2 Panel Data Data sets that combine time series and cross sections data are common in economics.

An independently pooled cross section is obtained by sampling randomly a large population at dierent points in time (e.g., yearly). Important feature: The data set consist of independently sampled observations. Allows to investigate the eect of time. E.g., whether relationships have changed. Raises typically minor statistical complications.

Version:

Jan 19, 2012

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A panel data set (longitudinal data) a sample of same individuals, families, rms, cities . . ., are followed across time. E.g., OECD statistics contain numerous series observed yearly from several countries. Similarly time series data on several rms, industries, etc., are these type of data.

2.1 Pooling independent cross section across time

Example 1 Womens fertility over time: Data from General Social Survey contains samples collected even years from 1972 to 1984. Model for explaining total number of children born to a woman. Data is available on the course web side (password protected).

* read data .insheet using "fertil1.csv", comma clear * describe data .des Contains data obs: 1,129 vars: 14 size: 24,838 (99.9% of memory free) -----------------------------------------------------------storage display value variable name type format label variable label -----------------------------------------------------------year byte %8.0g educ byte %8.0g meduc byte %8.0g feduc byte %8.0g age byte %8.0g kids byte %8.0g black byte %8.0g east byte %8.0g northcen byte %8.0g west byte %8.0g farm byte %8.0g othrural byte %8.0g town byte %8.0g smcity byte %8.0g

. tabstat kids, statistics( mean count ) by(year) columns(statistics) Summary for variables: kids by categories of: year year | mean N ---------+-------------------72 | 3.0 156 74 | 3.2 173 76 | 2.8 152 78 | 2.8 143 80 | 2.8 142 82 | 2.4 186 84 | 2.2 177 ---------+-------------------Total | 2.7 1129 ------------------------------

Number of children per woman

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N of children

2 70 72 74 76 78 Year 80 82 84 86

It is obvious that the fertility rate has declined over years

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The analysis can be substantially elaborated by regression analysis. After controlling other factors (educations, age, etc.), what has happened to fertility rate? Build a regression with year dummies: y74 for 1974, , y84 for year 1984. Year 1972 is the base year.

. reg kids educ age age2 black east northcen west farm /// y74 y76 y78 y80 y82 y84 Source | SS df MS -------------+-----------------------------Model | 389.777313 14 27.8412367 Residual | 2695.73199 1114 2.41986713 -------------+-----------------------------Total | 3085.5093 1128 2.73538059 Number of obs F( 14, 1114) Prob > F R-squared Adj R-squared Root MSE = = = = = = 1129 11.51 0.0000 0.1263 0.1153 1.5556

----------------------------------------------------kids | Coef. Std. Err. t P>|t| -------------+--------------------------------------educ | -.1242409 .0181486 -6.85 0.000 age | .5381453 .1384005 3.89 0.000 age2 | -.0058679 .0015645 -3.75 0.000 black | 1.083783 .1734035 6.25 0.000 east | .2276015 .1312518 1.73 0.083 northcen | .3713906 .1199679 3.10 0.002 west | .2188689 .1663522 1.32 0.189 farm | -.0918808 .122027 -0.75 0.452 y74 | .2586277 .1727165 1.50 0.135 y76 | -.1012358 .1787317 -0.57 0.571 y78 | -.0671507 .1814491 -0.37 0.711 y80 | -.0751199 .1827069 -0.41 0.681 y82 | -.5323518 .1723385 -3.09 0.002 y84 | -.5383952 .174472 -3.09 0.002 _cons | -7.894707 3.05159 -2.59 0.010 -----------------------------------------------------

Sharp drop in fertility in the early 1980s (others are not statistically signicant). E.g., the coecient on y82 indicates that, holding other factors xed (educ, age, and others), per 100 women there were about 53 less children than in 1972. In particular, since education is controlled, this decline is separate from the decline due to the increase in eduction. Women with more education have fewer children (coecient 0.12 is highly statistically signicant with t = 6.85 and p-value < 0.0005). Other things equal, per 100 women with a college education tend to have 4 0.124 = 0.496, i.e., about 50 children less than women with only high school education.

