OSU Economics 444: Elementary Econometrics

Ch.10 Heteroskedasticity

• (Pure) heteroskedasticity is caused by the error term of a correctly speciÞed equation:

V ar(²i ) = σi2 , i = 1, 2, · · · , n,

i.e., the variance of the error term depends on exactly which oberservation is.
1) Heteroskedasticity occurs in data sets in which there is a wide disparity between the largest and smallest
observed values. We may expect that the error term for very large observations might have a large
variance, but the error term for small observations might have a small variance.
2) Heteroskedasticity is more likely to take place on cross-sectional models. Cross-sectional models often
have observtions of widely different sizes in a sample.
3) Heteroskedasticity may take on many complex forms.
4) A simple but special model of heteroskedasticity assumes that the variance of the error term is related
to an exogenous variable z:
yi = β0 + β1 x1i + · · · + βk xki + ²i

with
var(²i ) = σ 2 zi2 .

(a) The variance of ²i is proportional to the square of zi . The higher the value of zi , the higher the
variance of ²i .
(b) An example: the consumption of a household to its income. The expenditures of a low income
household are not likely to be as variable in absolute varlue as the expenditures of a high income
one.
F igure 10.3 here

• Impure heteroskedasticity
— heteroskedasticity that is caused by an error in speciÞcation, such as an omitted variable.
1) An omitted variable may cause a heteroskedastic error because the portion of the omitted effect not
represented by included explanatory variables may be absorbed by the error term.
2) The correct remedy is to Þnd the omitted variable and include it in the regression
•• Consequences of (pure) Heteroskedasticity
1) Pure heteroskedasticity does not cause bias in the OLSEs of the regression coefficients.
(a) Consider the simple regression model yi = βxi + ²i with var(²i ) = σi2 .
The OLSE is Pn Pn
xi yi xi ²i
β̂ = Pi=1
n 2 = β + Pi=1
n 2 .
i=1 xi i=1 xi
Therefore, Pn
x E(² |x )
E(β̂) = β + Pni 2i i
i=1
= β.
i=1 xi

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2) The Gauss-Markov theorem does not hold. The OLSE may not be the estimator with the smallest
variance within the class of linear unbiased estimators.
3) The variance formula for the OLSE is not correct. The variance formula tends to underestimate the
true variance of the OLSE.
(a) For the simple regression model yi = βxi + ²i with var(²i ) = σi2 , the true variance of the OLSE β̂
is Pn
x2i σi2
var(OLS β̂) = Pi=1
n .
( i=1 x2i )2
(b) The variance formula from the computer (ignoring heteroskedastic variances) is
Pn 2
i=1 ei P 1
n 2
n−1 i=1 xi

. It can be shown that n n Pn

X X 2 2
2 2 i=1 xi σi
E( ei ) = σi − P n 2 .
i=1 i=1 i=1 xi

If σi2 and x2i are positively correlated, one has

Pn 2
Pn Pn Pn
i=1 xi σi2 − i=1 x2i σi2
i=1 P
2 2
i=1 xi σi
n ≤ P n .
(n − 1)( i=1 x2i )2 ( i=1 x2i )2
That is, the expected value of the estimated variance is smaller than the true variance.
•• Testing for Heteroskedasticity
There are many test statistics depending on models. The following are two familiar tests.
• The Park Test
It is designed to test possible heteroskedasticity of the form

var(²i ) = σ 2 ziδ .

It has three steps:

1. Obtain the OLS residuals: Estimate the regression model by OLS (ignoring possible heteroskedasticity)
β̂ and compute
ei = yi − β̂0 − β̂1 x1i − · · · − β̂k xki , i = 1, · · · , n.

2. Run thhe regression

ln(e2i ) = α0 + α1 ln(zi ) + ui ,

where zi = is a possible (best choice) proportionality factor.

3. Test the signiÞcance of α̂ with a t-test. If it is signiÞcant, this is evidence of heteroskedasticity; otherwise,
not.
4. An empirical example: Woody’s restaurants
OLSE:
ŷi = 102, 192−9075Ni + 0.355Pi + 1.288Ii
(2053) (0.073) (0.543)
t = − 4.42 4.88 2.37
n = 33 R̄2 = 0.579 F = 15.65,

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where
y = the check volume at a Woody’s restaurant
N = the number of nearby competitors
P = the nearby population
I = the average household income of the local area.

Park’ test: try to see if the residuals give any indication of heteroskedasticity by using the population
P — because large error term variances might exist in more heavily populated areas.

ˆ 2 ) = 21.05−0.2865 ln P
ln(e i i

(0.6263)
t = − 0.457

n = 33 R2 = 0.0067 F = 0.209.

The calculated t-score of -0.457 is too small and there is no strong evidence for heteroskedasticity.

• The White Test

It is more general than the Park test and does not need to decide on possible z factor (as in the Park
test).
1) It runs a regression with the squared residuals on all the original independent variables, their squares
and cross products.
2) For example, for y = β0 + β1 x1 + β2 x2 + ², the White’s test regression equation is

e2i = α0 + α1 x1i + α2 x2i + α3 x21i + α4 x22i + α5 x1i x2i + ui .

3) Test the overall signiÞcance of regression coefficients of the test regression of e2i (excluding constant term)
by a F -statistic. Alternatively, use nR2 , where R2 from the test regression equation, as a chi-square
test with degrees of freedom equal to the number of slope coefficients.

