Econometrics – II

BA (H) Econ Core– Spring, 2024 (February to May)

Chapter 9: More on specification and data issues

Wooldridge, J.M. (2015) Introductory Econometrics, 6e

Tirtha Chatterjee
Topics we cover

• What is functional form misspecification or model misspecification

• Tests to detect model misspecification
• Nested and non-nested models
• Drawbacks with the methods
• Functional mis-specification because of Omission of variables
• Using proxy variables
• Measurement Error in dependent and explanatory variables
• Missing Data
• Outliers or Outlying observations

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Functional form misspecification

• Occurs when we do not account for the relationship b/w dependent and observed
explanatory variables
• Can be because of omitting important explanatory variables
• Also, can be because of wrong functional form of the dependent variable
• Say we use wage instead of log(wage)
• Biased estimators

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Misspecification because of Omission

• Example- suppose hourly wage is determined by

log 𝑤𝑎𝑔𝑒 = 𝛽! + 𝛽"𝑒𝑑𝑢𝑐 + 𝛽#𝑒𝑥𝑝𝑒𝑟 + 𝛽$𝑒𝑥𝑝𝑒𝑟 # + 𝑢
• but we omit 𝑒𝑥𝑝𝑒𝑟 #, then we are committing a functional form misspecification.
• biased estimators of all parameters
• Could arise from omitting any other variable – say some interaction variable
• Could be 𝑒𝑥𝑝𝑒𝑟* 𝑒𝑑𝑢𝑐

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Misspecification because of Omission- nested models

• F test for joint exclusion restrictions can be used to detect functional form
misspecification
• Sometimes difficult to pinpoint the precise reason for the misspecification
• Regression Specification Error Test- RESET (Ramsey, 1969)

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RESET

• Useful to detect general functional form misspecification

• Say the original model to be estimated is
𝑦 = 𝛽! + 𝛽"𝑥" + 𝛽#𝑥# + ⋯ + 𝛽% 𝑥% + 𝑢
• RESET is implemented to test if we should include non-linear or higher order terms in
our model
• RESET adds polynomials of fitted values to equation to detect general kinds of
functional form misspecification.
• To implement RESET, we must decide how many functions of the fitted values to include in an
expanded regression.
• There is no right answer to this question, but the squared and cubed terms have proven to be useful
in most applications.

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RESET - Implementation

• First, we estimate our original model-𝑦 = 𝛽! + 𝛽"𝑥" + 𝛽#𝑥# + ⋯ + 𝛽% 𝑥% + 𝑢

• Let 𝑦3 denote the OLS fitted values.
• Next ,we regress y on 𝑥" … 𝑥% , 𝑦3 #, 𝑦3 $
• 𝑦( ! and 𝑦( " are just nonlinear functions of the 𝑥#
• The expanded/auxiliary regression is
𝑦 = 𝛽! + 𝛽"𝑥" + 𝛽#𝑥# + ⋯ + 𝛽% 𝑥% + 𝛿"𝑦3 # + 𝛿#𝑦3 $ + 𝑣
• We are not interested in the estimated parameters
• We only use this equation to test whether original model has missed important
nonlinearities.

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RESET - Implementation

• The null hypothesis is that original model is correctly specified.

• 𝐻$ : 𝛿% = 0, 𝛿! = 0
• RESET is the F statistic for testing the null
• A significant F statistic suggests some sort of functional form problem.
• the test can be made robust to heteroskedasticity using the methods discussed in Chapter 8