In summary, pooled cross section data (independent samples) problems can be analyzed utilizing dummy variables.

2.2 Two-period panel data analysis From each individual (people, rms, schools, cities, countries, etc.) data is collected at two time points, t = 1 and t = 2. In usual regression one major source of bias is caused by omitted (important) variables. For example, if the true model is (1) yi = 0 + 1xi + 2zi + ui,

but we estimate (2) where (3) vi = 2zi + ui, 1 from model (2) the bias in OLS estimator is (4) 1 1 = 2 E
n (x x )zi i=1 i , n (x x 2 ) i=1 i

yi = 0 + 1xi + vi,

which can be substantial if x and z are correlated and 2 is large.

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Use of panel data makes it possible to eliminate the omitted variable bias in certain cases. Suppose that we have the following situation in terms of model (1) (5) yit = 0 + 1xit + 2zi + uit,

where i refers to individual i and t to time point t. Thus, we have panel data where data is collected from each individual i at dierent time points t (in the two period case, t = 1, 2). Note that in (5) zi does not have the time index, which implies that variable z is time invariant (or at least changing very slowly with time).

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Suppose we have from each of the n individuals observations on yit and xit at time points t = 1 and t = 2, thus altogether 2n observations. However, we do not observe zi. Suppose further that we allow the possibility that intercept 0 may be dierent at dierent time points, such that (5) can be written as (6) yit = 0 + 0Dt + 1xit + 2zi + uit,

where Dt = 0 for t = 1 and Dt = 1 for t = 2 (time dummy).

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Then taking dierences of the form yi = yi2 yi1, the model in (6) becomes (7) yi = 0 + 1xi + ui,

i.e., the (unobserved) omitted variable disappears and estimating the slope parameter 1 with OLS is unbiased.

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The above generalizes immediately such that if we denote (8) ai = z i = 1zi1 + 2zi2 + + q ziq

and enhance (6) to (9) yit = 0 + 0Dt + xit + ai + uit,

taking dierences reduces again to estimation model (7).

The above model is called the xed eect (FE) model in which ai is xed over the time periods (ai can be a random variable, and can correlate with the explanatory variable xit ).

If ai is not correlated with other explanatory variables, the model is called random eect (RE) model and is estimated with dierent techniques that are supposed to yield more ecient estimators to -parameters than the xed eect methods (that are basically OLS methods). We will return to the RE model later.

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In the FE case the resulting estimators of the regression parameters from the rst-dierenced equation wit OLS are called the rst-dierenced estimators (FD estimators). We will deal other xed eect estimators later. In summary, dierencing eliminates all unobserved time invariant factors from the model. A major pitfall is that dierencing also wipes out observed time invariant variables (like gender) from the model! Thus, this method cannot be used in such cases (if we want to estimate these eects), or in cases where the explanatory variables change very slowly across time (the dierence is nearly zero).

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In many cases the FD-method is useful, however. The following example highlight the biasing eect of unobserved factors and how panel estimation with the simple FD-method likely solves the problem.

Example 2 Data set crime2.xls (Wooldridge) contains data on crime and unemployment rates for 46 US cities for 1982 (t = 1) and 1987 (t = 2). Running simple cross section regression of crmrte on unem by using only 1987 yields
. regress crmrte unem if year==87 Source | SS df MS -------------+-----------------------------Model | 1775.90928 1 1775.90928 Residual | 52674.6428 44 1197.15097 -------------+-----------------------------Total | 54450.5521 45 1210.01227 Number of obs F( 1, 44) Prob > F R-squared Adj R-squared Root MSE = = = = = = 46 1.48 0.2297 0.0326 0.0106 34.6

----------------------------------------------------crmrte | Coef. Std. Err. t P>|t| -------------+--------------------------------------unem | -4.161134 3.416456 -1.22 0.230 _cons | 128.3781 20.75663 6.18 0.000 -----------------------------------------------------

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Coecient of crmrte is negative, 4.16! However, not statistically signicant. Likely suers from omitted variables problem (age distribution, gender distribution, eduction levels, . . .). Most of these can be expected to be fairly stable across time. Thus, use of panel data techniques may be helpful. Before proceeding to the panel data estimation, let us see what happens if we simply pool the two years and estimate (10)

crmrte = 0 + 0D87 + 1unem + u,

where D87 is the year 1987 dummy.

