Functional Forms of Linear Regression

Models

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 Functional Forms of Regression Models

• Until now, we have considered models that were linear in parameters as well as in
variables.

• But for regression models to be called as linear, only requirement is linearity in

parameters; the Y and X variables do not necessarily have to be linear.

• There are many economic phenomena for which the linear-in-variables regression models
may not be adequate or appropriate.

• In this chapter, we consider some commonly used regression models that may be
nonlinear in the variables but are linear in the parameters or that can be made so by
suitable transformations of the variables.

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 Functional Forms of Regression Models

S
X and Y are linear

X and Y are in logratithmic form

logarithmic form
Y is logarithmic, X is
linear
Y is linear, X is
l``````````````````````````````````````````````````````````````````````` logarithmic
X is in inverse form

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 Log-Linear or Double Log Model
Consider the Cobb-Douglas Production Function:
 

Here Q = output, L = labour input, K = capital and is a constant

This model is non-linear in parameters and to estimate it as it stands requires non-linear

estimation techniques. However, if we take the (natural) log of this function:

Let
Therefore,
The model now becomes linear in parameters although it is non-linear in variables Q, L
and K.
Adding the error term to this equation, the linear regression model becomes:

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 Interpretation of Slope Coefficients in Log Linear
Models
  A key feature of the log linear or double log models is that the slope coefficients can
be interpreted as elasticities.

Here,
Therefore, is the partial elasticity of output with respect to the labour input, holding
all other variables constant (here Capital).

Also,

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 Interpretation of Slope Coefficients in Log Linear
Models
 

• Similarly, gives the (partial) elasticity of output with respect to the capital input,
holding all other inputs constant.

• Since these elasticities are constant over the range of observations, the double-log
model is also known as a constant elasticity model.

• An advantage of elasticities is that they are pure numbers, that is, devoid of units in
which the variables are measured, such as dollars, person-hours, or capital-hours,
because they are ratios of percentage changes.

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 Illustration of Log Linear Model

• Data from Econometrics by Example textbook

• The database has data on output (as measured by value added, in thousands of dollars),
labour input (worker hours, in thousands), and capital input (capital expenditure, in
thousands of dollars) for the US manufacturing sector.

• The data is cross-sectional, covering 50 states and Washington, DC, for the year 2005.

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 Illustration of Log Linear Model

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 Interpretation of Regression Results
• The first point to notice is that all the regression coefficients (i.e. elasticities) are
individually statistically highly significant, for their p values are quite low (less than
0.05).

• Secondly, on the basis of the F statistic we can also conclude that collectively the two
factor inputs, labor and capital, are highly statistically significant, because its p value
is also very low.

• The R2 value of 0.96 is also quite high.

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 Interpretation of Regression Results

• The interpretation of the coefficient of LLABOUR of about 0.47 is that if we increase

the labor input by 1 %, on average, output goes up by about 0.47 %, holding the
capital input constant.
• Similarly, holding the labor input constant, if we increase the capital input by 1%, on
average, the output increases by about 0.52 %.
• Relatively speaking, it seems a percentage increase in the capital input contributes
more towards the output than a percentage increase in the labor input.
• The original production function is as follows:
• Qi = 48.79 L0.47 K0.51
• Note: 48.79 is approximately the anti-log of 3.8876.
• The sum of the two slope coefficients is about 0.9896, which is close to 1. This would
suggest that the US Cobb-Douglas production function was characterized by constant
returns to scale in 2005.
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 Linear Production Function
  • Although the double-log specification of the Cobb-Douglas production function is
standard in the literature, for comparative purposes we also present the results of the
linear production function, namely,

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 Interpretation of Regression Results
• The labor and capital coefficients in this regression are statistically highly significant.

• If labor input increases by a unit, the average output goes up by about 48 units,
holding capital constant.

• Similarly, if capital input goes up by a unit, output, on average, goes up by about 10

units, ceteris paribus.

• Notice that the interpretations of the slope coefficients in the log-linear production
function and those in the linear production function are different.

• We cannot compare the R2 values of the two models, because to compare the R2s of
any two models the dependent variable must be the same in the two models.

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 Testing Validity of Linear Restrictions
  • The log-linear Cobb-Douglas production function fitted to the production data showed
that the sum of the output-labor and output-capital elasticities is 0.9896, which is
about 1. This would suggest that there were constant returns to scale.
• How do we test this explicitly?

Formal Test for Linear Restrictions: F Test

• is an example of a linear restriction.

• Other examples of linear restrictions are: Regression Coefficients equal to each other
eg. or coefficients are proportional to each other eg.
• We need to check whether these restrictions are valid statistically or not.
• One way of testing for these linear restrictions is to incorporate them directly into the
estimating procedure.

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 Testing Validity of Linear Restrictions for Cobb
  • Let Douglas Regression
• As a result, we can write the log-linear Cobb-Douglas production function as:

Here, is the output-labour ratio and is the capital-labour ratio.

• In words, Eq. 2 states that labour productivity is a function of capital labor ratio.
• Equation 2 is called the restricted (R) regression and the original equation 1 is called
the unrestricted (UR) regression. 14
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Regression Results of Restricted Regression

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 Interpretation of Regression Results

• These results suggest that if the capital-labor ratio goes up by 1 %, output-labour ratio
or labour productivity goes up by about 0.52%.

• In other words, the elasticity of labor productivity with respect to capital-labor ratio is
0.52, and this elasticity coefficient is highly significant.

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 Testing Validity of Linear Restriction
  • To test the validity of the linear regression, we first define:

(a) RSSR = residual sum of squares from the restricted regression, Eq. 2
(b) RSSUR= residual sum of squares from the unrestricted regression, Eq. 1
(c) m = number of linear restrictions (1 in the present example)
(d) k = number of parameters in the unrestricted regression (3 in the present example)
(e) n = number of observations (51 in the present example).

• To test the validity of the linear restriction, we use a variant of the F statistic

which follows the F probability distribution of statistics, where m and (n-k) are the
numerator and denominator degrees of freedom

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 Testing Validity of Linear Restriction
  The Hypothesis for the test is:

• If the value of F-statistic calculated using the formula

Is greater than at a given level of significance, we reject the null hypothesis. Otherwise,
we do not reject the null.

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 Testing Validity of Linear Restriction
 

From the tables, (Eviews Command: scalar fstat =@qfdist(0.95,1,48))

Since F calculated<F critical, we do not reject the null hypothesis.

• Therefore the conclusion in the present example is that the estimated Cobb-Douglas
production function probably exhibits constant returns to scale. So there is no harm in
using the production function given in Eq. 2, the restricted regression.
• But it should be emphasized that the F testing procedure outlined above is valid only
for linear restrictions, it is not valid for testing non-linear restriction(s), such as

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