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RESET- example
• We estimate two models for housing prices- sample size= 88
• The first one has all variables in level form:
𝑝𝑟𝑖𝑐𝑒 = 𝛽$ + 𝛽% 𝑙𝑜𝑡𝑠𝑖𝑧𝑒 + 𝛽! 𝑠𝑞𝑟𝑓𝑡 + 𝛽" 𝑏𝑑𝑟𝑚𝑠 + 𝑢
• The second one uses the logarithms of all variables except bdrms:
𝑙𝑝𝑟𝑖𝑐𝑒 = 𝛽$ + 𝛽% 𝑙𝑙𝑜𝑡𝑠𝑖𝑧𝑒 + 𝛽! 𝑙𝑠𝑞𝑟𝑓𝑡 + 𝛽" 𝑏𝑑𝑟𝑚𝑠 + 𝑢
• First model
• F statistics for the first model- 𝐹!,'! = 4.67, p = 0.012
• We reject the null hypothesis at 5% level of significance- evidence of misspecification
• Second model
• F statistics for the second model- 𝐹!,'! = 2.56, p = 0.084
• We do not reject the null hypothesis at 5% level of significance- no evidence of misspecification
• On the basis of RESET- log-log/ second model is preferred specification

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RESET- drawback

• It does not provide any direction on how to proceed if the model is rejected.
• In our previous example, when the first model was rejected, we could think of log-log model
because it is easy to interpret
• In this example, it so happens that it passes the functional form test as well.
• We might not be so lucky all the time- What if the second model got rejected too?
• RESET has no power for detecting omitted variables which are linear
• The bottom line is that RESET is a functional form test, and nothing more.

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Non-nested models

• Following are two non-nested models

𝑦 = 𝛽$ + 𝛽% 𝑥% + 𝛽! 𝑥! + 𝑢

𝑦 = 𝛽$ + 𝛽% log(𝑥% ) + 𝛽! log(𝑥! ) + 𝑢
• We cannot simply use a standard F test.
• Two approaches have been suggested.
• Mizon and Richard (1986)
• Davidson-MacKinnon test

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First approach-Mizon and Richard (1986)- Implementation

• Steps
• First construct a comprehensive model that contains each model as a special case and
• then test the restrictions that led to each of the models.
• The comprehensive model is
𝑦 = 𝛾! + 𝛾"𝑥" + 𝛾#𝑥# + 𝛾$log(𝑥") + 𝛾&log(𝑥#) + 𝑢
• We can first test H0: 𝛾$= 0, 𝛾& = 0 as a test of the first model
• We can also test H0: 𝛾" = 0, 𝛾#= 0 as a test of second model.

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Second approach-Davidson-MacKinnon test

• If the 1st model holds with E(u| 𝑥", 𝑥#) = 0, then fitted values from 2nd model should
be insignificant when added to the first model
• Therefore, to test whether first model is the correct model, we first estimate 2nd model
by OLS to obtain the fitted values; call these 𝑦.
<
• 𝑦I are just nonlinear functions of 𝑥% and 𝑥!
• Then estimate this auxiliary regression
𝑦 = 𝛽$ + 𝛽% 𝑥% + 𝛽! 𝑥! + 𝜃% 𝑦I + 𝑒𝑟𝑟𝑜𝑟
• Davidson-MacKinnon test is obtained from the t-stat on 𝑦< from this auxiliary
regression
• Significant t-test means rejection of first model

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Second approach-Davidson-MacKinnon test

• The same thing can be done to test if the second model is correctly specified
• We estimate the first model and then the fitted values are used as regressors in the
second model.
• A significant t test is a rejection of our hypothesis
• This approach can be followed for testing any 2 non-nested models with the same
dependent variable

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Problems with testing non-nested alternatives

• First, a clear winner need not emerge.

• Both models could be rejected or neither model could be rejected.
• If neither model is rejected, we can use the adjusted R-squared to choose between them.
• If both models are rejected, more work needs to be done.
• A second problem is that rejecting the first model does not directly imply that second
is correct
• First model can be rejected for a variety of functional form misspecifications.