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. regress crmrte d87 unem Source | SS df MS -------------+-----------------------------Model | 989.717314 2 494.858657 Residual | 80055.7864 89 899.503218 -------------+-----------------------------Total | 81045.5037 91 890.609931 Number of obs F( 2, 89) Prob > F R-squared Adj R-squared Root MSE = 92 = 0.55 = 0.5788 = 0.0122 = -0.0100 = 29.992

----------------------------------------------------crmrte | Coef. Std. Err. t P>|t| -------------+--------------------------------------d87 | 7.940413 7.975324 1.00 0.322 unem | .4265461 1.188279 0.36 0.720 _cons | 93.42026 12.73947 7.33 0.000 -----------------------------------------------------

The situation does not change much qualitatively!

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For example, Stata has very sophisticated panel data procedures. We discuss some of them later. The FD-method can be applied by using the regress routine by rst declaring the data as a panel data with the xtset command (Menu: Statistics > Longitudinal/panel data > Setup and utilities > Declare data set to be panel data). In Eviews: Proc > Structure/Resize Current Page. . ., and follow the instructions. In SAS: proc panel data = crime2; model crmrte = unemp; id = state year; end; Before applying proc panel the data must be sorted by proc sort. Whichever software is used, identiers for the individuals (in particular) are needed to indicate the multiple measurements on an individual.
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After declaring to the program the panel structure, the model (11) crmrte = 0 + 1 umem + u

can be estimated with the FD dierence method e.g., in Stata as (d.crmrte means crmrte87 crmrte82 ):
. reg d.crmrte d.unem Source | SS df MS -------------+-----------------------------Model | 2566.43056 1 2566.43056 Residual | 17689.5426 44 402.035059 -------------+-----------------------------Total | 20255.9732 45 450.132737 Number of obs F( 1, 44) Prob > F R-squared Adj R-squared Root MSE = = = = = = 46 6.38 0.0152 0.1267 0.1069 20.051

----------------------------------------------------D.crmrte | Coef. Std. Err. t P>|t| -------------+--------------------------------------unem | D1. | 2.217996 .8778657 2.53 0.015 | _cons | 15.40219 4.702116 3.28 0.002 -----------------------------------------------------

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In Eviews, after the data has been reshaped to panel data, the FD-estimatation can be worked out using Quick > Estimate Equation. . . to open the Equation Estimation command window to input d(cmrte) c d(unem) to get the results similar to above.
1 2.22 is now highly The coecient estimate of the statistically signicant and of expected sign. The model predicts that one percent increase in unemployment increases crimes by about 2.2 per 1, 000 people. The constant term indicates that even if the change in unemployment rate were zero, the crime rate has generally increased during the period from 1982 to 1987 by about 15.4 crimes per 1,000 people. Note that the time dummy component 0 in (11) captures all unobserved time eect that are common to all cross-sectional individuals. That is, we can consider 0 to represent 0 = z t = 1 z1t + 2 z2t + + p zpt , where zt s are common trend components aecting all individual crime rates with same intensity.

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2.3 More than two time periods Dierencing can be used with more than two time periods to work out xed eect estimation. As an example consider a three period model.

(12) yit = 1 + 2D2t + 3D3t +1xit1 + + k xitk + uit for t = 1, 2, 3, where D2t = 1 for period t = 2 and zero otherwise and D3t = 1 for t = 3 and zero othewrise. Dierencing yields (13) yit = 2 + 3 + 1xit1 + + k xitk + uit t = 2, 3. Again it is simple to estimate with OLS the model.
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3.3 Fixed eect method An alternative method, which works in certain cases better than the FD-method, is called the xed eects method. Consider the simple case model of (14) yit = 1xit + ai + uit,

i = 1, . . . , n, t = 1, . . . , T . Thus there are altogether n T observations. Dene means over the T time periods
(15) 1 y i = T
T

yit ,
t=1

1 x i = T

xit ,
t=1

1 u i = T

uit .
t=1

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Then (16) Note that 1 T 1 ai = T ai = ai. T t=1 T Thus, subtracting (16) from (14) eliminates ai and gives (17) or (18) y it = 1x it + u it, yit y i = 1(xit x i) + (uit u i) y i = 1x i + ai + u i.

where e.g., y it = yit y i is the time demeaned data on y . This transformation is also called the within transformation and resulting (OLS) estimators of the regression parameters applied to (18) are called xed eect estimators or within estimators.

