Economics 141: Problem Set 2

Solutions
University of California, Berkeley
Due date: Monday, March 8, 2010
Note: Problem numbers refer to those found in Wooldridges Introductory Econometrics, fourth
edition.
Problem 4.1
Issue (i) results in inconsistent standard errors and issue (iii) yields biased parameter estimates.
Subsequently, the resulting t-statistics are inaccurate. Issue (ii) may produce wide standard errors,
but they are consistent.
Problem 4.5
i. The 95% condence interval using the normal approximation is

z
c
0.025
_

Var
_

_
= 0.412 1.96 0.094 or

[0.23, 0.60],
where z
c
0.025
is the 0.025 critical value for the upper tail of a normal distribution and is equal
to 1.96.
ii. Since 0.4 is included in the 95% condence interval, we cannot reject this value as a null
hypothesis at the 5% level.
iii. Since 1 is outside the 95% condence interval, we can reject this null hypothesis at the 5%
level.
Problem 4.7
i. The coecients in the two models are similar. Note that the standard errors all decreased
with the addition of the new data points. This is not guaranteed and only occurs if the non-
unionized rms in the original equation are suciently similar to the unionized rms that
were added.
1
1
Suciently similar really means that both groups follow the same linear model with the same parameters and
have the same variance
2
.
1
ii. Let r denote the amount of scrap, h the hours of training, y the sales of the rm, and l the
level of employment. We see that
log(r) =
0
+
1
log(h) +
2
log(y) +
3
log(l) +
=
0
+
1
log(h) +
2
log(y)
2
log(l) +
2
log(l) +
3
log(l) +
=
0
+
1
log(h) +
2
(log(y) log(l)) + (
2
+
3
) log(l) +
=
0
+
1
log(h) +
2
log
_
y
l
_
+
3
log(l) +
as required. If
3
= 0, this implies that
2
=
3
; that is, if the amount of labor and sales
each increase by 1%, then there is no increase in scrap.
iii. The t-statistic for the null hypothesis that
3
= 0 is 0.2, which implies that we cannot
reject the null hypothesis that, controlling for the sales-to-employee ratio, larger rms have
dierential scrap rates.
iv. The t-statistic for the null hypothesis that
2
= 1 is 0.13 and thus we cannot reject the
null.
Problem 4.10
i. We can do an F test using the given statistics for the joint test that all coecients (excluding
the intercept) are 0. Let N be the number of observations and K be the number of predictors
(i.e., coecients not including the intercept). Then the F statistic is
F =
N (K + 1)
K
R
2
1 R
2
=
142 5
4
0.0395
1 0.0395
=
137
4
0.0395
0.9605
= 1.41.
The critical value for an F
(4,137)
distribution is above 2.37 and thus we cannot reject the null
hypothesis.
ii. The R
2
is essentially unchanged and thus our inference from part (i) is the same; calculation
of the F statistic conrms this.
iii. You should not, as the value of log(x) is undened for x 0.
iv. This model oers little ability to predict stock returns; less than 4% of the variance in returns
can be predicted using the included covariates.
Problem C4.5
i. In equation 4.31, the coecient on home runs was insignicant. Removing RBIs and running
a regression yields a highly signicant coecient on home runs. We see that the coecient
on home runs more than doubles and the standard error decreases. The dramatic change in
signicance is likely due in part to the fact that the correlation between home runs and RBIs
is 0.89.
ii. Of these covariates, only runs per year is individually signicant at the 5% level.
iii. The F statistic for this joint test is 0.69, with a corresponding p-value 0.56. We cannot reject
the null hypothesis that all three coecients are 0.
2
Problem C4.9
i. See Table 1. We see that the coecient on proportion black is signicant at the 5% level, but
not at the 1% level.
Table 1: Regression results for C4.9(i)
Covariate Coecient Std. Error
Proportion black 0.073 0.031
Log income 0.137 0.027
Proportion poverty 0.380 0.133
Intercept -1.463 0.294
ii. The correlation between the proportion in poverty and log income is -0.839. Despite this
high degree of correlation, the standard errors are suciently precise that both covariates are
signicant at the 1% level.
iii. The coecient on log median housing value is 0.12. This implies that, for every 1% increase
in median housing value, the price of soda increases by 0.12%. The p-value for its coecient
is 0.
iv. With the addition of log median housing values, log income and proportion in poverty are
no longer individually signicant. Nonetheless, the two are jointly signicant with a p-value
of 0.030. Since housing values better reect wealth relative to current income levels, this
variable may be a better predictor of local demand conditions.
v. If we are most concerned with racial discrimination, we should rst note that the coecient
on proportion black changes little between the two regressions, which is reassuring. For the
reasons mentioned in part (iv), housing prices ought to be included and thus we should report
the regression from part (iii). Additionally, the coecient on housing values is individually
signicant, suggesting that this covariate ought to be included, and its exclusion from the
model can yield biased results
Problem E.1
Let X = [x
1
. . . x
N
]

be an N (K + 1) matrix, where x
t
is a row vector of covariates (including
a constant) for observation t. We know that the OLS estimator

= (X

X)
1
X

Y . We see that
X

X = [x

1
. . . x

N
] [x
1
. . . x
N
]

