HETEROSCEDASTICITY: WHAT HAPPENS IF THE ERROR

VARIANCE IS NONCONSTANT?
Domodar N. Gujarati

Textbook:
(GP) Damodar N. Gujarati and Dawn C Porter (2004) Basic
Econometrics, 5th edition, The McGraw-Hill Companies Chapter 11

(DG) Damodar Gujarati, (2015) “Econometrics by Example” Second

Edition, McMillan Education Chapter 5
Learning Objectives
We seek answers to the following
questions:
1. What is the nature of
heteroscedasticity? 2. What are its
consequences?
3. How does one detect it?
4. What are the remedial measures?
THE NATURE OF HETEROSCEDASTICITY

• One of the important assumptions of the classical linear

regression model is that the variance of each disturbance
term ui, conditional on the chosen values of the
explanatory variables, is some constant number equal to
σ2.
• This is the assumption of homoscedasticity, or equal
(homo) spread (scedasticity), that is, equal variance.
Symbolically,
E(u2i) = σ2i = 1, 2, . . . , n (1) Basic Econometrics Haleema Sadia

The nature of heteroscedasticity Continued…

 Figure 1: Homoscedastic (Equal Spread)
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The nature of heteroscedasticity Continued…

• In contrast to Figure 1, consider Figure 2, the variances

 of Yiare not the same. Hence, there is
heteroscedasticity. Symbolically,
E(u2i) = σ2i(2)
• Notice the subscript of σ2, which reminds us that the
conditional variances of ui(= conditional variances of
Yi) are no longer constant.

Basic Econometrics Haleema Sadia

The nature of heteroscedasticity Continued…
 Figure 2:
Heteroscedasticity (non-equal spread)
Basic Econometrics Haleema Sadia
• Note that the problem of heteroscedasticity is likely
to be more common in cross-sectional data than in
 time series.
• In cross-sectional data, members may be of different
sizes, such as small, medium, or large firms or low,
medium, or high income.
• In time series data, on the other hand, the variables
tend to be of similar orders of magnitude. Examples
are GNP, consumption expenditure, savings.

Basic Econometrics Haleema Sadia

Difference between homoscedasticity and heteroscedasticity

Assume that in the two-variable model Yi = β1 + β2Xi + ui,

 Y represents savings and X represents income. Figures 1
and 2 show that as income increases, savings on the
average also increase. But in Figure 1 the variance of
savings remains the same at all levels of income, whereas
in Figure 2 it increases with income. It seems that in
Figure 2 the higher income families on the average save
more than the lower-income families, but there is also
more variability in their savings.

Basic Econometrics Haleema Sadia

Reasons for heteroscedasticity

There are several reasons why the variances of ui may be

 variable, some of which are as follows.
1. Following the error-learning models, as people learn,
their errors of behavior become smaller over time. In this
case, σ2iis expected to decrease. As an example, consider
Figure 3, which relates the number of typing errors made
in a given time period on a test to the hours put in typing
practice.

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Reasons for heteroscedasticity Continued…
 Figure 3:
Illustration of heteroscedasticity

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Reasons for heteroscedasticity Continued…
 2. As incomes grow, people have more discretionary income
and hence more scope for choice about the disposition of their
income. Hence, σ2iis likely to increase with income. Similarly,
companies with larger profits are generally expected to show
greater variability in their dividend policies than companies
with lower profits.
3. As data collecting techniques improve, σ2iis likely to
decrease. Thus, banks that have sophisticated data processing
equipment are likely to commit fewer errors in the monthly or
quarterly statements of their customers than banks without such
facilities.

Basic Econometrics Haleema Sadia

Reasons for heteroscedasticity Continued…
4. Heteroscedasticity can also arise as a result of the presence
of outliers, (either very small or very large) in relation to the
observations in the sample Figure 4. The inclusion or exclusion
of such an observation, especially if the sample size is small,
can substantially alter the results of regression analysis. Chile
can be regarded as an outlier because the given Y and X values
are much larger than for the rest of the countries. In situations
such as this, it would be hard to maintain the assumption of
homoscedasticity.

Basic Econometrics Haleema Sadia

Reasons for heteroscedasticity Continued…
 Figure 4: The
relationship between stock prices and consumer prices

Basic Econometrics Haleema Sadia

Reasons for heteroscedasticity Continued…
5. Another source of heteroscedasticity arises from violating
Assumption 9 of CLRM, namely, that the regression model is
correctly specified, very often what looks like heteroscedasticity
may be due to the fact that some important variables are omitted
from the model. But if the omitted variables are included in the
model, that impression may disappear.
6. Another source of heteroscedasticity is Skewness in the
distribution of one or more regressors included in the model.
Examples are economic variables such as income, wealth, and
education. It is well known that the distribution of income and
wealth in most societies is uneven, with the bulk of the income
and wealth being owned by a few at the top.