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In the two period case the FD method and FE lead to identical results.
Remark 1 The slope coecient 1 estimated from (16) is called the between estimator. vi = ai + u i is the error term. The estimator is biased, however, if the unobserved component ai is correlated with x.

Remark 2 When estimating the unobserved eect by the xed eect (FE) method, it is unfortunately not clear how the goodness-of-t R-square should be computed. Stata produces three dierent R-squares: within, between, and total.

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2.4 Dummy variable regression Yet another method is to introduce dummy variables for the cross section unit (N 1 dummy variables) and (possibly) for the periods (T 1 dummies). If N and T are large this is not very practical. Gives the same estimates for the regression coecients as the time demeaned method and the standard errors and major statistics are the same.

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Example 3 Papke (1994), Journal of Public Economics 54, 3749, studied the eect of Indiana enterprise zone program on unemployment, years 19801988 (Wooldridges data base, le: ezunem.xls). Six zones designated 1984 and four mode in 1984. Twelve cities did not receive a zone (control group). An evaluation model of the policy is (19) log(uclmsit ) = t + 1 Dit + ai + uit

where t indicates time varying intercept, ucclms is the number unemployment claims, and Dit = 1 if the city i had the zone in year t and zero otherwise. Fixed Dierence estimates for 1 :

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. reg d.luclms d82 d83 d84 d85 d86 d87 d88 d.ez Source | SS df MS -------------+-----------------------------Model | 12.8826331 8 1.61032914 Residual | 7.79583815 167 .046681666 -------------+-----------------------------Total | 20.6784713 175 .118162693 Number of obs F( 8, 167) Prob > F R-squared Adj R-squared Root MSE = = = = = = 176 34.50 0.0000 0.6230 0.6049 .21606

----------------------------------------------------D.luclms | Coef. Std. Err. t P>|t| -------------+--------------------------------------(Year dummy variable estimates results deleted) ez | D1. | -.1818775 .0781862 -2.33 0.021 _cons | -.3216319 .046064 -6.98 0.000 -----------------------------------------------------

Fixed Eect estimation results

. xtreg luclms d82 d83 d84 d85 d86 d87 d88 ez, fe R-sq: within = 0.8148 between = 0.0002 overall = 0.3415 = -0.0040 F(8,168) Prob > F = = 92.36 0.0000

corr(u_i, Xb)

----------------------------------------------------luclms | Coef. Std. Err. t P>|t| -------------+--------------------------------------ez | -.1044148 .059753 -1.75 0.082 _cons | 11.53358 .0325925 353.87 0.000 -------------+--------------------------------------sigma_u | .55551522 sigma_e | .21619434 rho | .86846297 (fraction of variance due to u_i) ----------------------------------------------------------F test that all u_i=0: F(21, 168) = 59.31 Prob > F = 0.0000 28

Dummy variable regression:

. reg luclms d82 d83 d84 d85 d86 d87 d88 /// c2 c3 c4 c5 c6 c7 c8 c9 c10 c11 c12 c13 /// c14 c15 c16 c17 c18 c19 c20 c21 c22 ez Source | SS df MS -------------+-----------------------------Model | 92.6439601 29 3.19461932 Residual | 7.85231887 168 .046739993 -------------+-----------------------------Total | 100.496279 197 .510133396 Number of obs F( 29, 168) Prob > F R-squared Adj R-squared Root MSE = = = = = = 198 68.35 0.0000 0.9219 0.9084 .21619

----------------------------------------------------luclms | Coef. Std. Err. t P>|t| -------------+--------------------------------------(dummy variable results removed) ez | -.1044148 .059753 -1.75 0.082 _cons | 11.51534 .0799536 144.03 0.000 -----------------------------------------------------

The results show that the FE and DVRM results are exactly the same. Using the FE results, the coecient 0.104 implies about 10.4 percent drop in the unemployment claims due to the program. The estimate is signicant in one-tailed testing but not in two-tailed testing.