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Functional form misspecification- omission of key variables

• Omission of key explanatory variables could be because of data unavailability

• Suppose we want to estimate the following model & estimate : 𝛽"& 𝛽#

log 𝑤𝑎𝑔𝑒 = 𝛽$ + 𝛽% 𝑒𝑑𝑢𝑐 + 𝛽! 𝑒𝑥𝑝𝑒𝑟 + 𝛽" 𝑎𝑏𝑖𝑙 + 𝑢

• Now, it is very difficult to collect data for ability
• And educ is correlated with ability
• Putting ability in the error term causes the OLS estimator of 𝛽" (and 𝛽#) to be biased
• This is nothing but omitted variable bias
• Possible solution is to use proxy variables for omitted variable

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Proxy variables

• Proxy variable is something that is related to the unobserved variable that we would
like to control for in our analysis.
• One proxy could be IQ
• IQ does not have to be the same thing as ability;
• what we need is for IQ to be correlated with ability
• Let us estimate the following model- 𝑦 = 𝛽! + 𝛽"𝑥" + 𝛽#𝑥# + 𝛽$𝑥$∗ + 𝑢
• We assume that data are available on y, 𝑥", and 𝑥#
• The explanatory variable 𝑥$∗ is unobserved, but we have a proxy variable for 𝑥$∗
• Let us call the proxy variable 𝑥$.
• In our example, 𝑥$∗ is ability and 𝑥$ is IQ

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Using proxy variables for unobserved explanatory variables

• What do we require of 𝑥$(proxy variable)?

• First, it should have some relationship to 𝑥$∗ (unobserved explanatory variable).
• This is captured by the simple regression equation
𝑥$∗ = 𝛿! + 𝛿$𝑥$ + 𝑣$
• Where 𝑣$ is an error because 𝑥$∗ and 𝑥$ are not exactly related
• Parameter 𝛿$measures the relationship b/w 𝑥$∗ and 𝑥$
• If 𝛿" >0, 𝑥"∗ and 𝑥" are positively related, if >0, then negatively related.
• If 𝛿" =0, then 𝑥" is not a suitable proxy for 𝑥"∗

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Using proxy variables for unobserved explanatory variables

• How can we use 𝑥$ to get unbiased (or at least consistent) estimators of 𝛽"& 𝛽#?
• We can plug in 𝑥$ for 𝑥$∗ & run the regression of y on 𝑥", 𝑥#, 𝑥$.
• We call this the plug-in solution to the omitted variables problem
• because 𝑥" is just plugged in for 𝑥"∗ before we run OLS.
• If 𝑥$ is truly related to 𝑥$∗ , this seems like a sensible thing.
• However, since 𝑥$ and 𝑥$∗ are not the same, we need some assumptions

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Assumptions needed for the plug-in solution to work

𝑦 = 𝛽! + 𝛽" 𝑥" + 𝛽# 𝑥# + 𝛽$ 𝑥$∗ + 𝑢

𝑥$∗ = 𝛿! + 𝛿$ 𝑥$ + 𝑣$
• (1) 𝐸(𝑢|𝑥", 𝑥#, 𝑥$∗, 𝑥$) = 0 - The error u is uncorrelated with 𝑥", 𝑥# 𝑎𝑛𝑑 𝑥$∗ & and 𝑥$
• 𝐸(𝑢|𝑥% , 𝑥! , 𝑥"∗ )=0 is standard assumption of the model we want to estimate
• In addition, u is uncorrelated with 𝑥" . This means that 𝑥" is irrelevant in the population model, once
𝑥% , 𝑥! , 𝑥"∗ have been included. 𝑥" is a proxy for 𝑥"∗ . It is 𝑥"∗ that directly affects y and not 𝑥"
• (2) The error 𝑣$is uncorrelated with 𝑥", 𝑥#, and 𝑥$.
• 𝑣" is uncorrelated with 𝑥% 𝑎𝑛𝑑 𝑥! requires 𝑥" to be a “good” proxy for 𝑥"∗
• In terms of conditional expectations.
𝐸(𝑥"∗ | 𝑥% , 𝑥! , 𝑥" ) = 𝐸(𝑥"∗ | 𝑥" )=𝛿$ + 𝛿" 𝑥"
• Once 𝑥" is controlled for, the expected value of 𝑥"∗ does not depend on 𝑥% or 𝑥! .
• Alternatively, 𝑥"∗ has zero correlation with 𝑥% and 𝑥! once 𝑥" is partialled out.