•• Remedies for Heteroskedasticity

• Weighted Least Squares — a version of GLS, specially for the heteroskedastic problem.
The method is to transform the ²i into a new disturbance with constant variance σ 2 . The OLS approach
is then applied to the transformed equation. The resulted OLS estimator for the transformed equation is
called the weighted least squares estimator.
1) This approach requires knowledge on the speciÞcation of the variance function.
2) For the model yi = β0 + β1 x1i + ²i where the variance of ²i is speciÞed as

var(²i ) = σ 2 x22 .

The transformed equation is

yi 1 x1i
= β0 + β1 + ui ,
zi zi zi

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 ²i
because ui = zi which is homoskedastic.
y
a) Estimate the transformed equation by OLS with dependent variable z and explanatory variables
1 x1i
zi and zi .
b) Note the transformed equation may not have an intercept term. That is ok.
c) An intercept term may appear if z is one of the explanatory variable x. For example, if z = x1 ,
then the transformed equation is
yi 1
= β0 + β1 + u i ,
x1i x1i
where β1 becomes the intercept term in the transformed equation.
3) The interpretation of the weighted least squares estimates should be the coefficients of the original (not
transformed) regression equation.
4) The weighted least squares is the BLUE (assuming that the variance function) is correctly speciÞed.

• Robust variance estimates for OLSE with an unknown form of heteroskedasticity

1) The OLSE (by ignoring heteroskedastic variances) is unbiased, but the standard variance formula for
the OLSE is valid.
2) This approach is not attempting to get a possible better coefficient estimate. But, it attempts to get a
valid (for large sample) estimate of the proper variance of an OLSE.
3) For example, for the model yi = βxi + ²i (with only a single regressor and no intercept term, for
illustration purpose), the heteroskedasticity-corrected standard errors of OLSE β̂ is
Pn
x2i e2i
Pi=1
n ,
( i=1 x2i )2

where ei s are the OLS residuals.

4) The robust variance formula does not require any speciÞcation of the variance function. The technique
works better in large samples.
5) The robust variance can be used in t-tests in hypothesis testing. – use the value of the robust variance
in the denominator of the t ratio formulae.

• RedeÞning the variables

Select variables within theoretical reasoning in the formulation of a regression model which might be
less likely subject to heteroskedasticity.
1) For an example, consider a model of total expenditures (EXP) by governments of different cities that
might be explained by aggregate income (INC), the population (POP), and the average wage (WAGE)
in each city.
A regression model speciÞed as

EXPi = β0 + β1 P OPi + β2 IN Ci + β3 W AGEi + ²i

might likely have heteroskedastic disturbances because larger cities have larger incomes and large expendi-
tures thatn the smaller ones.

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 Another theoretical model may be

EXPi IN Ci
= α0 + α1 + α2 W AGEi + ²i ,
P OPi P OPi

where the variables are formulated in per capita terms. The large and small size observations disappear
with the per capita variables and this speciÞed equation might be less likely subject to the heteroskedasticity
issue.

• An empirical example:
Try to explain petroleum consumption by state (PCON), using explanatory variables including the size
of the state and gasoline tax rate (TAX).
A possible speciÞcation is

P CONi = β0 + β1 REGi + β2 T AXi + ²i ,

where
P CONi = petroleum consumption in the ith state
REGi = motor vehicle registrations in the ith state
T AXi = the gasoline tax rate in the ith state
1) OLS approach: the estimated equation is

ˆ i = 551.7+0.1861REGi − 53.59T AXi

P CON

(0.0117) (16.86)

t =15.88 − 3.18
R̄2 = 0.861 n = 50.

The estimated coefficients are signiÞcant and have the expected sign.
2) The equation might be subject to heteroskedasticity caused by variation in the size of the states. A plot
of the OLS residuals with respect to REG appear to follow a wider distribution for large values of REG
than for small value of REG.
(F igure 10.8 here)

3) Run a Park test: with ln(REG) as factor

ˆ 2 ) = 1.650+0.952 ln(REG )
ln(ei i

(0.308)

t =3.09
R̄2 = 0.148 n = 50 F = 9.533.

The critical t-value for a 1% two-tailed t-test is about 2.7. The computed t = 3.09 is larger than 2.7
and, hence, we reject the null hypothesis of homoskedasticity.

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4) Use robust estimated variances for OLSEs

ˆ i = 551.7+0.1861REGi − 53.59T AXi

P CON
(0.022) (23.90)
t =8.64 − 2.24

R̄2 = 0.861 n = 50.

The robust variances of the OLSEs are larger than those without correction. So the uncorrected variance
formulas underestimate the proper variances of the OLSE.
5) Estimation with the weighted least squares method

ˆ i
P CON 1 T AXi
= 218.54 +0.168 − 17.389
REGi REGi REGi
(0.014) (4.682)

t =12.27 − 3.71

R̄2 = 0.333 n = 50.

The weighted least squares estimates of β1 and β2 have smaller (estimated) standard errors than those
of the OLSEs (compared with the robust variances) in 4). The overall Þt is worse but this has no
importance as the dependent variables are different in the two equations.
(P CON
6) An alternative formulation using per captit petroleum consumption P OP ) , where P OP is the popula-
tion of a state:
ˆ i
P CON REGi
= 0.168+0.1082 − 0.0103T AXi
P OPi P OPi
(0.0716) (0.0035)

t =1.51 − 2.95
R̄2 = 0.165 n = 50.
This approach is quite different. It is not necessarily better and is not directly comparable to the other
equations. Which specÞcation is better will depend on the purposes of research.