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2.5 Fixed eects or rst dierencing? If the number of periods is 2 (T = 2) FE and FD give identical results. When T 3 the FE and FD are not the same. Both are unbiased under assumptions FE.1 FE.4 Both are consistent under assumptions FE.1 FE.4 for xed T as n .
Assumptions:

FE.1: For each i, the model is yit = 1 xit1 + + k xitk + ai + uit , t = 1, . . . T . FE.2: We have a random sample from the cross section. FE.3: Each explanatory variables changes over time, and they are not perfectly collinear. FE.4: E[uit |X i , ai ] = 0 for all time periods (X i stands for all explanatory variables). 2 for all t = 1, . . . , T . FE.5: Var[uit |X i , ai ] = u FE.6: Cov[uit , uis ] = 0 for all t = s 2 ). FE.7: uit |X i , ai NID(0, u
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If uit is serially uncorrelated, FE is more efcient than FD (because of this FE is more popular). If uit is (highly) serially correlated, uit may be less serially correlated, which may favor FD over FE. However, typically T is rather small, such that serial correlation is dicult to observe. In sum, there are no clear cut guidelines to choose between these two. Thus, a good advise is to check them them both and try to determine why they dier if there is a big dierence.

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2.6 Balanced and unbalanced panels A data set is called a balanced panel if the same number of time series observations are available for each cross section units. That is T is the same for all individuals. The total number of observations in a balanced panel is nT . All the above examples are balanced panel data sets. If some cross section units have missing observations, which implies that for an individual i there are available Ti time period observations i = 1, . . . , n, Ti = Tj for some i and j , we call the data set an unbalanced panel. The total number of observations in an unbalanced panel is T1 + + Tn. In most cases unbalanced panels do not cause major problems to xed eect estimation. Modern software packages make appropriate adjustments to estimation results.
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2.7 Random eects models Consider the simple unobserved eects model (20) yit = 0 + 1xit + ai + uit,

i = 1, . . . , n, t = 1, . . . , T . Typically also time dummies are also included to (20). Using FD or FE eliminates the unobserved component ai. However, if ai is uncorrelated with xit using random eect (RE) estimation can lead to more ecient estimation of the regression parameters.

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Generally, we call the model in equation (20) the random eects model if ai is uncorrelated with all explanatory variables, i.e., (21) Cov[xit, ai] = 0, t = 1, . . . , T .

How to estimate 1 eciently? If (21) holds, 1 can be estimated consistently from a single cross section. Obviously this discards lots of useful information.

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If the data set is simply pooled and the error term is denoted as vit = ai + uit, we have the regression (22) Then (23)
2 a Corr[vit, vis] = 2 2 a + u

yit = 0 + 1xit + vit.

2 = Var[a ] and 2 = Var[u ]. for t = s, where a it i u

That is, the error terms vit are (positively) autocorrelated, which biases the standard er1. rors of the OLS

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2 and 2 were known, optimal estimators If a u (BLUE) would be obtained the generalized least squares (GLS), which in this case would reduce to estimate the regression slope coefcients from the quasi demeaned equation (24) yit y t = 0(1 ) + 1(xit x i) + (vit vi),

where (25) =1
2 u
1 2

2 + T 2 u a 2 and 2 are unknown, but they In practice u a

can be estimated.

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One method is to estimate (22) from the pooled data set and use the OLS residuals 2 and 2 and plug them into vit to estimate q u (25). There resulting GLS estimators for the regression slope coecients are called random eects estimators (RE estimators). Under the random eects assumptions the estimators are consistent, but not unbiased. They are also asymptotically normal as n for xed T . However, with small n and large T properties of the RE estimator is largely unknown.
The

ideal random eects assumptions include FE.1, FE.2, FE.4FE.6. FE.3 is replaced with RE.3: There are no perfect linear relationships among the explanatory variables. RE.4: In addition of FE.4, E[ai |Xi ] = 0.
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It is notable that = 1 results in (24) results to the pooled regression and FE obtained with = 0. RE estimation is available in modern statistical packages with dierent options.

