Dougherty5e Studyguide ch14

A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University
of London
International Programmes in Economics, Management, Finance, and the Social Sciences.
Chapter 14
Introduction to panel data
14.1 Overview
Increasingly, researchers are now using panel data where possible in preference to
cross-sectional data. One major reason is that dynamics may be explored with panel
data in a way that is seldom possible with crosssectional data. Another is that panel
data offer the possibility of a solution to the pervasive problem of omitted variable bias.
A further reason is that panel data sets often contain very large numbers of
observations and the quality of the data is high. This chapter describes fixed effects
regression and random effects regression, alternative techniques that exploit the
structure of panel data.
14.2 Learning outcomes

After working through the corresponding chapter in the text, studying the
corresponding slideshows, and doing the starred exercises in the text and the additional
exercises in this subject guide, you should be able to:
explain the differences between panel data, cross-sectional data, and time series
data
explain the benefits that can be obtained using panel data
explain the differences between OLS pooled regressions, fixed effects regressions,
and random effects regressions
explain the potential advantages of the fixed effects model over pooled OLS
explain the differences between the within-groups, first differences, and least
squares dummy variables variants of the fixed effects model
explain the assumptions required for the use of the random effects model
explain the advantages of the random effects model over the fixed effects model
when the assumptions are valid
explain how to use a Durbin–Wu–Hausman test to determine whether the random

effects model may be used instead of the fixed effects model.
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© Christopher Dougherty, 2016. All rights reserved.
Published on the Online Resource Centre to accompany Dougherty: Introduction to Econometrics, 5th edition, by Oxford University Press.
A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University of London
14. Introduction to panel data
14.3 Additional exercises
A14.1 The NLSY2000 data set contains the following data for a sample of 2,427 males
and 2,392 females for the years 1980–2000: years of work experience, EXP, years of
schooling, S, and age, AGE. A researcher investigating the impact of schooling on
willingness to work regresses EXP on S, including potential work experience,
PWE, as a control. PWE was defined as:
PWE = AGE − S − 5.
The following regressions were performed for males and females separately:
(1) an ordinary least squares (OLS) regression pooling the observations
(2) a within-groups fixed effects regression
(3) a random effects regression.
The results of these regressions are shown in the table below. Standard errors are
given in parentheses.
Males Females
OLS FE RE OLS FE RE
S 0.78 0.65 0.72 0.89 0.71 0.85
(0.01) (0.01) (0.01) (0.01) (0.02) (0.01)
PWE 0.83 0.94 0.94 0.74 0.88 0.87
(0.003) (0.001) (0.001) (0.004) (0.002) (0.002)
constant −10.16 dropped −10.56 −11.11 dropped −12.39
(0.09) (0.14) (0.12) (0.19)
R2 0.79 — — 0.71 — —
n 24,057 24,057 24,057 18,758 18,758 18,758
DHW χ2 (2) 10.76 1.43
• Explain why the researcher included PWE as a control.

• Evaluate the results of the Durbin–Wu–Hausman tests.
• For males and females separately, explain the differences in the coefficients of
S in the OLS and FE regressions.
• For males and females separately, explain the differences in the coefficients of
PWE in the OLS and FE regressions.
A14.2 Using the NLSY2000 data set, a researcher fits OLS and fixed effects regressions of
the logarithm of hourly wages on schooling, years of work experience, EXP,
ASVABC score, and dummies MALE, ETHBLACK, and ET HHISP for being
male, black, or hispanic. Schooling was split into years of high school, SH, and
years of college, SC. The results are shown in the table below, with standard errors
placed in parentheses.
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14.3. Additional exercises
OLS FE RE
SH 0.026 0.005 0.016
(0.002) (0.007) (0.004)
SC 0.063 0.073 0.067
(0.001) (0.004) (0.002)
EXP 0.033 0.032 0.033
(0.004) (0.003) (0.003)
ASVABC 0.012 — 0.011
(0.003) (0.001)
MALE 0.193 0.197
(0.004) (0.009)
ETHBLACK −0.040 — −0.030
(0.007) (0.015)
ETHHISP 0.047 — 0.033
(0.008) (0.018)
constant 5.639 — 5.751
(0.028) (0.051)
R2 0.0367 — —
DWH χ2 (3) — — 9.31
If an individual reported being in high school or college, the observation for that
individual for that year was deleted from the sample. As a consequence, the
observations for most individuals in the sample begin when the formal education of
that individual has been completed. However, a small minority of individuals,
having apparently completed their formal education and having taken employment,
subsequently resumed their formal education, either to complete high school with a
general educational development (GED) degree equivalent to the high school
diploma, or to complete one or more years of college.
• Discuss the differences in the estimates of the coefficient of SH.
• Discuss the differences in the estimates of the coefficient of SC.
A14.3 A researcher has data on G, the average annual rate of growth of GDP 2001–2005,
and S, the average years of schooling of the workforce in 2005, for 28 European
Union countries. She believes that G depends on S and on E, the level of
entrepreneurship in the country, and a disturbance term u:
G = β1 + β2 S + β3 E + u. (1)
u may be assumed to satisfy the usual regression model assumptions.

