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Dougherty

Introduction to Econometrics,
5th edition
Chapter heading
Chapter 5: Dummy Variables

© Christopher Dougherty, 2016. All rights reserved.

 TWO SETS OF DUMMY VARIABLES

COST = b1 + dOCC + eRES + b2N + u

The explanatory variables in a regression model may include multiple sets of dummy
variables. This sequence provides an example of a model with two types.

1
 TWO SETS OF DUMMY VARIABLES

COST = b1 + dOCC + eRES + b2N + u

We will continue with the school cost function model and extend it to take account of the
fact that some of the schools are residential.

2
 TWO SETS OF DUMMY VARIABLES

COST = b1 + dOCC + eRES + b2N + u

To model the higher overhead costs of residential schools, we introduce a dummy variable
RES which is equal to 1 for them and 0 for nonresidential schools. e is the extra annual
overhead cost of a residential school, relative to that of a nonresidential one.
3
 TWO SETS OF DUMMY VARIABLES

COST = b1 + dOCC + eRES + b2N + u

We will also make a distinction between occupational and regular schools, using the dummy
variable OCC defined in the first sequence. (It would be better to use the four-category
school classification, and in practice we would, but it would complicate the graphics.)
4
 TWO SETS OF DUMMY VARIABLES

COST = b1 + dOCC + eRES + b2N + u

Regular, nonresidential COST = b1 + b2N + u

(OCC = RES = 0)

If a school has a regular curriculum and is nonresidential, both dummy variables are 0 and
the cost function simplifies to its basic components.

5
 TWO SETS OF DUMMY VARIABLES

COST = b1 + dOCC + eRES + b2N + u

Regular, nonresidential COST = b1 + b2N + u

(OCC = RES = 0)

Regular, residential COST = (b1 + e) + b2N + u

(OCC = 0; RES = 1)

For a residential regular school, RES is equal to 1 and the intercept increases by an amount
e.

6
 TWO SETS OF DUMMY VARIABLES

COST = b1 + dOCC + eRES + b2N + u

Regular, nonresidential COST = b1 + b2N + u

(OCC = RES = 0)

Regular, residential COST = (b1 + e) + b2N + u

(OCC = 0; RES = 1)

Occupational, nonresidential COST = (b1 + d) + b2N + u

(OCC = 1; RES = 0)

Occupational, residential COST = (b1 + d + e) + b2N +

(OCC = 1; RES = 1) u

In the case of a nonresidential occupational school, RES is 0 and OCC is 1, so the overhead
cost increases by d. If the school is both occupational and residential, it increases by ( d +
e).
7
 TWO SETS OF DUMMY VARIABLES

COST
Occupational, residential
Occupational,
nonresidential
e Regular,
residential
b1+d +e d d +e
b1+d
e
b1+e
b1 Regular, nonresidential

The diagram illustrates the model graphically. Note that the effects of the different
components of the model are assumed to be separate and additive in this specification.

8
 TWO SETS OF DUMMY VARIABLES

COST
Occupational, residential
Occupational,
nonresidential
e Regular,
residential
b1+d +e d d +e
b1+d
e
b1+e
b1 Regular, nonresidential

In particular, we are assuming that the extra overhead cost of a residential school is the
same for regular and occupational schools.

9
 TWO SETS OF DUMMY VARIABLES

School Type Residential? COST  N  OCC RES

1 Occupational No 345,000 623 1 0

2 Occupational Yes 537,000 653 1 1
3 Regular No 170,000 400 0 0
4 Occupational Yes 526.000 663 1 1
5 Regular No 100,000 563 0 0
6 Regular No 28,000 236 0 0
7 Regular Yes 160,000 307 0 1
8 Occupational No 45,000 173 1 0
9 Occupational No 120,000 146 1 0
10 Occupational No 61,000 99 1 0

Here are the data for the first 10 schools. Note how the values of the dummy variables vary
according to the characteristics of the school.

10
 TWO SETS OF DUMMY VARIABLES

COST
600000

500000

400000

300000

200000

100000

0
0 200 400 600 800 1000 1200 N
-100000

Nonresidential regular Residential regular

Nonresidential occupational Residential occupational

Here is a scatter diagram showing the four types of school.