Example 4 Data set wagepan.xls (Wooldridge): n = 545, T = 8. Is there a wage premium in belonging to labor union? log(wageit ) = 0 + 1 educit + 3 exprit + 4 expr2 it +5 marriedit + 6 unionit + ai + uit Year dummies for 19801987 are included. It is notable that with inclusion of full set of year dummies implies that one cannot estimate with the FE method eects that change a constant amount over time. Experience (exper) is such a variable.

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------------------------------------------lwage | Pooled Random Fixed | OLS Effects Effects --------+---------------------------------educ | .0989945 .0906150 .. | (.0046227) (.0105807) exper | .0861696 .1027934 .. | (.0101415) (.0153853) exper2 | -.0027349 -.0046859 -.0051855 | (.0007099) (.0006896) (.0007044) married | .1230113 .0678821 .0466804 | (.0155714) (.0167369) (.0183104) union | .1685243 .1031103 .0800019 | (.0170652) (.0178388) (.0193103) -------------------------------------------

It is notable that OLS standard errors tend to be smaller than in the RE or FE cases. OLS standard errors underestimate the true standard errors. OLS coecient estimates also suer from the omitted variable problem accounted in panel estimation. Stata estimate of the correlation in (23) is .464.

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Random eects or xed eects FE is widely considered preferable because it allows correlation between ai and x variables. Given that the common eects, aggregated to ai is not correlated with x variables, an obvious advantage of the RE is that it allows also estimation of the eects of factors that do not change in time (like education in the above example). Typically the condition that common eects ai is not correlated with the regressors (xvariables) should be considered more like an exception than a rule, which favors FE.

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Hausman specication test Hausmanan (1978) devised a test for the orthogonality of the common eects (ai) and the regressors. The test compares the xed eect (OLS) and random eect (GLS) estimates utilizing the Wald testing approach.

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The basic idea of the test relies on the fact that under the null hypothesis of orthogonality both OLS and GLS are consistent, while under the alternative hypothesis GLS is not consistent. Thus, under the null hypothesis OLS and GLS estimates should not dier much from each other. The test compares these estimates with Wald statistic. In Stata performing Hausman requires that both OLS and GLS regression results are saved for availability for the postestimation test0 procedure.

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Example 5 Applying the Hausman test to the case of Examle 4 can be in Stata yields:

* Estimate fixed effects xtreg lwage y81 y82 y83 y84 y85 y86 y87 exper2 married union, fe * store the results into "hfixed" estimates store hfixed * Estimate the random effects model xtreg lwage y81 y82 y83 y84 y85 y86 y87 educ exper exper2 married union * store the results into "hrandom" estimates store hrandom * Hausman test hausman hfixed hrandom ---- Coefficients ---| (b) (B) (b-B) sqrt(diag(V_b-V_B)) | hfixed hrandom Difference S.E. --------+--------------------------------------------------------y81 | .1511912 .0427498 .1084414 . y82 | .2529709 .035577 .2173939 . y83 | .3544437 .0270943 .3273494 . y84 | .4901148 .052207 .4379078 . y85 | .6174822 .0690524 .5484299 . y86 | .7654965 .1053229 .6601736 . y87 | .9250249 .1505464 .7744785 . exper2 | -.0051855 -.0046859 -.0004996 .000144 married | .0466804 .0678821 -.0212017 .0074261 union | .0800019 .1031103 -.0231085 .0073935 ------------------------------------------------------------------b = consistent under Ho and Ha; obtained from xtreg B = inconsistent under Ha, efficient under Ho; obtained from xtreg Test: Ho: difference in coefficients not systematic chi2(10) = (b-B)[(V_b-V_B)^(-1)](b-B) = 26.77 Prob>chi2 = 0.0028 (V_b-V_B is not positive definite) 43

The test reject the orthogonality condition. Thus, FE should be used.