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Proxy variable
𝑦 = 𝛽! + 𝛽"𝑥" + 𝛽#𝑥# + 𝛽$𝑥$∗ + 𝑢
𝑥$∗ = 𝛿! + 𝛿$𝑥$ + 𝑣$
• If we substitute 𝑥$ for 𝑥$∗ and do simple algebra, we get
𝑦 = 𝛽! + 𝛽$𝛿! + 𝛽"𝑥" + 𝛽#𝑥#+ 𝛽$𝛿$𝑥$+u+ 𝛽$𝑣$
• Composite error in this equation 𝑒 = 𝑢 + 𝛽$𝑣$- It depends on u and 𝑣$
• Write this equation as 𝑦 = 𝛼! + 𝛽"𝑥" + 𝛽#𝑥#+ 𝛼$𝑥$+e
• where 𝛼$ = 𝛽$ + 𝛽" 𝛿$ and 𝛼" = 𝛽" 𝛿" is the slope parameter on the proxy variable 𝑥"
• e has zero mean and is uncorrelated with 𝑥", 𝑥#, and 𝑥$
• Since u and 𝑣" both have zero mean and each is uncorrelated with 𝑥% , 𝑥! , and 𝑥"
• The estimated model – regressing y on 𝑥" 𝑥# & 𝑥$will get unbiased (or at least
consistent) estimators of 𝛼!, 𝛽", 𝛽# and 𝛼$.

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Including a proxy could exacerbate problem of multicollinearity

• For example, Including variable like IQ as a proxy for ability in a regression that
includes educ
• But there are advantages
• First, the inclusion of IQ reduces the error variance because the part of ability explained by IQ has
been removed from the error- Reflected in a smaller standard error of the regression
• Second, the added multicollinearity is a necessary evil if we want to get an unbiased estimator of
educ
• There could be increase in multicollinearity even if we had data on ability and had included it in the
model
• Ultimately, it is a trade-off

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Using lagged dependent variable as proxy variables

• Sometimes we suspect that some of the x variables could be correlated with the error
but we are not aware of a good proxy
• In those cases, we can use observed dependent variable from a previous time point as
a proxy
• Lagged dependent variable
• Using past values increases data requirements but it is a way to account for historical
factors that could have an impact on the present
• Consider a simple equation to explain city crime rates:
𝑐𝑟𝑖𝑚𝑒 = 𝛽$ + 𝛽% 𝑢𝑛𝑒𝑚 + 𝛽! 𝑒𝑥𝑝𝑒𝑛𝑑 + 𝛽" 𝑐𝑟𝑖𝑚𝑒)% + 𝑢
• where crime is a measure of per capita crime, unem is the city unemployment rate, expend is per
capita spending on law enforcement, and 𝑐𝑟𝑖𝑚𝑒)% indicates the crime rate measured in some earlier
year (this could be the past year or several years ago).

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Using lagged dependent variable as proxy variables

• We want to find the effects of unemployment and law enforcement expenditures on

crime rate in the city
• We expect that 𝛽$> 0 because crime has inertia.
• What is the purpose of including 𝑐𝑟𝑖𝑚𝑒1" in the equation?
• Cities with high historical crime rates may spend more on crime prevention.
• Cities with higher historical crime rates may have effects on unemployment
• Engaged in criminal activities and not labour market

• Thus, factors unobserved to us (the econometricians) that affect crime are likely to be
correlated with expend (and unem).
• Using cross-sectional data is unlikely to give us unbiased estimator of causal effect of law
enforcement expenditure on crime

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Measurement error

• When we use an imprecise measure of an economic variable in a regression model,

then our model contains measurement error.
• Some reasons for measurement error
• Recorded measures might contain error- For example- reported annual income is a measure of
actual annual income but generally people do not report it correctly
• Coding errors, rounding errors, imprecise data collection, imperfect proxy
• Measurement error can be both in the dependent variable or the independent variable
or both
• We will study the consequences of measurement error for ordinary least squares
estimation.

