Suppose that you want to test whether dairy farmers who have access to formal credit Jhave better

production than who did not receive. You have a random sample of 500 dairy farmers from
Sirajganj district and their data of milk production per year. Consider access to formal credit as a
dummy variable (1 if have access, 0 otherwise) and yearly household income in Tk.
(a) What other factors would you control for the equation? Specify with measurement unit.
(b) Write the equation to find the impact of access to credit on milk production using control
variables you listed in question.
(c) Suppose that household income has measurement error. Why OLS estimation could be biased
in this case? Explain.
(d) Please select one valid IV to solve the endogeneity and why this is a valid IV?
(e) Write the reduced form of equation using the IV you selected in question 1

(a) In order to control for the impact of access to formal credit on milk production among dairy
farmers, you would want to include other relevant factors as control variables in your regression
equation. Some potential control variables to consider, along with their measurement units, could
include:

1. **Farm Size (in acres):** The size of the dairy farm could impact milk production, as larger
farms may have more resources and infrastructure for dairy production.

2. **Number of Cattle:** The number of cattle on the farm could affect milk production. More
cattle may lead to higher production.

3. **Experience (in years):** The experience of the dairy farmer in managing cattle and dairy
production could be a relevant factor.

4. **Feed Quality (e.g., % protein, % fiber):** The quality of the feed provided to the cattle could
influence milk production.

5. **Healthcare Expenditure (in Tk):** Investments in cattle healthcare could affect their
productivity.
6. **Education Level (e.g., years of education):** The education level of the farmer may also be
relevant.

7. **Access to Veterinary Services (binary, 1 if accessible, 0 otherwise):** Availability of

veterinary services may impact the health and productivity of cattle.

8. **Geographic Location (e.g., latitude and longitude):** The geographic location of the farm
could influence climate and access to resources.

(b) The regression equation to find the impact of access to credit on milk production while
controlling for the listed variables could look like this:

(c) OLS (Ordinary Least Squares) estimation could be biased in the presence of measurement error
in the household income variable because OLS assumes that the independent variables are
measured without error. If there is measurement error in the income variable, it can lead to bias in
the estimated coefficients. In particular, measurement error that is not random (systematic) can
lead to biased estimates of the relationships between variables. If income is measured with error,
it may not accurately capture the true relationship between income and milk production.

(d) One valid IV (Instrumental Variable) to solve the endogeneity problem between access to credit
and milk production could be "Distance to the Nearest Bank Branch." This could be a valid IV
because:
 - It is likely to be correlated with access to formal credit: Dairy farmers who live closer to a bank
branch are more likely to have easier access to credit services.
- It is plausibly exogenous to milk production: The distance to a bank branch is unlikely to be
directly related to milk production except through its impact on access to credit.

(e) The reduced form equation using the IV "Distance to the Nearest Bank Branch" might look
like this:

Q3.
a) Write the steps for testing endogeneity of a single explanatory variable.
b) Mention the steps of testing overidentifying restrictions of IVs.
a) Testing Endogeneity of a Single Explanatory Variable:

Endogeneity occurs when one or more of the explanatory variables in a regression model are
correlated with the error term, violating one of the key assumptions of OLS regression. To test for
the endogeneity of a single explanatory variable, you can follow these steps:
1. **Formulate the Hypotheses**:
- Null Hypothesis (H0): The explanatory variable is exogenous (not endogenous).
- Alternative Hypothesis (Ha): The explanatory variable is endogenous.

2. **Collect Data**: Gather the relevant data for your regression model.

3. **Specify the Regression Model**: Define the regression model you want to test. For example,
if you have a single explanatory variable (X) and a dependent variable (Y), your model may look
like Y = β0 + β1X + ε.

4. **Check for Correlation**: Examine the residuals (ε) from your regression model for any
correlation with the suspected endogenous explanatory variable (X). You can use scatterplots,
correlation coefficients, or other diagnostic plots to assess this correlation.

5. **Instrumental Variable (IV)**: If you find evidence of endogeneity, identify an appropriate

instrumental variable. An instrumental variable is a variable that is correlated with the endogenous
variable but uncorrelated with the error term. It helps you address the endogeneity problem.

6. **Estimate an IV Model**: Re-estimate your regression model using the instrumental variable
in place of the endogenous variable. This gives you the IV estimate.

7. **Test for Weak Instruments**: Assess the strength of your instrumental variable. Weak
instruments can lead to biased results. Common tests include the F-statistic or the Kleibergen-Paap
rank statistic.

8. **Conduct the Endogeneity Test**: Perform an appropriate statistical test to evaluate whether
the IV estimate is significantly different from the OLS estimate. Common tests include the
Hausman test or a Wald test comparing the two estimates.