In Eviews Hausman test is obtained by rst estimating the model as a random eect model and then selecting View > Fixed/Rendom Effect Testing > Correlated Random Effects - Hausman Test

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Policy analysis with panel data Panel data is useful for policy analysis, in particular, program evaluation.

Example 6 Continue Example 1.2, where training program on worker productivity was evaluated. The data include three years, 1987, 1988, and 1989. The training program was implemented rst time 1988. We focus on the years 1987 (no program) and 1988 (program implemented) to see whether the program benets rms. The model panel model is
(26) log(scarpit ) = 0 + 0 y 88 + 1 grantit + ai + uit ,

where y 88 is the year 1988 dummy (= 1 for year 1988 and = 0 otherwise) and ai includes the unobserved rm eects (worker skill, etc.).

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Ignoring panel structure OLS results suggested no improvement.

Dependent Variable: LOG(SCRAP) Method: Panel Least Squares Sample: 1 471 IF YEAR < 1989 Periods included: 2 Cross-sections included: 54 Total panel (balanced) observations: 108 ===================================================== Variable Coefficient Std. Error t-Statistic Prob. ----------------------------------------------------C 0.523144 0.159783 3.274086 0.0014 GRANT -0.058018 0.380949 -0.152299 0.8792 ----------------------------------------------------R-squared 0.000219 Adjusted R-squared -0.009213 S.E. of regression 1.507393 F-statistic 0.023195 Prob(F-statistic) 0.879241 =====================================================

The coecient for grant is not statistically signicant, suggesting that the program does not help in reducing the scrap rate.

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Accounting for the possible rm eects and imposing also the year dummy to account for possible time eect, yields
===================================================== Variable Coefficient Std. Error t-Statistic Prob. ----------------------------------------------------C 0.568716 0.048603 11.70126 0.0000 GRANT -0.317058 0.163875 -1.934753 0.0585 ----------------------------------------------------Effects Specification Cross-section fixed (dummy variables) Period fixed (dummy variables) R-squared 0.964308 Adjusted R-squared 0.926556 S.E. of regression 0.406642 F-statistic 25.54364 Prob(F-statistic) 0.000000

The estimate of the coecient for the grant is negative and close to statistically signicant in two sided testing and signicant in one sided testing (program improves) for the alternative H 1 : 1 < 0 signicant at the 5% level with p-value 0.0265. According to the estimate participating the program degreases the scrap-rate on average 32% (more accurately 27%, since exp(.317058) 1 0.272).

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Dynamic Panel Models Many economic relationships are dynamic. These may be characterized by the presence of lagged dependent variables (27) where (28) vit = ai + uit yit = yi,t1 + xit + vit,

2 ) and u iid(0, 2 ) are inwith ai iid(0, a it u dependent, i = 1, . . . , n, t = 1, . . . , T .

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Alternatively the one-way error component model in (28) can be a two-way specication such that (29) vit = ai + bt + uit,

where all the components are assumed again independent. After dierencing, we have (30) y = yt1 + xit + uit

The lagged term yi,t1 as a regressor variable is correlated with ui,t1, which causes problems in estimation.

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Once regressor variables are correlated with the error term, OLS or GLS estimators become inconsistent. A typical solution to the problem is to apply some kind of instrumental variable estimation. These are least squares (LS) or some other type of methods, where instrumental variables are utilized to remove the inconsistency due to the error term correlation with the regressors. A variable is suitable for an instrumental variable if it is not correlated with the error term, but is correlated with the regressors. Thus, those regressors that are not correlated with the error term can be used also as instruments.

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Example 7 2SLS (two state least squares). Consider a standard regression model (31) yi = xi + ui ,

where xi is a k-vector of regressors (including the constant term) Cov(xi , ui ) = 0, i = 1, . . . , n. Suppose we have m k, additional variables in zi (mvector) such that Cov(zi , ui ) = 0 but Cov(zi , xi ) = 0. 2SLS solution for the problem is such that rst (rst stage) use OLS to regress x-variables on z-variables. In the second stage replace the original regressors xi by the predicted variables xi from the rst stage, and estimate from the regression (32) The estimator (33) 2SLS = (X X )1 X y yi = xi + ui.

is called the 2SLS estimator of .

