Fixed Effects Model (FEM)

Outline
 An illustrative example of the Fixed
Effects Model (FEM).
 Cautions on the use of FEM.
 Application of FEM.
An illustrative example
 Consider the following pooling
estimation model:

Yit  1   2 X 2it   3 X 3it  it

i  1,2,3,4
t  1,2,...,20
Assumptions of a pooling
estimation
 The intercept value is the same across
units or entities (in this case,
companies).
 The slope coefficient is constant across
units or entities (companies).
Limitations of a Pooled
Regression
 Assumptions of constant intercept and
slope coefficients are highly restricted
and far-fetched.
 May distort the “true” relationship
between the dependent and
independent variables across entities
(companies).
Account for the
“individuality”of each entity.
 FIXED EFFECTS APPROACH
A. Slope coefficients constant but the
intercept varies across entities.
B. Slope coefficients are constant but the
intercept varies over individuals and
time.
C. Slope coefficients and the intercept
vary across entities.
A. Slope coefficients constant but the intercept
varies across entities.

 To see this, consider the following

model (1):
Yit   1i   2 X 2it   3 X 3it   it

 The subscript i on the intercept

suggests that the intercepts of the four
firms may be different.
Fixed Effects Model (FEM)
 Model (16.3.2) is an example of the
fixed effects (regression) model.
 The term fixed effects is due to the fact
that, although the intercept may differ
across individual (in this case firms),
each individual’s intercept does not
vary over time.
How to account for the
“individual” intercept?
 Differential intercept dummies.
Yit   1   2 D2i   3 D3i   4 D4i   2 X 2it   3 X 3it   it

 The differential intercepts tell us by how

much the intercepts of GM, US, and
West differ from the intercept of GE.
The Time Effect
 Just as we used the dummy variables to
account for individual (firm) effect, we
can allow for time effect (the function
shifts over time) by introducing time
dummies.
 The Time Effect (continued)

Yit  0  1 Dum35   2 Dum36  ...  19 Dum53   2 X 2it   3 X 3it   it

 Where Dum35 takes a value of 1 for

observation in year 1935 or 0
otherwise, etc. (1954 is the base year).
B. Slope coefficients are constant but the
intercept varies over individuals and time.

 Combine models 16.3.3 and 16.3.6 to

find individual (firm) effect as well as
time effect.

Yit   1   2 DGM i   3 DUSi   4 DWESTi  0  1 Dum35

 ...  19 Dum53   2 X 2it   3 X 3it   it
C. Slope coefficients and the intercept vary
across entities.

 To account for differences in the

intercepts and slope coefficients, the
individual (firm) dummies are
introduced in an additive manner (like
model 16.3.3) and in an interactive
manner (multiply the dummy by each of
the X variables).
Differential intercepts and
slope coefficients.
 Model (16.3.8)

Yit   1   2 D2i   3 D3i   4 D4i   2 X 2it   3 X 3it   1 ( D2i X 2it )   2 ( D2i X 3it )
  3 ( D3i X 2it )   4 ( D3i X 3it )   5 ( D4i X 2it )   6 ( D4i X 3it )   it
Cautions on the use of FEM
 Lost of degrees of freedom.
 Multicollinearity.
 Unable to identify the impact of certain
time-invariant variables (e.g. sex,
ethnicity, and color).
 The error term follows the classical
assumptions (which may have to be
modified).
Application of FEM
 Many studies have been done on
whether FDI and exports are substitutes
or complements. There has been no
consensus (results have varied).
(Archaic).
 “New trade theory” brings an industrial
organization approach to international
trade.
Motivation for Research
 I want to investigate the relationship
between FDI (foreign direct investment)
and exports given the degree of
concentration in an industry.
 Research Question: How does market
structure impact the link between FDI
and exports?
Data
 One home country (the UK) and one
host country (the US).
 1997 US manufacturing industries.
 Using NAICS five-digit level data.
Empirical Specification
 FDI = f (Exports, Ownership-Location-
Internalization factors).
 FDI = FDI of the UK in the US manufacturing
industries.
 Exports = Exports from the UK in the US
manufacturing industries.
 OLI = Factors in the US manufacturing
industries that impact and/or determine FDI.
OLI factors
 Ownership (O) = CR4
 Location (L) = Sales
 Internalization (I) = Advertising cost
Using FEM
 To find out the differences in the relationship
between FDI and exports across market
structures, I introduce dummy and interactive
dummy variables.
 The dummy variables will capture the
differential intercepts and the interactive
dummies, the differential slope coefficients.
Using FEM (continued)
 I am interested in the three main types
of market structure: Perfect
competition, Monopoly, and Oligopoly.
Hence, I create two dummy variables.
 MD = Monopoly Dummy
 OD = Oligopoly Dummy
 Base Category = Perfect competition
Using FEM (continued)
 The creation of the dummy variables is
based on the HHI (Herfindahl-
Herschman Index) level. The HHI
ranges from 0 to 10,000.
 HHI < 1000 implies competition
 1000 <=HHI<1800 implies Oligopoly
 HHI >=1800 implies Monopoly
Using FEM (continued)
 OD=1 if 1000<=HHI<1800
0 Otherwise
 MD=1 if HHI >=1800
0 Otherwise
Using FEM (continued)
 Since the goal is to capture the
differences in the link between FDI and
exports across market structures, the
dummy variables (MD and OD) are
interacted with the independent
variable Exports. The interactive terms
are ExportsMD and ExportsOD.
Simultaneity?
 Bi-directional link between Exports and
FDI (e.g. Graham, 1997).
 Simultaneity problems can result from
the bi-directional link .
 To deal with the simultaneity problems,
I change the specification of the model.
Instead of estimating a linear model, I
estimate a log-linear model.
Estimating FEM
 The estimated model is the following:

Log ( FDI i )   0   1 * Log ( Exports i )   2 * Log (CR 4 i ) 

 3 * Log ( Sales i )   4 * Log ( ADVi )   5 * (ODi )   6 * ( MDi )
  7 * Log ( Exports i ODi )   8 * Log ( Exports i MDi )   i
Empirical Results
 The coefficients of CR4 and Sales are as
expected and significant. The
coefficient of advertising cost is
negative (as expected) but insignificant.
 The relationship between FDI and
exports vary across market structures,
but never significant.
Empirical Results (continued)
 Consider the differential intercepts and
slope coefficients for the three types of
market structure.
 Competition: Log(FDI) = -3.95 – 0.02 Log(Exports)
 Oligopoly: Log(FDI) = -6.74 + 0.14 Log(Exports)
 Monopoly: Log(FDI) = -7.43 + 0.12 Log(Exports)
Heteroscedasticity?
 Heteroscedasticy is likely when dealing with a
cross-sectional dataset and when having
qualitative variables.
 Both the graphical test and the Breusch-
Pagan-Godfrey (BPG) test suggest that
heteroscedasticity is present in the fixed-
effects estimation.
 Weighted least squares (WLS) is used to
correct for heteroscedasticity.
WLS Results
 The WLS results are similar to the previous
results except that the coefficient of
advertising cost becomes significant.
 Consider the differential intercepts and slope
coefficients of the WLS for the three types of
market structure.
 Competition: Log(FD)I = -3.13 – 0.002Log(Exports)
 Oligopoly: Log(FDI) = -6.09 + 0.16Log(Exports)
 Monopoly: Log(FDI) = -6.37 + 0.20Log(Exports)
Conclusion
 FEM can be cautiously used to account
for “individuality” or differences across
units.
 The link between FDI and exports is
positive in imperfect markets and
negative in a perfect market (although
the results are insignificant).