Econometrics II

Dummy Variable Regression

 Introduction

•Definition: A dummy variable is an artificial (proxy)

variable constructed such that it takes the value unity
whenever the qualitative phenomenon it represents occurs,
and zero otherwise.
• They can be introduced with intercept or without
intercept in a model.
• When all categories are introduced in the model the
intercept must be dropped.
 Introduction

Dummy variable trap: if we include all the categories

with the intercept in our regression model a perfect
multicollinearity would result.
• This is because the intercept variable, a column of ones,
would equal the sum of the three dummy variables) and the
regression could not be run.
• Nonetheless, more often than not, equations with dummy
variables do contain an intercept.
• As mentioned above, this is accomplished by omitting one of
the dummies to avoid perfect multicollinearity.
 Intercept shift with single attribute

ANOVA model example

Example 1: the model Rregresses wage rate on female. And the
regression result is

o In this model female represents a dummy variable which take a

value 1 if the individual is female and 0 if the observed data
belongs to male.
o Since the model only have a categorical Variable as independent
variable it is ANOVA.
 Intercept shift with single attribute
• The intercept is the average wage of male in the sample.
• The coefficient of the dummy variable (-2.51) is the difference
between the average wage of female and male in the data (wage
deferential).
• In other words, on averaged female workers earns 2.51 dollar
less than male workers.
– Therefor the average wage of female worker is 4.59 dollar per hour.
• We can observe both estimated values are statistically significant.
• Generally, simple regression on a constant and a dummy variable
is a straightforward way to compare the means of two
groups.
 Intercept shift with single attribute
• In this model the wage deference between the two categories is
large because we are not controlling for other factors which could
affect wage earing by the two groups.
• Controlling for such effects may reduce wage deferential
estimate.
 Intercept shift with single attribute
ANCOVA model example
Example 2: Jeffery M. Wooldridge example 7.1 estimates’ the
following model:

o Where (education), (experience) and () quantitative variables

female is a dummy variable explained earlier.
 Intercept shift with single attribute

o Obviously having a negative intercept does not make any sense at all and it
suggests that the model is miss specified in some way, because given the
available information it cannot be negative.
o The coefficient female shows that holding educ, exper and tenure female
workers earn 1.81 dollar per hour less than their male counter parts.
o Since we are controlled for the above variables, the wage difference is explained
by other gender associated factors not incorporated in the model (baby birth).
o The most interesting thing to notice here is that when we control for other
factors which affects wage the coefficient of the dummy variable reduces. Why?
 Intercept shift with single attribute
Using Dummy Explanatory Variables in Equations for log(y)

• Using the rough calculation and this is interpreted as women

workers earn 29.7 percent below what their male counterparts

earn.

• To overcome the approximation error, we can use the exact

calculation as you can see the exact calculation result shows on

average women earns 25.7% less than what males earn.

 Intercept shift with multiple categories and several
attributes

Example 1: a researcher has specified the following wage model:

• Where: female is a dummy variable which takes a value of

1 if the individual is female and zero otherwise,
• medium (large) is a dummy variable which take a value 1
if the firm is hiring workers in between 50 and 199
workers (more than 200) and zero otherwise.
 Intercept shift with multiple categories and several
attributes

• Question? What is your benchmark category?

– A male workers working in small firms!

• Question? find whether the size of the firm and gender

jointly are two relevant factors in determining wage?

• Your hypothesis here would be;

• Then we would have a restricted model of:

 Intercept shift with multiple categories and several
attributes

• Therefor we use F test

• Then we would have a restricted model of:

• The following is a regression result based on the above

specification:

• Question? Interpret each coefficient of the dummy

variables?
 Intercept shift with multiple categories and several
attributes

• What is the on average wage deference between male workers employed in

small firms and large firms?
– 16.8 percent
• What is the on average wage deference between male workers employed in
small firms and medium firms?
– 30.8 percent
• What would happen to wage rate if education increases by one more year?
– Wage increases by 4.99%
• What does the coefficient of female imply?
– That female workers working in small firms earn 32.7 percent lower wage than their male
counterparts.
• What is the wage difference between females working medium size firms and
males working in the same location?
– 32.7 percent
 Intercept shift with multiple categories and several
attributes

• If the restricted model is estimated as

• There for the F statics is

• Therefore, according to the value of F, we can conclude that the size of the firm
and gender jointly have a significant influence in wage determination