=
N

i=1
x

i
x
i
,
which is a (K + 1) (K + 1) matrix.
2
Similarly, we see that
X

Y =
N

i=1
x

i
Y
i
,
2
Think of [x

1
. . . x

N
] as a 1 N vector and [x1 . . . xN]

as a N 1 vector.
3
a (K + 1) 1 vector. We now arrive at our result that

=
_
X

X
_
1
X

Y =
_
N

i=1
x

i
x
i
_
1
N

i=1
x

i
Y
i
,
which is a function of sample averages if we multiply by
1
N
1
N
.
Problem E.3
i. By OLS, we know that

= (Z

Z)
1
Z

Y . Plugging in Z = XA and recalling that (AB)

=
B

, we get

=
_
(XA)

XA
_
1
(XA)

Y
=
_
A

XA
_
1
A

Y.
Since A is non-singular, both it and its transpose are invertible. Also, note the rule that
(ABC)
1
= C
1
B
1
A
1
. Now,

= A
1
_
X

X
_
1
_
A

_
1
A

Y
= A
1
_
X

X
_
1
X

Y
= A
1

as desired.
ii. We see that

Y = Z

= XAA
1

= X

=

Y .
iii. To calculate the variance, we rst recall the result that OLS estimators are unbiased when
they include an intercept.
3
. Dene

to be an unbiased estimator of b. Hence,
4
Var
_

X
_
= E
_
_

b
__

b
_

X
_
.
See that

b =
_
Z

Z
_
1
Z

Y b
=
_
Z

Z
_
1
Z

(Zb +) b
= b +
_
Z

Z
_
1
Z

b
=
_
Z

Z
_
1
Z

= A
1
_
X

X
_
1
X

.
Then,
E
_
_

b
__

b
_

X
_
= E
_
_
A
1
_
X

X
_
1
X

__
A
1
_
X

X
_
1
X

X
_
= E
__
A
1
_
X

X
_
1
X

__

X
_
X

X
_
1
_
A
1
_

X
_
.
3
We assume that X includes an intercept and we know that an intercept term is inherited by XA because A is
non-singular.
4
Note the vector form of squaring; this gives a (K + 1) (K + 1) matrix as required.
4
We assume that E[

|X] =
2
I and note that A is just a matrix of constants. Now,
E
__
A
1
_
X

X
_
1
X

__

X
_
X

X
_
1
_
A
1
_

X
_
= A
1
_
X

X
_
1
X

E
_

X
_
X

X
_
1
_
A
1
_

= A
1
_
X

X
_
1
X

2
IX
_
X

X
_
1
_
A
1
_

=
2
A
1
_
X

X
_
1
X

X
_
X

X
_
1
_
A
1
_

=
2
A
1
_
X

X
_
1
_
A
1
_

.
To get an estimate, we replace
2
with
2
and we reach the desired result.
iv. From (i),

= A
1

. So, for j {1, . . . , K + 1},

j
= A
1
j

. This question implies that A is

a diagonal matrix with elements a
j
. We see that

j
=

a
j
in this case.
v. An application of the variance formula yields
Var
_

_
= Var
_

a
j
_
=
1
a
2
j
Var
_

_
.
Taking the square root of the variance gives the standard error:
_
Var
_

_
=

1
a
2
j
Var
_

_
=
1
a
j
_
Var
_

_
.
vi. Calculating the t statistic:
t

=

b
_
Var
_

_
=

a
j
b
1
a
j
_
Var
_

_
=
1
a
j
1
a
j

b
a
j
_
Var
_

_
=

b
a
j
_
Var
_

_
.
We see that, if our hypothesis is b for

, the corresponding null for

is
b
a
j
, which is sensible.
5
Problem E.5
i. Note that Z = G(X) is only a function of X and thus is non-random when X is conditioned
upon. We have
E
_

X
_
= E
_
_
Z

X
_
1
Z

X
_
= E
_
_
Z

X
_
1
Z

(X +)

X
_
= E
_
_
Z

X
_
1
Z

X +
_
Z

X
_
1
Z

X
_
= +
_
Z

X
_
1
Z

E[ | X]
= .
ii. Using the unbiasedness result of part (i), we have
Var
_

X
_
= E
_
_

__

X
_
= E
_
_
_
Z

X
_
1
Z

__
_
Z

X
_
1
Z

X
_
=
_
Z

X
_
1
Z

E
_

Z
_
Z

X
_
1
=
2
_
Z

X
_
1
Z

Z
_
Z

X
_
1
.
A symmetric matrix M can be written as AA

. Letting A = (Z

X)
1
Z

, we see that this

variance matrix is indeed symmetric.
iii. The Gauss-Markov assumptions apply here, making

BLUE. Though

is unbiased, it is not
best and thus we choose the standard OLS estimate.
6
Stata code for C4.5
** Load the data
cd "./Documents/Grad School/Fourth year/Econ 141/Wooldridge/"
use MLB1.DTA
** Run the baseline regression (equation 4.31 in Wooldridge)
reg lsalary years gamesyr bavg hrunsyr rbisyr
** Rerun the baseline regression dropping rbisyr
reg lsalary years gamesyr bavg hrunsyr
** Check the correlation between rbisyr and hrunsyr
cor hrunsyr rbisyr
** Add additional covariates
reg lsalary years gamesyr bavg hrunsyr runsyr fldperc sbasesyr
** Test joint significance
test bavg fldperc sbasesyr
Stata code for C4.9
** Load the data
use discrim.dta, clear
** Baseline regression
reg lpsoda prpblck lincome prppov
** Check correlation
cor lincome prppov
** Add housing values
codebook hseval
reg lpsoda prpblck lincome prppov lhseval
** Joint test
test lincome prppov
7