Unfortunately the researcher does not have data on E.
• Explain intuitively and mathematically the consequences of performing a

simple regression of G on S. For this purpose S and E may be treated as
nonstochastic variables.
The researcher does some more research and obtains data on G∗ , the average
annual rate of growth of GDP 1996–2000, and S ∗ , the average years of
schooling of the workforce in 2000, for the same countries. She thinks that she
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can deal with the unobservable variable problem by regressing ∆G, the change
in G, on ∆S, the change in S, where:
∆G = G − G∗
∆S = S − S ∗
assuming that E would be much the same for each country in the two periods.
She fits the equation:
∆G = δ1 + δ2 ∆S + w (2)
where w is a disturbance term that satisfies the usual regression model

assumptions.
• Compare the properties of the estimators of the coefficient of S in (1) and of

the coefficient of ∆S in (2).
• Explain why in principle you would expect the estimate of δ1 in (2) not to be
significant. Suppose that nevertheless the researcher finds that the coefficient is
significant. Give two possible explanations.
Random effects regressions have potential advantages over fixed effect regressions.
• Could the researcher have used a random effects regression in the present case?
A14.4 A researcher has the following data for 3,763 respondents in the National
Longitudinal Survey of Youth 1979– : hourly earnings in dollars in 1994 and 2000,
years of schooling as recorded in 1994 and 2000, and years of work experience as
recorded in 1994 and 2000. The respondents were aged 14–21 in 1979, so they were
aged 29–36 in 1994 and 35–42 in 2000. 371 of the respondents had increased their
formal schooling between 1994 and 2000, 210 by one year, 101 by two years, 47 by
three years, and 13 by more than three years, mostly at college level in non-degree
courses. The researcher performs the following regressions:
(1) the logarithm of hourly earnings in 1994 on schooling and work experience in
1994
(2) the logarithm of hourly earnings in 2000 on schooling and work experience in
2000
(3) the change in the logarithm of hourly earnings from 1994 to 2000 on the
changes in schooling and work experience in that interval.
The results are shown in columns (1) – (3) in the table (t statistics in parentheses),
and are presented at a seminar.
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14.3. Additional exercises
(1) (2) (3) (4) (5)

Dependent log earnings log earnings Change in log earnings Change in
variable 1994 2000 log earnings 2000 log earnings
1994–2000 1994–2000
Schooling 0.114 0.116 — 0.108 —
(30.16) (28.99) (24.53)
Experience 0.052 0.038 — 0.037 —
(18.81) (14.59) (14.10) —
Cognitive — — — 0.004 —
ability score (4.79)
Male 0.214 0.229 — 0.230 —
(12.03) (11.77) (11.88)
Black −0.149 −0.199 — −0.167 —
(−5.23) (−6.44) (−5.29)
Hispanic 0.039 0.053 — 0.071 —
(1.11) (1.38) (1.84)
Change in — — 0.090 — −0.006
schooling (5.00) (−0.16)
Change in — — 0.024 — 0.003
experience (2.75) (0.15)
constant 4.899 5.023 0.102 4.966 0.389
(74.59) (65.02) (2.13) (63.69) (3.05)
R2 0.265 0.243 0.007 0.248 0.0002
n 3,763 3,763 3,763 3,763 371
• The researcher is unable to explain why the coefficient of the change in

