to the associated increase in the inputs (the
factors of production).
There are three possible types of returns to scale:
1. Increasing returns to scale: refers to a case of production in
which increase in inputs increase output by higher proportion.
2. Constant returns to scale: refers to a case of production in
which increase in inputs increase output by same proportion.
3. Diminishing (decreasing) returns to scale: refers to a case of
production in which increase in inputs increase in output by
less proportion.
 double log or
constant elasticity
models
Consider the Cobb–Douglas production function, which may be
expressed as

where
Q = output, L = labor input, K = capital input, and is a constant.
 Log-linear, double log or constant elasticity
models
The Cobb–Douglas production function,

It is non-linear in parameters. So we can not use OLS.

But it can be transformed into linear model by taking the natural
logarithm of this function, we obtain

By writing we obtain

Adding the error term, we obtain the following LRM

 Log-linear, double log or constant elasticity
models

It is known as a log-log, double-log, log-linear, or constant elasticity

model, because both the regressand and regressors are in the log
form.
An interesting property of the Cobb–Douglas function is that the
sum of the partial slope coefficients, , gives information about
returns to scale, that is, the response of output to a proportional
change in the inputs.
If, we have increasing returns to scale.
If, we have constant returns to scale.
If, we have decreasing returns to scale.
 Log-linear, double log or constant elasticity
models
Another interesting feature of the log-linear model is that the slope
coefficients can be interpreted as elasticities.
Elasticity:
Elasticity measures how much one variable responds to changes in another
variable.
 Coefficients are pure numbers not units.
Specifically, is the (partial) elasticity of output with respect to the labor input,
holding all other variables constant (here capital, or K). That is, it gives the
percentage change in output for a percentage change in the labor input,
ceteris paribus. Similarly, gives the (partial) elasticity of output with respect to
the capital input, holding all other inputs constant.
Since these elasticities are constant over the range of observations, the
double-log model is also known as constant elasticity model.
 Log-linear, double log or constant elasticity
models
Example:
The Cobb–Douglas production function for the USA
Data: US manufacturing sector
Year: 2005
Variables:
Output: (value added, 000 US$)
Labour input: (worker hours in 000)
Capital input: (capital expenditure in 000 US$)
Coverage: 50 states + Washington DC = 51
 Log-linear, double log or constant elasticity
models
Class activity-4.1
 Download data from file Table 2.1 from LMS
 Import data to EViews
 Estimate the following regression model (constant elasticity
model)

 Save the results for discussion

 Interpret the results of constant elasticity model
 Log-linear, double log or constant elasticity
models
Results: Dependent Variable: LNOUTPUT
Method: Least Squares
Date: 02/22/23 Time: 14:25
 
 
 
 
 
 
Sample: 1 51      
Included observations: 51    
         
         
Variable Coefficient Std. Error t-Statistic Prob.  
         
         
C 3.887600 0.396228 9.811514 0.0000
LNLABOR 0.468332 0.098926 4.734170 0.0000
LNCAPITAL 0.521279 0.096887 5.380274 0.0000
         
         
R-squared 0.964175    Mean dependent var 16.94139
Adjusted R-squared 0.962683    S.D. dependent var 1.380870
S.E. of regression 0.266752    Akaike info criterion 0.252028
Sum squared resid 3.415520    Schwarz criterion 0.365665
Log likelihood -3.426721    Hannan-Quinn criter. 0.295452
F-statistic 645.9311    Durbin-Watson stat 1.946387
Prob(F-statistic) 0.000000      
         
         
 Log-linear, double log or constant elasticity
models
Interpretation:
1. Statistical significance?
2. Overall significance?
3. value?
4. Interpretation of LNLABOR?
5. Interpretation of LNCAPITAL?
6. The sum of the two slopes?
The sum of the two slopes:

(constant returns to scale)

 Log-linear, double log or constant elasticity
models
Original model: The Cobb–Douglas production function,