Basic Econometrics Haleema Sadia

Reasons for heteroscedasticity Continued…
7. Other sources of heteroscedasticity: As David Hendry notes,
heteroscedasticity can also arise because of
(1) incorrect data transformation (e.g., ratio or first
difference transformations)
(2) incorrect functional form (e.g., linear versus log–linear
models).

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OLS Estimation in the Presence of Heteroscedasticity

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11.3 THE METHOD OF GENERALIZED LEAST SQUARES (GLS)
 Basic Econometrics Haleema Sadia
The method of Generalized Least Squares (GLS) Continued…

• Examining Table on slide 19, we would like to weight

 observations coming from employment classes 10–19
and 20–49 more heavily than those coming from
employment classes like 5–9 and 250–499, for the
former are more closely clustered around their mean
values than the latter, thereby enabling us to estimate
the PRF more accurately.

Basic Econometrics Haleema Sadia

The method of Generalized Least Squares (GLS) Continued…
The method of Generalized Least Squares (GLS) Continued…
 Unfortunately, the usual OLS method does not follow this
strategy, but a method of estimation, known as generalized
least squares (GLS), takes such information into account
explicitly and is therefore capable of producing estimators
that are BLUE. To see how this is accomplished, let us
continue with the now-familiar two-variable model:
Yi = β1 + β2Xi + ui(3) which for ease of algebraic manipulation
we write as Y i = β1X0i + β2Xi + ui(4) where X0i = 1 for each i.
Now assume that the heteroscedastic variances σ2iare known.
Divide through by σito obtain:

Basic Econometrics Haleema Sadia

The method of Generalized Least Squares (GLS) Continued…
 Basic Econometrics Haleema Sadia
The method of Generalized Least Squares (GLS) Continued…
 Basic Econometrics Haleema Sadia

Difference between GLS and OLS

• Recall from Chapter 3 that in OLS we minimize:
Σuˆ2i =Σ(Yi − βˆ1 − βˆ2Xi)2(8)
but in GLS we minimize the expression
Σwiuˆ2i = Σwi(Yi − βˆ*1X0i − βˆ*2Xi)2(9)
where wi = 1/σ2i
• Thus, in GLS we minimize a weighted sum of residual squares with
wi = 1/σ2iacting as the weights, but in OLS we minimize an
unweighted or (what amounts to the same thing) equally weighted
RSS.
In GLS the weight assigned to each observation is inversely
proportional to its σi, that is, observations coming from a population
with larger σi will get relatively smaller weight and those from a
population with smaller σi will get proportionately larger weight in
minimizing the RSS (9).
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Difference between GLS and OLS Continued…

• To see the difference between OLS and GLS clearly, consider the
hypothetical scattergram given in Figure 5.

Figure 5: Hypothetical Scattergram

Basic Econometrics Haleema Sadia
• In the (unweighted) OLS, each uˆ2iassociated with points
A, B, and C will receive the same weight in minimizing
the RSS. Obviously, in this case the uˆ2iassociated with
point C will dominate the RSS. But in GLS the extreme
observation C will get relatively smaller weight than the
other two observations.
• Since (9) minimizes a weighted RSS, it is appropriately
known as weighted least squares (WLS), and the
estimators thus obtained are known as WLS estimators.
• But WLS is just a special case of the more general
estimating technique, GLS. In the context of
heteroscedasticity, one can treat the two terms WLS and
GLS interchangeably.
Basic Econometrics Haleema Sadia
Consequences of Using OLS in the Presence of Heteroscedasticity

• Both βˆ*2and βˆ2are (linear) unbiased estimators but we

know that it is βˆ*2that is efficient, that is, has the smallest
variance.
• What happens to our confidence interval, hypotheses
testing, and other procedures if we continue to use the
OLS estimator βˆ2? We distinguish two cases.

OLS Estimation Allowing for Heteroscedasticity • Using

OLS variance, and assuming σ2iare known, can we establish
confidence intervals and test hypotheses with the usual t and
F tests?
Basic Econometrics Haleema Sadia
• The answer generally is no because it can be shown that var
(βˆ*2) ≤ var (βˆ2), which means that confidence intervals
based on the latter will be unnecessarily larger.
• As a result, the t and F tests are likely to give us inaccurate
results.

OLS Estimation Disregarding Heteroscedasticity

• The situation can become serious if we not only use OLS

estimates but also continue to use the usual
(homoscedastic) variance formula given even if
heteroscedasticity is present or suspected, whatever
conclusions we draw or inferences we make may be very
misleading.
• OLS, with or without correction for heteroscedasticity,
overestimates the standard errors.