schooling in regression (3) is so much lower than the schooling coefficients in
(1) and (2). Someone says that it is because he has left out relevant variables
such as cognitive ability, region of residence, etc, and the coefficients in (1) and
(2) are therefore biased. Someone else says that cannot be the explanation
because these variables are also omitted from regression (3). Explain what
would be your view.
• He runs regressions (1) and (2) again, adding a measure of cognitive ability.
The results for the 2000 regression are shown in column (4). The results for
1994 were very similar. Discuss possible reasons for the fact that the estimate
of the schooling coefficient differs from those in (2) and (3).
• Someone says that the researcher should not have included a constant in
regression (3). Explain why she made this remark and assess whether it is
valid.
• Someone else at the seminar says that the reason for the relatively low
coefficient of schooling in regression (3) is that it mostly represented
non-degree schooling. Hence one would not expect to find the same
relationship between schooling and earnings as for the regular pre-employment
schooling of young people. Explain in general verbal terms what investigation
the researcher should undertake in response to this suggestion.
• Another person suggests that the small minority of individuals who went back
to school or college in their thirties might have characteristics different from
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those of the individuals who did not, and that this could account for a
different coefficient. Explain in general verbal terms what investigation the
researcher should undertake in response to this suggestion.
• Finally, another person says that it might be a good idea to look at the
relationship between earnings and schooling for the subsample who went back
to school or college, restricting the analysis to these 371 individuals. The
researcher responds by running the regression for that group alone. The result
is shown in column (5) in the table. The researcher also plots a scatter
diagram, reproduced below, showing the change in the logarithm of earnings
and the change in schooling. For those with one extra year of schooling, the
mean change in log earnings was 0.40. For those with two extra years, 0.37.
For those with three extra years, 0.47. What conclusions might be drawn from
the regression results?
2
change in log earnings
0
0 1 2 3 4 5
-1
-2
-3
-4
change in schooling
A14.5 In the discussion of the DWH test, it was stated that the test compares the
coefficients of those variables not dropped in the FE regression. Explain why the
constant is not included in the comparison.
14.4 Answer to the starred exercise in the textbook

14.9 The NLSY2000 data set contains the following data for a sample of 2,427 males
and 2,392 females for the years 1980–2000: weight in pounds, years of schooling,
age, marital status in the form of a dummy variable MARRIED defined to be 1 if
the respondent was married, 0 if single, and height in inches. Hypothesizing that
weight is influenced by schooling, age, marital status, and height, the following
regressions were performed for males and females separately:
(1) an ordinary least squares (OLS) regression pooling the observations
(2) a within-groups fixed effects regression
(3) a random effects regression.
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14.4. Answer to the starred exercise in the textbook
The results of these regressions are shown in the table. Standard errors are given in
parentheses.
Males Females
OLS FE RE OLS FE RE
Year of −0.98 −0.02 −0.45 −1.95 −0.60 −1.25
schooling (0.09) (0.23) (0.16) (0.12) (0.27) (0.18)
Age 1.61 1.64 1.65 2.03 1.66 1.72
(0.04) (0.02) (0.02) (0.05) (0.03) (0.03)
Married 3.70 2.92 3.00 −8.27 3.08 1.98
(0.48) (0.33) (0.32) (0.59) (0.46) (0.44)
Height 5.07 dropped 4.95 3.48 dropped 3.38
(0.08) (0.18) (0.10) (0.21)
constant −209.52 dropped −209.81 −105.90 dropped −107.61
(5.39) (12.88) (6.62) (13.43)
R2 0.27 — — 0.17 — —
n 17,299 17,299 17,299 13,160 13,160 13,160
DWH χ2 (3) 7.22 92.94
Explain why height is excluded from the FE regression.
Evaluate, for males and females separately, whether the fixed effects or random
effects model should be preferred.
For males and females separately, compare the estimates of the coefficients in the
OLS and FE models and attempt to explain the differences.
Explain in principle how one might test whether individual-specific fixed effects
jointly have significant explanatory power, if the number of individuals is small.
Explain why the test is not practical in this case.
Answer:
Height is constant over observations. Hence, for each individual:
HEIGHT it − HEIGHT i = 0
for all t, where HEIGHT i is the mean height for individual i for the observations
for that individual. Hence height has to be dropped from the regression model.
The critical value of chi-squared, with three degrees of freedom, is 7.82 at the 5
percent level and 16.27 at the 0.1 percent level. Hence there is a possibility that the
random effects model may be appropriate for males, but it is definitely not
appropriate for females.
Males
The OLS regression suggests that schooling has a small (one pound less per year of
schooling) but highly significant negative effect on weight. The fixed effects
regression eliminates the effect, indicating that an unobserved effect is responsible:
males with unobserved qualities that have a positive effect on educational
attainment, controlling for other measured variables, have lower weight as a
consequence of the same unobserved qualities. We cannot compare estimates of the
effect of height since it is dropped from the FE regression. The effect of age is the
same in the two regressions. There is a small but highly significant positive effect of
being married, the OLS estimate possibly being inflated by an unobserved effect.
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Females
The main, and very striking, difference is in the marriage coefficient. The OLS
regression suggests that marriage reduces weight by eight pounds, a remarkable
amount. The FE regression suggests the opposite, that marriage leads to an
increase in weight that is similar to that for males. The clear implication is that
women who weigh less are relatively successful in the marriage market, but once
they are married they put on weight.
For schooling the story is much the same as for males, except that the OLS
coefficient is much larger and the coefficient remains significant at the 5 percent
level in the FE regression. The effect of age appears to be exaggerated in the OLS
regression, for reasons that are not obvious.
One might test whether individual-specific fixed effects jointly have significant
explanatory power by performing a LSDV regression, eliminating the intercept in
the model and adding a dummy variable for each individual. One would compare
RSS for this regression with that for the regression without the dummy variables,
using a standard F test. In the present case it is not a practical proposition
because there are more than 17,000 males and 13,000 females.
14.5 Answers to the additional exercises