Double-log form model: LRM

Since and
So, taking antilog
So the estimated original model
 Log-linear, double log or constant elasticity
models
Evaluation of the results
Possibility of Heteroscedasticity: This is because our “sample”
consists of very diverse states, with diverse manufacturing
sectors. Also, the physical size and population density varies
from state to state.
Specification Errors: we will also find out if the error term is
normally distributed, for the t and F tests dependent critically on
the normality assumption, especially if the sample size is small.
We will discuss these later!
 Log-linear, double log or constant elasticity
models
Class activity-4.2
 Download data from file Table 2.1 from LMS
 Import data to EViews
 Estimate the following regression model (linear
regression model)

 Save the results for discussion

 Interpret the results
 Log-linear, double log or constant elasticity
models
Results: Dependent Variable: OUTPUT
Method: Least Squares
 
 
 
 
Date: 02/22/23 Time: 14:44    
Sample: 1 51      
Included observations: 51    
         
         
Variable Coefficient Std. Error t-Statistic Prob.  
         
         
C 233621.6 1250364. 0.186843 0.8526
LABOR 47.98736 7.058245 6.798766 0.0000
CAPITAL 9.951891 0.978116 10.17455 0.0000
         
         
R-squared 0.981065    Mean dependent var 43217548
Adjusted R-squared 0.980276    S.D. dependent var 44863661
S.E. of regression 6300694.    Akaike info criterion 34.20724
Sum squared resid 1.91E+15    Schwarz criterion 34.32088
Log likelihood -869.2846    Hannan-Quinn criter. 34.25066
F-statistic 1243.514    Durbin-Watson stat 1.684519
Prob(F-statistic) 0.000000      
         
         
 Log-linear, double log or constant elasticity
models
Comparison
Double log regression model Linear regression model
Dependent Variable: LNOUTPUT     Dependent Variable: OUTPUT    
Method: Least Squares     Method: Least Squares    
Date: 02/22/23 Time: 14:25     Date: 02/22/23 Time: 14:44    
Sample: 1 51       Sample: 1 51      
Included observations: 51     Included observations: 51    
                   
                   
Variable Coefficient Std. Error t-Statistic Prob.   Variable Coefficient Std. Error t-Statistic Prob.  
                   
                   
C 3.887600 0.396228 9.811514 0.0000 C 233621.6 1250364. 0.186843 0.8526
LNLABOR 0.468332 0.098926 4.734170 0.0000 LABOR 47.98736 7.058245 6.798766 0.0000
LNCAPITAL 0.521279 0.096887 5.380274 0.0000 CAPITAL 9.951891 0.978116 10.17455 0.0000
                   
                   
R-squared 0.964175    Mean dependent var 16.94139 R-squared 0.981065    Mean dependent var 43217548
Adjusted R-squared 0.962683    S.D. dependent var 1.380870 Adjusted R-squared 0.980276    S.D. dependent var 44863661
S.E. of regression 0.266752    Akaike info criterion 0.252028 S.E. of regression 6300694.    Akaike info criterion 34.20724
Sum squared resid 3.415520    Schwarz criterion 0.365665 Sum squared resid 1.91E+15    Schwarz criterion 34.32088
Log likelihood -3.426721    Hannan-Quinn criter. 0.295452 Log likelihood -869.2846    Hannan-Quinn criter. 34.25066
F-statistic 645.9311    Durbin-Watson stat 1.946387 F-statistic 1243.514    Durbin-Watson stat 1.684519
Prob(F-statistic) 0.000000       Prob(F-statistic) 0.000000      
                   
 Log-linear, double log or constant elasticity
models
Comparison
Which is a better model, the linear model or the double log
one? Unfortunately, we cannot compare the two models
directly, the dependent variables in the two models are
different.
Also, we cannot compare the values of the two models,
because to compare the s of any two models the dependent
variable must be the same in the two models.