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Detection of Heteroscedasticity

• Some of the informal and formal methods are used for

detecting heteroscedasticity.
• Most of these methods are based on the examination of the
 OLS residuals uˆisince they are the ones we observe, and
not the disturbances ui. One hopes that they are good
estimates of ui, a hope that may be fulfilled if the sample
size is fairly large.
Informal Methods
Nature of the Problem
• In cross-sectional data involving heterogeneous units,
heteroscedasticity may be the rule rather than the
exception.
Basic Econometrics Haleema Sadia
Detection of Heteroscedasticity Continued…

• In a cross-sectional analysis involving the investment

expenditure in relation to sales, rate of interest, etc.,
heteroscedasticity is generally expected if small, medium-,
 and large-size firms are sampled together.
Graphical Method
If there is no a priori or empirical information about the
nature of heteroscedasticity, in practice one can do the
regression analysis on the assumption that there is no
heteroscedasticity and then do an examination of the
residual squared uˆ2ito see if they exhibit any systematic
pattern.
Detection of Heteroscedasticity Continued…

• An examination of the uˆ2i may reveal patterns such as those shown in

Figure 6.

• In Figure 6a we see that there is no systematic pattern between the

two variables, suggesting that perhaps no heteroscedasticity is
present in the data. Figure 6b to e, however, exhibits definite
 patterns. For instance,
• Figure 6c suggests a linear relationship, whereas Figure 6d and e
indicates a quadratic relationship between uˆ2iand Yˆi.
• Using such knowledge, albeit informal, one may transform the data in
such a manner that the transformed data do not exhibit
heteroscedasticity.
Figure 6: Patterns of Estimated Squared Residuals
Formal Methods
Park Test
Park suggests that σ2iis some function of the explanatory variable Xi. The
functional form he suggested was
σ2i = σ2Xβievi
or
ln σ2i = ln σ2 + β ln Xi + vi(i) where viis the stochastic disturbance term. Since
σ2iis generally not known, Park suggests using uˆ2ias a proxy and running
the following regression: ln uˆ2i = ln σ2 + β ln Xi + vi = α + β ln Xi + vi(ii) If β
turns out to be statistically significant, it would suggest that
heteroscedasticity is present in the data.
• The Park test is a two stage procedure. In the first stage
we run the OLS regression disregarding the
heteroscedasticity question. We obtain uˆifrom this
regression, and then in the second stage we run the
regression (ii).
 • Although empirically appealing, the Park test has some
problems. Goldfeld and Quandt have argued that the
error term vientering into (11.5.2) may not satisfy the
OLS assumptions and may itself be heteroscedastic.

• Example 11.1 Page 379

Glejser Test. test is similar in spirit to the Park test. After
obtaining the residuals uˆifrom the OLS regression, Glejser
suggests regressing the absolute values of uˆi on the X
variable that is thought to be closely associated with σ2i. In
his experiments, Glejser used the following functional forms:
where viis the error term.
EXAMPLE 11.2 RELATIONSHIP BETWEEN COMPENSATION AND
PRODUCTIVITY: THE GLEJSER TEST
• Continuing with Example 11.1, the absolute value of the
residuals obtained from regression(11.5.3) were regressed on
 average productivity (X), giving the following results: |uˆi| =
407.2783 − 0.0203Xi
se = (633.1621) (0.0675) r2 = 0.0127 (11.5.5) t = (0.6432)
(−0.3012)
• As you can see from this regression, there is no relationship
between the absolute value of the residuals and the
regressor, average productivity. This reinforces the
conclusion based on the Park test.
Goldfeld-Quandt Test.
• This popular method is applicable if one assumes that the
heteroscedastic variance, σ2i, is positively related to one of the
explanatory variables in the regression model. For simplicity,
consider the usual two-variable model:
Yi = β1 + β2Xi + ui
• Suppose σ2iis positively related to Xias
σ2i = σ2X2i(11.5.10)
where σ2is a constant.
• Assumption (11.5.10) postulates that σ2iis proportional to the square of
the X variable.
• If (11.5.10) is appropriate, it would mean σ2i would be larger, the larger
the values of Xi. If that turns out to be the case, heteroscedasticity is
most likely to be present in the model. To test this explicitly,
Goldfeld and Quandt suggest the following steps:
Step 1. Order or rank the observations according to the values of Xi, beginning
with the lowest X value.
Step 2. Omit c central observations, where c is specified a priori, and divide the
remaining (n − c) observations into two groups each of (n − c) / 2 observations.
Step 3. Fit separate OLS regressions to the first (n − c) 2 observations and the
last (n − c) / 2 observations, and obtain the respective residual sums of squares
RSS1and RSS2, RSS1representing the RSS from the regression corresponding to
the smaller Xi values (the small variance group) and RSS2 that from the larger Xi
values (the large variance group). These RSS each have (n− c) / 2 − k or (n− c −
2k) / 2 df where k is the number of parameters to be estimated, including the
intercept.
Step 4. Compute the ratio
 λ = RSS2/df / RSS1/df
(11.5.11)
If ui are assumed to be normally distributed (which we usually do), and if the
assumption of homoscedasticity is valid, then it can be shown that λ of (11.5.10)
follows the F distribution with numerator and denominator df each of (n− c −
2k)/2.
• If in an application the computed λ (= F) is greater
than the critical F at the chosen level of
significance, we can reject the hypothesis of
homoscedasticity, that is, we can say that
heteroscedasticity is very likely.
• Example 11.4
White’s General Heteroscedasticity Test.