A14.1 Explain why the researcher included PWE as a control.
Clearly actual work experience is positively influenced by PWE. Omitting it would
cause the coefficient of S to be biased downwards since PWE and S are negatively
correlated.
Evaluate the results of the Durbin–Wu–Hausman tests
With two degrees of freedom, the critical value of chi-squared is 5.99 at the 5
percent level and 9.21 at the 1 percent level. Thus the random effects model is
rejected for males but seemingly not for females.
For males and females separately, explain the differences in the coefficients of S in
the OLS and FE regressions.
For both sexes the OLS estimate is greater than the FE estimate. One possible
reason is that some unobserved characteristics, for example drive, are positively
correlated with both acquiring schooling, and seeking and gaining employment.
For males and females separately, explain the differences in the coefficients of PWE
in the OLS and FE regressions.
Since S and PWE are negatively correlated, these same unobserved characteristics
would cause the OLS estimate of the coefficient of PWE to be biased downwards.
A14.2 First, note that the DWH statistic is significant at the 5 per cent level (critical
value 7.82) but not at the 1 per cent level (critical value 11.35).
The coefficients of SH and SC in the OLS regression is an estimate of the impact
of variations in years of high school and years of college among all the individuals
in the sample. Most individuals in fact completed high school and so had SH = 12.
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14.5. Answers to the additional exercises
However, a small minority did not and this variation made possible the estimation
of the SH coefficient. The majority of the remainder did not complete any years of
college and therefore had SC = 0, but a substantial minority did have a partial or
complete college education, some even pursuing postgraduate studies, and this
variation made possible the estimation of the SC coefficient.
Most individuals completed their formal education before entering employment. For
them, SHit = SHi for all t and hence SHit − SHi = 0 for all t. As a consequence,
the observations for such individuals provide no variation in the SH variable.
Likewise they provide no variation in the SC variable. If all observations pertained
to such individuals, schooling would be washed out in the FE regression along with
other unchanging characteristics such as sex, ethnicity, and ASVABC score. The
schooling coefficients in the FE regression therefore relate to those individuals who
returned to formal education after a break in which they found employment.
The fact that these individuals account for a relatively small proportion of the
observations in the data set has an adverse effect on the precision of the FE
estimates of the coefficients of SH and SC. This is reflected in standard errors that
are much larger than those obtained in the OLS pooled regression.
Discuss the differences in the estimates of the coefficient of SH.
Most of the variation in SH in the FE regressions come from individuals earning
the GED degree. This degree provides an opportunity for high school drop-outs to
make good their shortfall by taking courses and passing the examinations required
for this diploma. These courses may be civilian or military adult education classes,
but very often they are programmes offered to those in jail. In principle the GED
should be equivalent to the high school diploma, but there is some evidence that
standards are sometimes lower. The results in the table appear to corroborate this
view. The OLS regression indicates that a year of high school raises earnings by 2.6
per cent, with the coefficient being highly significant, whereas the FE coefficient
indicates that the effect is only 0.5 per cent and not significant.
Discuss the differences in the estimates of the coefficient of SC.
Some of the variation in SC in the FE regressions comes from individuals entering
employment for a year or two after finishing high school and then going to college,
resuming their formal education. However, most comes from individuals returning
to college for a year or two after having been employment for a number of years. A
typical example is a high school graduate who has settled down in an occupation
and who has then decided to upgrade his or her professional skills by taking a
two-year associate of arts degree. Similarly one encounters college graduates who
upgrade to masters level after having worked for some time. One would expect such
students to be especially well motivated – they are often undertaking studies that
are relevant to an established career, and they are often bearing high opportunity
costs from loss of earnings while studying – and accordingly one might expect the
payoff in terms of increased earnings to be relatively high. This seems to be borne
out in a comparison of the OLS and FE estimates of the coefficient of SC, though
the difference is not dramatic.
On the surface, this exercise appeared to be about how one might use FE to
eliminate the bias in OLS pooled regression caused by unobserved effects. Has the
analysis been successful in this respect? Absolutely not. In particular, the apparent
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conclusion that high school education has virtually no effect on earnings should not
be taken at face value. The reason is that the issue of biases attributable to
unobserved effects has been overtaken by the much more important issue of the
difference in the interpretation of the SH and SC coefficients discussed in the
exercise. This illustrates a basic point in econometrics: understanding the context
of the data is often just as important as being proficient at technical analysis.
A14.3 Explain intuitively and mathematically the consequences of performing a simple