11
 TWO SETS OF DUMMY VARIABLES

. reg COST N OCC RES

Source | SS df MS Number of obs = 74

---------+------------------------------ F( 3, 70) = 40.43
Model | 9.3297e+11 3 3.1099e+11 Prob > F = 0.0000
Residual | 5.3838e+11 70 7.6911e+09 R-squared = 0.6341
---------+------------------------------ Adj R-squared = 0.6184
Total | 1.4713e+12 73 2.0155e+10 Root MSE = 87699

------------------------------------------------------------------------------
COST | Coef. Std. Err. t P>|t| [95% Conf. Interval]
---------+--------------------------------------------------------------------
N | 321.833 39.40225 8.168 0.000 243.2477 400.4183
OCC | 109564.6 24039.58 4.558 0.000 61619.15 157510
RES | 57909.01 30821.31 1.879 0.064 -3562.137 119380.2
_cons | -29045.27 23291.54 -1.247 0.217 -75498.78 17408.25
------------------------------------------------------------------------------

Here is the Stata output for the regression. We will start by interpreting the regression
coefficients. The coefficient of N indicates that the marginal cost per student is 322 yuan
per year.
12
 TWO SETS OF DUMMY VARIABLES

. reg COST N OCC RES

Source | SS df MS Number of obs = 74

---------+------------------------------ F( 3, 70) = 40.43
Model | 9.3297e+11 3 3.1099e+11 Prob > F = 0.0000
Residual | 5.3838e+11 70 7.6911e+09 R-squared = 0.6341
---------+------------------------------ Adj R-squared = 0.6184
Total | 1.4713e+12 73 2.0155e+10 Root MSE = 87699

------------------------------------------------------------------------------
COST | Coef. Std. Err. t P>|t| [95% Conf. Interval]
---------+--------------------------------------------------------------------
N | 321.833 39.40225 8.168 0.000 243.2477 400.4183
OCC | 109564.6 24039.58 4.558 0.000 61619.15 157510
RES | 57909.01 30821.31 1.879 0.064 -3562.137 119380.2
_cons | -29045.27 23291.54 -1.247 0.217 -75498.78 17408.25
------------------------------------------------------------------------------

The constant provides an estimate of the annual overhead cost of the reference category,
nonresidential regular schools. It is still negative, which does not make any sense.

13
 TWO SETS OF DUMMY VARIABLES

. reg COST N OCC RES

Source | SS df MS Number of obs = 74

---------+------------------------------ F( 3, 70) = 40.43
Model | 9.3297e+11 3 3.1099e+11 Prob > F = 0.0000
Residual | 5.3838e+11 70 7.6911e+09 R-squared = 0.6341
---------+------------------------------ Adj R-squared = 0.6184
Total | 1.4713e+12 73 2.0155e+10 Root MSE = 87699

------------------------------------------------------------------------------
COST | Coef. Std. Err. t P>|t| [95% Conf. Interval]
---------+--------------------------------------------------------------------
N | 321.833 39.40225 8.168 0.000 243.2477 400.4183
OCC | 109564.6 24039.58 4.558 0.000 61619.15 157510
RES | 57909.01 30821.31 1.879 0.064 -3562.137 119380.2
_cons | -29045.27 23291.54 -1.247 0.217 -75498.78 17408.25
------------------------------------------------------------------------------

The coefficient of OCC indicates that the annual overhead costs of occupational schools
are 110,000 yuan more than those of regular schools.

14
 TWO SETS OF DUMMY VARIABLES

. reg COST N OCC RES

Source | SS df MS Number of obs = 74

---------+------------------------------ F( 3, 70) = 40.43
Model | 9.3297e+11 3 3.1099e+11 Prob > F = 0.0000
Residual | 5.3838e+11 70 7.6911e+09 R-squared = 0.6341
---------+------------------------------ Adj R-squared = 0.6184
Total | 1.4713e+12 73 2.0155e+10 Root MSE = 87699

------------------------------------------------------------------------------
COST | Coef. Std. Err. t P>|t| [95% Conf. Interval]
---------+--------------------------------------------------------------------
N | 321.833 39.40225 8.168 0.000 243.2477 400.4183
OCC | 109564.6 24039.58 4.558 0.000 61619.15 157510
RES | 57909.01 30821.31 1.879 0.064 -3562.137 119380.2
_cons | -29045.27 23291.54 -1.247 0.217 -75498.78 17408.25
------------------------------------------------------------------------------

The coefficient of RES indicates that the annual overhead costs of residential schools are
58,000 yuan greater than those of nonresidential schools.

