Properties of best estimates: BLUE (Best, Linear, Unbiased, Estimate)

How do we ensure the best estimate?

Capital E is expected

Sample has to be a random one

How much linearity to be avoided between Xs on the RHS

For all Uis, Variances should be same

Normality of error terms: Residuals

How do we decide the functional form? – Linear or non-linear

- First decide from your knowledge and intuition, talk to domain experts, literature review
- Non-linear converted to linear using natural log

Cross-section data

3 returns to scale

- Increasing
- Constant
- Decreasing

Marginal productivity of labor

Ln brings the relative change and not the normal absolute change

Absolute change in Y due to relative change in X

Log of a variable becomes a % or relative change; otherwise absolute or unit change

Demo 5: Income change should be a % change and not absolute

Proposing a lin-lin model

Sequence to interpret the output

1) R2
2) Coefficients and their signs
- Wealth is counter-intuitive
3) P-value (throw the model)
4) F-value (keep the model) Why is this case?

Where did we go wrong? – Multicollinearity

How is t-statistic different from F?

- t checks for individual variables (keeping other variables constant)

- F allows changing of all the variables together

Regress wealth on income

How is correlation and linearity related?

- Correlation coeff goes to make the linearity coeff

Multicollinearity id

Best property is affected by MC, variance will be inflated sue to MC

Look at centered VIF (482)

Drop the variable with higher p-value (we drop wealth)

This was about the hands on Multicollinearity!

1- No MC
3-Moderate
3-10: Moderate to Severe
>10- Severe

Soln: 1) drop a variable

2) Create a new variable combining the existing two

How to improve R- more variables, but then again MC