regression of G on S. For this purpose S and E may be treated as nonstochastic
variables.
If one fits the regression:
G
b = βb1 + βb2 S
then
P
Si − S Gi − G
βb2 = P 2
Si − S
P
Si − S (β1 + β2 Si + β3 Ei + ui ) − β1 + β2S + β2E + u
= P 2
Si − S
P P
SiS Ei − E Si − S (ui − u)
= β2 + β3 P 2 + P 2 .
Si − S Si − S
Taking expectations, and making use of the invitation to treat S and E as

nonstochastic:
P P
SiS Ei − E Si − S E (ui − u)
E(βb2 ) = β2 + β3 P 2 + P 2
Si − S Si − S
P
S i − S Ei − E
= β2 + β3 P 2 .
Si − S
Hence the estimator is biased unless S and E happen to be uncorrelated in the

sample. As a consequence, the standard errors will be invalid.
Compare the properties of the estimators of the coefficient of S in (1) and of the
coefficient of ∆S in (2).
Given (1), the differenced model should have been:
∆G = δ2 ∆S + w
where w = u − u∗ .
The estimator of the coefficient of ∆S in (2) should be unbiased, while that of S in
(1) will be subject to omitted variable bias. However:
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• it is possible that the bias in (1) may be small. This would be the case if E
were a relatively unimportant determinant of G or if its correlation with S
were low.
• it is possible that the variance in ∆S is smaller than that of S. This would be
the case if S were changing slowly in each country, or if the rate of change of S
were similar in each country.
Thus there may be a trade-off between bias and variance and it is possible that the
estimator of β2 using specification (1) could actually be superior according to some
criterion such as the mean square error. It should be noted that the inclusion of δ1
in (2) will make the estimation of δ2 even less efficient.
Explain why in principle you would expect the estimate of δ1 in (2) not to be
significant. Suppose that nevertheless the researcher finds that the coefficient is
significant. Give two possible explanations.
If specification (1) is correct, there should be no intercept in (2) and for this reason
the estimate of the intercept should not be significantly different from zero. If it is
significant, this could have occurred as a matter of Type I error. Alternatively, it
might indicate a shift in the relationship between the two time periods. Suppose
that (1) should have included a dummy variable set equal to 0 in the first time
period and 1 in the second. δb1 would then be an estimate of its coefficient.
Could the researcher have used a random effects regression in the present case?
Random effects requires the sample to be drawn randomly from a population and
for unobserved effects to be uncorrelated with the regressors. The first condition is
not satisfied here, so random effects would be inappropriate.
A14.4 The researcher is unable to explain why the coefficient of the change in schooling in
regression (3) is so much lower than the schooling coefficients in (1) and (2).
Someone says that it is because he has left out relevant variables such as cognitive
ability, region of residence, etc, and the coefficients in (1) and (2) are therefore
biased. Someone else says that cannot be the explanation because these variables are
also omitted from regression (3). Explain what would be your view.
Suppose that the true model is:
LGEARN = β1 + β2 S + β3 EXP + β4 ASVABC + β5 MALE
+β6 ETHBLACK + β7 ETHHISP + β8 X8 + u
where X8 is some further fixed characteristic of the respondent. ASVABC and X8
are absent from regressions (1) and (2) and so those regressions will be subject to
omitted variable bias. In particular, since ASVABC is likely to be positively
correlated with S, and to have a positive coefficient, its omission will tend to bias
the coefficient of S upwards.
However, if the specification is valid for both 1994 and 2000 and unchanged, one can
eliminate the omitted variable bias by taking first differences as in regression (3):
∆LGEARN = β2 ∆S + β3 ∆EXP + ∆u.
By fitting this specification one should obtain unbiased estimates of the coefficients
of schooling and experience, and the former should therefore be smaller than in (1)
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and (2). Note that all the fixed characteristics have been washed out. The
suggestion that ASVABC should have been included in (3) is therefore incorrect.
Note that (3) should not have included an intercept. This is discussed later in the
question.
He runs regressions (1) and (2) again, adding a measure of cognitive ability. The
results for the 2000 regression are shown in column (4). The results for 1994 were
very similar. Discuss possible reasons for the fact that the estimate of the schooling
coefficient differs from those in (2) and (3).
The estimate of the coefficient of S differs from that in (2) because the omitted
variable bias attributable to the omission of ASVABC in that specification has now