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Measurement error in dependent variable

• Let 𝑦 ∗ denote the variable that we would like to explain- say, annual family savings.
• The regression model has the usual form
𝑦 ∗ = 𝛽! + 𝛽"𝑥" + ⋯ + 𝛽% 𝑥% + 𝑢
• and we assume it satisfies the Gauss-Markov assumptions.
• Say there is measurement error in 𝑦 ∗ or we do not measure it correctly
• Let y represent the observable measure of 𝑦 ∗ . In the savings case, y is reported annual
savings.
• Unfortunately, families are not perfect in their reporting of annual family savings

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Measurement error in dependent variable

• Measurement error is the difference between the observed value and the actual value:
𝑒! = 𝑦 − 𝑦 ∗
• important thing is how the measurement error in the population is related to other
factors.
• To obtain an estimable model, we plug 𝑦 ∗ = 𝑦 − 𝑒! into equation, and rearrange:
y = 𝛽! + 𝛽"𝑥" + ⋯ + 𝛽% 𝑥% + 𝑢 + 𝑒!
• The error term is 𝑢 + 𝑒!. We estimate this model by OLS.

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Measurement error in dependent variable

• We can estimate the model using OLS and ignore measurement error if 𝑒! also has
zero mean like u and is uncorrelated with each 𝑥2 .
• Biased estimators for the intercept if measurement error doesn’t have zero mean
• If we assume corr(x, 𝑒$ )=0, then no endogeneity and OLS estimators are unbiased and consistent.
• Measurement error in dependent variable results in larger variances of the OLS
estimators.
• Since, if 𝑒$ and u are uncorrelated, then 𝑉𝑎𝑟 𝑢 + 𝑒$ = 𝜎*! + 𝜎$! > 𝜎*! .
• Basically, if the measurement error is uncorrelated with the independent variables,
then OLS estimation has good properties.
• Otherwise, endogeneity and biased estimates

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Measurement error in explanatory variable

• Much more serious problem compared to measurement error in dependent variable.

𝑦 = 𝛽! + 𝛽"𝑥"∗ + 𝑢
• The problem is that 𝑥"∗ is not observed. Instead, we have a measure of 𝑥"∗ ; call it 𝑥".
• For example, 𝑥%∗ could be actual income and 𝑥% could be reported income
• The measurement error in the population is 𝑒" = 𝑥" − 𝑥"∗
• This can be positive, negative, or zero.
• We assume that
• average measurement error in the population is zero: E(𝑒% ) = 0.
• 𝐸(𝑦|𝑥%∗, 𝑥% ) = 𝐸(𝑦|𝑥%∗), which just says that 𝑥% does not affect y after 𝑥%∗ has been controlled for.

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Measurement error in explanatory variable

• We can estimate OLS model by plugging in 𝑥" in place of 𝑥"∗

𝑦 = 𝛽! + 𝛽" 𝑥" − 𝑒" + 𝑢

𝑦 = 𝛽! + 𝛽"𝑥" + (𝑢 − 𝛽" 𝑒")
𝑦 = 𝛽! + 𝛽"𝑥" + 𝑢G
• But additional assumptions required for OLS to have good properties
• The first assumption is that 𝑒% is uncorrelated with the observed measure, 𝑥% : 𝐶𝑜rr(𝑥% , 𝑒% ) = 0
• If this is true, then 𝑒% must be uncorrelated with 𝑥%∗ - Classical errors-in-variables (CEV)
assumption

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Classical errors-in-variables (CEV) assumption

• Measurement error is uncorrelated with the unobserved explanatory variable (𝑥"∗ )-

𝐶𝑜rr(𝑥"∗ , 𝑒") = 0
• But 𝑒" = 𝑥" − 𝑥"∗
• Thus CEV implies that 𝑒" is correlated with the observed measure, 𝑥"
• Thus, even with CEV, OLS regression of y on 𝑥" gives a biased and inconsistent
estimator- with cov(𝑥", composite error ) ≠ 0