9. **Interpret Results**: Based on the test results, make a decision regarding the null hypothesis.
If you reject the null hypothesis, it suggests that the explanatory variable is indeed endogenous.
10. **Report Findings**: Present your findings, including the test statistic, p-value, and
conclusion regarding the endogeneity of the explanatory variable.

b) Testing Overidentifying Restrictions of IVs (Based on Jeffrey M. Wooldridge's

Approach):

In instrumental variable (IV) estimation, overidentifying restrictions refer to the additional

conditions that can be tested when you have more than one instrumental variable for an
endogenous variable. These tests help assess the validity of your instruments. Here are the steps
for testing overidentifying restrictions of IVs:

1. **Formulate the Hypotheses**:

- Null Hypothesis (H0): The overidentifying restrictions are valid, meaning the instruments are
exogenous and satisfy the necessary conditions.
- Alternative Hypothesis (Ha): The overidentifying restrictions are invalid, suggesting that at
least one instrument is endogenous.

2. **Collect Data**: Gather the relevant data, including your dependent variable, explanatory
variables, and instrumental variables.

3. **Specify the IV Model**: Define the instrumental variable (IV) model that includes all the
instruments for your endogenous variable.

4. **Estimate the IV Model**: Use IV estimation techniques (e.g., two-stage least squares) to
estimate the parameters of your IV model.

5. **Calculate Overidentifying Restrictions Test Statistic**: Compute the overidentifying

restrictions test statistic, typically using an appropriate test like the Sargan-Hansen J-test. This
statistic is used to assess the validity of the instruments.

6. **Determine Degrees of Freedom**: Determine the degrees of freedom for your test, which
depend on the number of instruments and the number of endogenous variables.
7. **Conduct the Test**: Compare the calculated test statistic to the critical values from the chi-
squared distribution with the degrees of freedom. Calculate the p-value associated with your test
statistic.

8. **Interpret Results**: Based on the test results, make a decision regarding the null hypothesis.
If you fail to reject the null hypothesis, it suggests that the overidentifying restrictions are valid,
and your instruments are likely exogenous.
9. **Report Findings**: Present your findings, including the test statistic, degrees of freedom, p-
value, and conclusion regarding the validity of the instruments and overidentifying restrictions.

Q4. Now, suppose that the following equation has been estimated by OLS using STATA where
farm size is in hectare, livestock =l if the household has livestock, livestock = 0 otherwise, and
yearly income in logarithm fomm. Calorie is thekilocalorie consumption per day per capita.

Calorie = 4.32 + 2.801 Farm size+ 10.174 Livestock + 140 In Income

p-value: (0.32) (0.035) (0.041) (0.084)
n=209, R'= 0.243

(a) Test that income has a positive impact on calorie consumption using appropriate significance
level.
b) Interpret the coefficient of income variable. Do you think that the positive sign of income is
expected? Why?
c) Suppose that the model in question 4 has omitted variable bias. List any 2 omitted variables
with reason that could be included in this model.
Let's go through each part of your question step by step:

(a) Test that income has a positive impact on calorie consumption using an appropriate significance
level.

To test whether income has a statistically significant positive impact on calorie consumption, you
can use the t-statistic and the p-value associated with the coefficient of the income variable. The
null hypothesis for this test is that the coefficient of the income variable is equal to zero (no impact
on calorie consumption), and the alternative hypothesis is that it is not equal to zero (positive or
negative impact). You should compare the p-value to your chosen significance level (e.g., 0.05 or
0.01).

In your output, the p-value for the income variable is 0.084. Assuming a typical significance level
of 0.05, since 0.084 > 0.05, you would fail to reject the null hypothesis. This means that, at the
0.05 significance level, you do not have enough evidence to conclude that income has a statistically
significant positive impact on calorie consumption. In other words, the effect of income on calorie
consumption may not be significant in this model.

(b) Interpret the coefficient of the income variable. Do you think that the positive sign of income
is expected? Why?

The coefficient of the income variable is 140. This coefficient represents the estimated change in
calorie consumption for a one-unit increase in income while holding all other variables (farm size
and livestock) constant.

In this case, the positive sign of the income coefficient (140) suggests that, on average, an increase
in income is associated with an increase in calorie consumption. This means that as households'
incomes rise, they tend to consume more kilocalories per day per capita.

Whether this positive sign is expected or not depends on the context and theory. In many economic
and nutritional studies, a positive relationship between income and calorie consumption is
expected because higher income allows households to afford a more diverse and nutritionally rich
diet. However, the actual relationship can vary based on factors such as cultural preferences, food
prices, and dietary habits in the specific population being studied. So, the positive sign aligns with
the general expectation, but you would need to consider the broader context to make a definitive
judgment.
(c) Suppose that the model in question has omitted variable bias. List any 2 omitted variables with
reasons that could be included in this model and solve it.