been corrected. However it is still biased if X8 (representing other omitted
characteristics) is a determinant of earnings and is correlated with S. This partial
rectification of the omitted variable problem accounts for the fact that the
coefficient of S in (4) lies between those in (2) and (3).
Someone says that the researcher should not have included a constant in regression
(3). Explain why she made this remark and assess whether it is valid.
Given the specification in (1) and (2), there should have been no intercept in the
first differences specification (3). One would therefore expect the estimate of the
intercept to be somewhere near zero in the sense of not being significantly different
from it. Nevertheless, it is significantly different at the 5 percent level. However,
suppose that the relationship shifted between 1994 and 2000, and that the shift
could be represented by a dummy variable D equal to zero in 1994 and 1 in 2000,
with coefficient δ. Then (3) should have an intercept δ. Its estimate, 0.102, suggests
that earnings grew by 10 percent from 1994 to 2000, holding other factors constant.
This seems entirely reasonable, perhaps even a little low.
Alternatively, the apparently significant t statistic might have arisen as a matter of
Type I error.
Someone else at the seminar says that the reason for the relatively low coefficient of
schooling in regression (3) is that it mostly represented non-degree schooling. Hence
one would not expect to find the same relationship between schooling and earnings
as for the regular preemployment schooling of young people. Explain in general
verbal terms what investigation the researcher should undertake in response to this
suggestion.
Divide S into two variables, schooling as of 1994 and extra schooling as of 2000,
with separate coefficients. Then use a standard F test (or t test) of a restriction to
test whether the coefficients are significantly different.
Another person suggests that the small minority of individuals who went back to
school or college in their thirties might have characteristics different from those of
the individuals who did not, and that this could account for a different coefficient.
Explain in general verbal terms what investigation the researcher should undertake
in response to this suggestion.
The issue is sample selection bias and an appropriate procedure would be that
proposed by Heckman. One would use probit analysis with an appropriate set of
determinants to model the decision to return to school between 1994 and 2000, and
a regression model to explain variations in the logarithm of earnings of those
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respondents who do return to school, linking the two models by allowing their
disturbance terms to be correlated. One would test whether the estimate of this
correlation is significantly different from zero.
Finally, another person says that it might be a good idea to look at the relationship
between earnings and schooling for the subsample who went back to school or
college, restricting the analysis to these 371 individuals. The researcher responds by
running the regression for that group alone. The result is shown in column (5) in
the table. The researcher also plots a scatter diagram, reproduced below, showing the
change in the logarithm of earnings and the change in schooling. For those with one
extra year of schooling, the mean change in log earnings was 0.40. For those with
two extra years, 0.37. For those with three extra years, 0.47. What conclusions
might be drawn from the regression results?
The schooling coefficient is effectively zero! [These are real data, incidentally.] The
scatter diagram shows why. Irrespective of whether the respondent had one, two, or
three years of extra schooling, the gain is about the same, on average. (These are
the only categories with large numbers of observations, given the information at the
beginning of the question, confirmed by the scatter diagram.) So the results
indicate that the fact of going back to school, rather than the duration of the
schooling, is the relevant determinant of the change in earnings. The intercept
indicates that this subsample on average increased their earnings between 1994 and
2000 by 38.9 percent. (As a first approximation. The actual proportion would be
better estimated as e0.389 − 1 = 0.476.) This figure is confirmed by the diagram, and
it would appear to be much greater than the effect of regular schooling. One
explanation could be sample selection bias, as already discussed. A more likely
possibility is that the respondents were presented with opportunities to increase
their earnings substantially if they undertook certain types of formal course, and
they took advantage of these opportunities.
A14.5 In a random effects regression, the interpretation of an intercept is not affected by