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Missing data
• Can arise because of various reasons- collected information & later saw some info
missing
• Will reduce the sample size
• Are there any statistical consequences of using the OLS estimator and ignoring the
missing data?
• No statistical problem if the data are missing completely at random (MCAR)
• If MCAR- then units which have all data are not systematically different from those which don’t
• Reason for missing data is is independent, in a statistical sense
• Don’t replace missing with Zeros- can cause substantial bias in the OLS estimators.
• For MCAR-, one could create a dummy variable –missing data indicator
• which equals the actual data from variable, and zero if the data is missing
• All the variables including this new dummy variable is included in the regression

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Missing data- Non random samples

• Say the missing data is not random

• For example
• individuals with higher income do not report their savings/income
• Or say in the birth weight data set, probability that education is missing is higher for those people
with lower than average levels of education
• The random sampling assumption MLR.2 is violated, and we must worry about these
consequences for OLS estimation.
• Sample selection two types- exogenous and endogenous

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Exogenous sample selection

• When sample is selected on the basis of independent variables

• Example- Suppose that we are estimating a saving function,
𝑠𝑎𝑣𝑖𝑛𝑔 = 𝛽! + 𝛽"𝑖𝑛𝑐𝑜𝑚𝑒 + 𝛽#𝑎𝑔𝑒 + 𝛽$𝑠𝑖𝑧𝑒 + 𝑢
• Data set comprises of survey of people over 35 years age
• This is nonrandom sample of adults- but is a case of exogenous sample selection
• We can still get unbiased and consistent estimators of the parameters in the population
model using the nonrandom sample
• E(saving|income,age,size) is the same for any subset of the population described by income, age, or
size.
• Not so serious problem if there is enough variation in the independent variables

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Endogenous sample selection

• Sample selection is based on the dependent variable

• For example, suppose we wish to estimate the relationship between individual wealth
and several other factors in the population of all adults:
𝑤𝑒𝑎𝑙𝑡ℎ = 𝛽! + 𝛽"𝑒𝑑𝑢𝑐 + 𝛽#𝑒𝑥𝑝𝑒𝑟 + 𝛽$𝑎𝑔𝑒 + 𝑢
• Suppose that only people with wealth below $250,000 are included in the sample.
• This is a nonrandom sample from the population of interest, and it is based on the
value of the dependent variable.
• This will result in biased and inconsistent estimators of the parameters in
• Because the population regression E(wealth|educ,exper,age) is not the same as the
expected value conditional on wealth being less than $250,000.

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Outliers

• Outlying observations can occur for two reasons.

• Mistake has been made in entering the data. Adding extra zeros to a number or misplacing a decimal point can
throw off the OLS estimates.
• Outliers can also arise when sampling from a small population if one or several members of the population are
very different in some relevant aspect from the rest of the population.
• OLS is susceptible to outlying observations because it minimizes the sum of squared
residuals
• Least Absolute Deviations (LAD) method of estimation less sensitive to outliers

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Least Absolute Deviation estimators

• The LAD estimators of the 𝛽2 in a linear model minimize the sum of the absolute
values of the residuals
• LAD does not give increasing weight to larger residuals
• it is much less sensitive to changes in the extreme values of the data than OLS.
• LAD is designed to estimate the parameters of the conditional median of y given
explanatory variables rather than the conditional mean.
• Because the median is not affected by large changes in the extreme observations, it
follows that the LAD parameter estimates are more resilient to outlying observations.

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What to do in case of outliers?

• We can report and compare results with and without outliers

• Differentially weight observations based on outlier quality (robust regression)
• Formal approach of dealing with outliers beyond the scope of this course
• Excluding outliers might not be the best approach
• statistical properties of the resulting estimators are complicated.
• Outlying observations can provide important information by increasing the variation in the
explanatory variables

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