Omitted variable bias occurs when important variables are left out of the regression model, leading
to biased and unreliable coefficient estimates. To address this, you need to identify potential
omitted variables and add them to the model if they are theoretically justified and available. Here
are two possible omitted variables and their reasons:

1. Education Level: The education level of household members can have a significant impact on
both income and calorie consumption. More educated individuals may have higher incomes and a
better understanding of nutrition, leading to different dietary choices. Including education level as
a control variable could help reduce omitted variable bias.

2. Food Prices: The prices of different food items can influence households' dietary choices. For
example, if the prices of healthy foods like fruits and vegetables are high, households with lower
incomes may consume fewer kilocalories and opt for cheaper, less nutritious options. Including
data on food prices in the model could help account for this factor.

After adding these variables to the model, you should re-estimate the regression and assess whether
the coefficients of the existing variables (farm size, livestock, income) change substantially. If they
do, it suggests that the omitted variable bias was affecting the original results, and the new
estimates may provide a more accurate understanding of the relationships between the variables.

Q2. Given that an estimated function of potato production is as follows: log(yield) =

0.0041 + 0.092 Seed + 0.096 Fertilizer – 0.003 Fertilizer2 + 0.022 Irrigation
Yield, seed, and fertilizer in Kg, Irrigation in Tk
a) Find the turning point of using fertilizer in the above equation. Interpret this finding in relation
economic impact
b) Discuss the points that need to be considered while using a quardratic term in an econometric
equation
a) To find the turning point of fertilizer usage in the equation, you need to calculate the derivative
of the yield with respect to fertilizer (Fertilizer) and set it equal to zero. The turning point occurs
where the derivative changes from positive to negative or vice versa. In other words, it's where the
slope of the yield-fertilizer relationship changes.

The estimated function for potato production is:

\[ \log(\text{yield}) = 0.0041 + 0.092 \cdot \text{Seed} + 0.096 \cdot \text{Fertilizer} - 0.003 \cdot
\text{Fertilizer}^2 + 0.022 \cdot \text{Irrigation} \]

To find the turning point, take the derivative of the log(yield) with respect to Fertilizer and set it
equal to zero:

\[ \frac{d}{d\text{Fertilizer}}(\log(\text{yield})) = 0.096 - 0.006 \cdot \text{Fertilizer} = 0 \]

Solving for Fertilizer:

\[ 0.096 - 0.006 \cdot \text{Fertilizer} = 0 \]
\[ 0.006 \cdot \text{Fertilizer} = 0.096 \]
\[ \text{Fertilizer} = \frac{0.096}{0.006} = 16 \text{ Kg} \]

So, the turning point of fertilizer usage is 16 Kg. Now, let's interpret this finding in relation to its
economic impact:

Interpretation: The turning point of 16 Kg of fertilizer represents the level at which the marginal
benefit of using additional fertilizer equals the marginal cost. Below 16 Kg, increasing fertilizer
usage has a positive impact on potato yield, meaning that using more fertilizer increases yield.
Above 16 Kg, increasing fertilizer usage has a negative impact on yield, meaning that using more
fertilizer actually decreases yield. Therefore, farmers should aim to use around 16 Kg of fertilizer
to maximize their potato yield while minimizing input costs.

b) When using a quadratic term in an econometric equation, several points need to be considered:
1. **Interpretability**: Quadratic terms can make the interpretation of coefficients more complex.
In this case, the coefficient of the quadratic term (-0.003) suggests a non-linear relationship
between fertilizer usage and yield.

2. **Economic Theory**: The inclusion of a quadratic term should be theoretically justified. In

this example, it suggests that there may be diminishing returns to fertilizer usage beyond a certain
point, which aligns with agricultural theory.

3. **Data Quality**: Using a quadratic term requires a sufficient range of data points for the
variable of interest. In this case, there should be variation in fertilizer usage across observations to
estimate the quadratic effect accurately.

4. **Model Fit**: It's essential to assess the goodness of fit of the model. Inclusion of a quadratic
term should improve the model's fit compared to a linear model, which can be tested using
statistical criteria like the F-statistic or the adjusted R-squared.

5. **Overfitting**: Be cautious not to overfit the model with higher-order terms. Including too
many quadratic or higher-order terms can lead to an overly complex model that fits the data well
but generalizes poorly to new data.

6. **Econometric Assumptions**: Ensure that the assumptions of your econometric model, such
as linearity, independence of errors, and homoscedasticity, are not violated when including
quadratic terms.

In summary, using quadratic terms in econometric equations can capture non-linear relationships,
but it's important to interpret them carefully, ensure theoretical justification, and assess model fit
and assumptions. The turning point represents a critical threshold beyond which the relationship
changes direction, which can have significant economic implications, as demonstrated in this
example.