the estimation technique. In a fixed effects regression, the intercept is washed out.
Hence there is no basis for a comparison. In general, the model is fitted without an
intercept. The only case where an intercept should be included is in first-differences
fixed effects estimation of a model containing a deterministic trend. For example,
suppose one is fitting the model:
Yit = β1 + β2 Xit + δt + uit .
For individual i in the previous time period, one has:
Yi, t−1 = β1 + β2 Xi, t−1 + δ(t − 1) + ui, t−1 .
Subtracting, one obtains:
Yit − Yi, t−1 = β2 (Xit − Xi, t−1 ) + δ + uit − ui, t−1 .
The model now does have an intercept, but its meaning is different from that in the
original specification. It now provides an estimate of δ, not β1 .
311

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A study guide produced by Christopher Dougherty to accompany the module "EC2020 Elements of Econometrics" offered as part of the University

14.2 Learning outcomes

explain the benefits that can be obtained using panel data

explain how to use a Durbin–Wu–Hausman test to determine whether the random

14. Introduction to panel data

14.3 Additional exercises

• Explain why the researcher included PWE as a control.

14.3. Additional exercises

u may be assumed to satisfy the usual regression model assumptions.

• Explain intuitively and mathematically the consequences of performing a

14. Introduction to panel data

where w is a disturbance term that satisfies the usual regression model

• Compare the properties of the estimators of the coefficient of S in (1) and of

14.3. Additional exercises

(1) (2) (3) (4) (5)

• The researcher is unable to explain why the coefficient of the change in

14. Introduction to panel data

14.4 Answer to the starred exercise in the textbook

14.4. Answer to the starred exercise in the textbook

14. Introduction to panel data

14.5 Answers to the additional exercises

14.5. Answers to the additional exercises

14. Introduction to panel data

A14.3 Explain intuitively and mathematically the consequences of performing a simple

Taking expectations, and making use of the invitation to treat S and E as

Hence the estimator is biased unless S and E happen to be uncorrelated in the

14.5. Answers to the additional exercises

14. Introduction to panel data

14.5. Answers to the additional exercises

A14.5 In a random effects regression, the interpretation of an intercept is not affected by

Yit = β1 + β2 Xit + δt + uit .

For individual i in the previous time period, one has:

Yi, t−1 = β1 + β2 Xi, t−1 + δ(t − 1) + ui, t−1 .

Subtracting, one obtains:

Yit − Yi, t−1 = β2 (Xit − Xi, t−1 ) + δ + uit − ui, t−1 .

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