15
 TWO SETS OF DUMMY VARIABLES

^ = –29,000 + 110,000OCC + 58,000RES + 322N

COST

Regular, nonresidential ^
COST = –29,000 + 322N
(OCC = RES = 0)

The regression result is shown at the top in equation form. Putting both dummy variables
equal to 0, we obtain the implicit cost function for nonresidential regular schools.

16
 TWO SETS OF DUMMY VARIABLES

^ = –29,000 + 110,000OCC + 58,000RES + 322N

COST

Regular, nonresidential ^
COST = –29,000 + 322N
(OCC = RES = 0)

Regular, residential ^
COST = –29,000 + 58,000 + 322N
(OCC = 0; RES = 1) = 29,000 + 322N

Putting RES equal to 1, but keeping OCC at 0, we obtain the cost function for residential
regular schools.

17
 TWO SETS OF DUMMY VARIABLES

^ = –29,000 + 110,000OCC + 58,000RES + 322N

COST

Regular, nonresidential ^
COST = –29,000 + 322N
(OCC = RES = 0)

Regular, residential ^
COST = –29,000 + 58,000 + 322N
(OCC = 0; RES = 1) = 29,000 + 322N
^
Occupational, nonresidential COST = –29,000 + 110,000 + 322N
(OCC = 1; RES = 0) = 81,000 + 322N

Occupational, residential ^
COST = –29,000 + 110,000 + 58,000 + 322N
(OCC = 1; RES = 1) = 139,000 + 322N

And similarly the cost functions for nonresidential and residential occupational schools are
derived by putting OCC equal to 1 and RES equal to 0 and 1, respectively.

18
 TWO SETS OF DUMMY VARIABLES

COST
600000
O, R
500000 O, N
R, R
400000 R, N

300000

200000

100000

0
0 200 400 600 800 1000 1200 N
-100000

Nonresidential regular Residential regular

Nonresidential occupational Residential occupational

Here is the scatter diagram with the four cost functions implicit in the regression result.

19
 TWO SETS OF DUMMY VARIABLES

. reg COST N OCC RES

Source | SS df MS Number of obs = 74

---------+------------------------------ F( 3, 70) = 40.43
Model | 9.3297e+11 3 3.1099e+11 Prob > F = 0.0000
Residual | 5.3838e+11 70 7.6911e+09 R-squared = 0.6341
---------+------------------------------ Adj R-squared = 0.6184
Total | 1.4713e+12 73 2.0155e+10 Root MSE = 87699

------------------------------------------------------------------------------
COST | Coef. Std. Err. t P>|t| [95% Conf. Interval]
---------+--------------------------------------------------------------------
N | 321.833 39.40225 8.168 0.000 243.2477 400.4183
OCC | 109564.6 24039.58 4.558 0.000 61619.15 157510
RES | 57909.01 30821.31 1.879 0.064 -3562.137 119380.2
_cons | -29045.27 23291.54 -1.247 0.217 -75498.78 17408.25
------------------------------------------------------------------------------

t tests and F tests can be performed in the usual way. The coefficient of the occupational
school dummy variable is significantly different from 0 at the 0.1% significance level.

20
 TWO SETS OF DUMMY VARIABLES

. reg COST N OCC RES

Source | SS df MS Number of obs = 74

---------+------------------------------ F( 3, 70) = 40.43
Model | 9.3297e+11 3 3.1099e+11 Prob > F = 0.0000
Residual | 5.3838e+11 70 7.6911e+09 R-squared = 0.6341
---------+------------------------------ Adj R-squared = 0.6184
Total | 1.4713e+12 73 2.0155e+10 Root MSE = 87699

------------------------------------------------------------------------------
COST | Coef. Std. Err. t P>|t| [95% Conf. Interval]
---------+--------------------------------------------------------------------
N | 321.833 39.40225 8.168 0.000 243.2477 400.4183
OCC | 109564.6 24039.58 4.558 0.000 61619.15 157510
RES | 57909.01 30821.31 1.879 0.064 -3562.137 119380.2
_cons | -29045.27 23291.54 -1.247 0.217 -75498.78 17408.25
------------------------------------------------------------------------------

However, the t ratio for the coefficient of RES is only 1.87. Fortunately we may perform a
one-sided test (why?), so it is significantly different from 0 at the 5% level (but not the 1%
level).
21
Copyright Christopher Dougherty 2016.

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Introduction to Econometrics, fifth edition 2016, Oxford University Press.
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2016.05.03