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In particular, if m = k then (33) becomes (34) IV = (Z X)1 Z y,

which is called the Instrumental Variable estimator of

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Example 8 (Data: http://eu.wiley.com/college/baltagi/ > Student companion site > datasets) Demand for cigarettes in 46 US States [annual data, 19631992]. Estimated equation (35) where (36) vit = ai + bt + uit , cit = + 1 ci,t1 + 2 pit + 3 yit + 4 pn it + vit ,

2 ), and all the ai and bt are xed eects, uit NID(0, u observable variables are in logarithms: cit = real per capita sales of cigarettes by persons of smoking age (14 and older). cigarette average price per pack pit = real average retail price of a pack of cigarettes yit = real per capital disposable income pn it = the minimum real price of cigarettes in any neighboring state (proxy for casual smuggling eect across state borders) ci,t1 is very likely correlated with uit .

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For reference purposes, estimating with panel OLS (average of within group regressions with time dummies) yields
Fixed-effects (within) regression Group variable: state R-sq: within = 0.9283 between = 0.9859 overall = 0.9657 Number of obs Number of groups = = 1334 46 29 29.0 29 508.07 0.0000

Obs per group: min = avg = max = F(32,1256) Prob > F = =

corr(u_i, Xb)

= 0.4743

----------------------------------------------------lc | Coef. Std. Err. t P>|t| -------------+--------------------------------------lc | L1. | .8302514 .0126242 65.77 0.000 | lp | -.2916822 .0230847 -12.64 0.000 ly | .1068698 .0233417 4.58 0.000 lpn | .0354559 .02656 1.33 0.182 _cons | .8204374 .2228775 3.68 0.000 -------------+--------------------------------------sigma_u | .02738301 sigma_e | .03504776 rho | .37905103 (fraction of variance due to u_i) ----------------------------------------------------F test that all u_i=0: F(45, 1256) = 4.52 Prob > F = 0.0000

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Several method are proposed to estimate when there is potential correlation between the error term and (some) regressors. GMM (Generalized Method of Moments) estimation has gained lately much popularity, in particular when there are non-linear moment restrictions. Stata has xtdpd procedure which produces the Arellano and Bond or the Arellano-Bover/Blundell-Bond estimator, which are GMM estimators, where instruments are dened in a particular way (the idea will be discussed in the classroom).

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xtdpd l(0/1).lc lp ly lpn y66-y92, div(lp ly lpn y66-y92) dgmmiv(lc)

Dynamic panel-data estimation Number of obs Group variable: state Number of groups Time variable: year Obs per group: min avg max Number of instruments = 437

= 1334 = 46 = = = 29 29 29

Wald chi2(31) = 13273.45 Prob > chi2 = 0.0000

One-step results ----------------------------------------------------lc | Coef. Std. Err. z P>|z| -------------+--------------------------------------lc | L1. | .8201729 .0161446 50.80 0.000 | lp | -.3607549 .0311244 -11.59 0.000 ly | .1871102 .0334027 5.60 0.000 lpn | -.0215713 .0399233 -0.54 0.589 ----------------------------------------------------Instruments for differenced equation GMM-type: L(2/.).lc Standard: D.lp D.ly D.lpn D.y66 D.y67 D.y68 D.y69 D.y70 D.y71 D.y72 D.y73 D.y74 D.y75 D.y76 D.y77 D.y78 D.y79 D.y80 D.y81 D.y82 D.y83 D.y84 D.y85 D.y86 D.y87 D.y88 D.y89 D.y90 D.y91 D.y92 Instruments for level equation Standard: _cons

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Test for the orthogonality conditions of the instruments

Sargan test of overidentifying restrictions H0: overidentifying restrictions are valid chi2(405) Prob > chi2 = = 561.5047 0.0000

The orthogonality conditions are rejected. The reason may be that that the errors are MA(1), which implies that the GMM instruments (lct2 , . . .) are correlated with the error term. This can be tried to x by dening starting from t 3 with command dgmmiv(lc, lagrange(3 .)). Doing this improved slightly the situation but still lead to rejection of the orthogonality conditions. We however, do not continue the analysis here further.

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