• Unlike the Goldfeld– Quandt test, which requires

reordering the observations with respect to the X
variable that supposedly caused heteroscedasticity,
 or the BPG test, which is sensitive to the normality
assumption, the general test of heteroscedasticity
proposed by White does not rely on the normality
assumption and is easy to implement.
• As an illustration of the basic idea, consider the
following three-variable regression model (the
generalization to the k-variable model is
straightforward):
White’s General Heteroscedasticity Test Continued…
Obtain the R2 from this (auxiliary) regression.
Step 3. Under the null hypothesis that there is no heteroscedasticity, it
can be shown that sample size (n) times the R2 obtained from the
auxiliary regression asymptotically follows the chi-square distribution
with df equal to the number of regressors (excluding the constant
term) in the auxiliary regression. That is,
n · R2 ∼asy χ2 df (11.5.23)
where df is as defined previously. In our example, there are 5 df since
there are 5 regressors in the auxiliary regression.

Step 4. If the chi-square value obtained in (11.5.23) exceeds the

critical chi-square value at the chosen level of significance, the
conclusion is that there is heteroscedasticity. If it does not exceed the
critical chi-square value, there is no heteroscedasticity, which is to say
that in the auxiliary regression (11.5.21), α2 = α3 = α4 = α5 = α6= 0
(see footnote 25).
Example 11.6
• In other words, the White test can be a test of
(pure) heteroscedasticity or specification error
or both. It has been argued that if no cross
 product terms are present in the White test
procedure, then it is a test of pure
heteroscedasticity.
• If cross-product terms are present, then it is a test
of both heteroscedasticity and specification
bias.
11.6 REMEDIAL MEASURES
As we have seen, heteroscedasticity does not destroy the
unbiasedness and consistency properties of the OLS estimators,
but they are no longer efficient, not even asymptotically (i.e.,
large sample size). This lack of efficiency makes the usual
hypothesis-testing procedure of dubious value. Therefore,
remedial measures may be called for. There are two approaches
to remediation:
• when σ2i is known
 • when σ2 i is not known.
• when σ2i Is Known: We use the Method of Weighted Least
Squares
• Example 11.7
When σi2 Is Not Known
• As noted earlier, if true σ2i are known, we can use the WLS method
to obtain BLUE estimators.
• Since the true σ2i are rarely known, is there a way of obtaining
consistent (in the statistical sense) estimates of the variances and
covariances of OLS estimators even if there is heteroscedasticity?
The answer is yes.
White’s Heteroscedasticity-Consistent Variances and Standard
Errors
• White has shown that this estimate can be performed so that
asymptotically valid (i.e., large-sample) statistical inferences can be
made about the true parameter values.
• White’s heteroscedasticity-corrected standard errors are also known
 as robust standard errors.
Example 11.8
• As the preceding results show, (White’s) heteroscedasticity
corrected standard errors are considerably larger than the OLS
standard errors and therefore the estimated t values are much
smaller than those obtained by OLS. On the basis of the latter,
both the regressors are statistically significant at the 5 percent
level, whereas on the basis of White estimators they are not.
• However, it should be pointed out that White’s
heteroscedasticity-corrected standard errors can be larger or
smaller than the uncorrected standard errors. Since White’s
heteroscedasticity-consistent estimators of the variances are
now available in established regression packages, it is
recommended that the reader report them. As Wallace and
Silver note:
• Generally speaking, it is probably a good idea to use the
WHITE option [available in regression programs]
routinely, perhaps comparing the output with regular
 OLS output as a check to see whether heteroscedasticity
is a serious problem in a particular set of data.

• Please read Example 9, 10, 11 from textbook