Violations of assumptions of the CLRM

Heteroscedasticity of errors
• Heteroscedasticity often occurs in cross-sectional data.

• Consider the case of data on income and expenditure of

individual families.

• Here the assumption of homoscedasticity is not very

plausible since we expect less variation in
consumption for low income families than for high
income families.
• At low levels of income, the average level of
consumption is low and the variation around this level is
restricted:

• consumption can not fall too far below the average

level because this might mean starvation
• it can not rise too far above the average level
because the asset does not allow it

• These constraints are likely to be less binding at higher

income levels.
Consequences heteroscedasticity

• What happens if the errors are heteroscedastic, but this

fact is ignored and we proceed with estimation and
inference using OLS?

• In this case, the OLS estimators will still be unbiased, but

the standard errors could be wrong.

• Hence, any inferences made could be misleading.

Detection of heteroscedasticity

• One possibility is to use a graphical method.

• However, one rarely knows the cause or the form of the

heteroscedasticity from the plot.

• Fortunately, there are a number of formal statistical tests

for heteroscedasticity.
• One problem with WLS is that we need to identify the
regressor that induced heteroscedasticity in order to
perform appropriate linear transformation.

• This difficulty can be resolved by using White’s

heteroscedasticity consistent estimators.

• These estimators are robust to the violation of the

homoscedasticity assumption and thereby help us
perform consistent statistical inference in the face of
heteroscedasticity.
Illustration
Example: The following EViews output pertains to OLS regression
of the rental value (Y) of a random sample of n = 68 commercial
properties on floor area (𝑋2 ) and frontage size of plot (𝑋3 ):

𝑌𝑖 = 𝛽1 + 𝛽2 𝑋2𝑖 + 𝛽3 𝑋3𝑖 + 𝜀𝑖
Heteroscedasticity diagnostics in EViews
To get a scatter plot of the residuals against floor area, click on
Quick and then select Graph…
Type floor_area resid in the box titled Series List (separated by
space)
Click on OK and select Scatter
Click on OK to get a scatter plot of OLS residuals against floor area.
• It can clearly be seen that the scatter of the residuals
(i.e., the variance of the residuals) increases with floor
area.

• This is an indication of a heteroscedasticity problem.

• However, we should not come to a final conclusion

before formal statistical tests.

• One such test is White test.

Click on View in the equation window, select Residual Diagnostics
and then Heteroskedasticity Tests…
Select White. Note that the auxiliary regression to be used in the
test considers all cross-product terms by default.

If you have many regressors and the sample size is small, you
can exclude such terms by unchecking Include White cross
terms box.
The p-values (corresponding to all versions of the test) are
less than 0.05.

Thus, we reject the null hypothesis of homoscedasticity.

• The conventional test of significance (t-test) is invalid
since the disturbances are heteroscedastic.

• One possible solution is to use White’s

heteroscedasticity consistent estimators which are
robust to the violation of the homoscedasticity
assumption.
Click on Quick and then select Estimate Equation…
Type the following under Equation Estimation:

rental_value c floor_area frontage

Click on Options and then select Huber-White
Click on OK to view the fitted model with heteroscedasticity
consistent standard errors
• The value of R-squared and F-statistic are unchanged,
but the standard errors are now larger than those
reported earlier.

• Thus, the OLS standard errors of the coefficient

estimates in the original fitted model were under-
estimated due to heteroscedasticity, leading to inflated t-
ratios.

• This explains why frontage size is now insignificant

(p-value = 0.0519 > 0.05), while it was significant in
the original model.