Static Panel Data Suitable For Viewing

L14205 Applied Microeconometrics
Lecture 1:
Static Panel Data Modelling
Professor Sourafel Girma

sourafel.girma@nottingham.ac.uk
Lecture 1: Static panel data modelling
Slide 1 of 48
Lecture objectives :
1. Explain the nature of panel data
2. Discuss the modelling of time effects and estimation
of robust standard errors.
3. Discuss the estimation and testing of the random and
fixed effects models.
4. Explain the Hausman test for correlated effects.

5. Demonstrate the practical estimation of panel data
models.
Slide 2 of 48
1. Introduction
2. The example dataset
3. Time effects
4. Robust standard errors
5. The random effects model
6. The fixed effects model
7. Summary
Slide 3 of 48
1
Introduction
Slide 4 of 48
1. Introduction
Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
Firm 1
Invest Assets
33.1 1170.6
45
2015.8
77.2 2803.3
44.6 2039.7
48.1 2256.2
74.4 2132.2
113 1834.1
91.9
1588
61.3 1749.4
56.8 1687.2
93.6 2007.7
Firm 2
Invest Assets
317.6 3078.5
391.8 4661.7
410.6 5387.1
257.7 2792.2
330.8 4313.2
461.2 4643.9
512 4551.2
448 3244.1
499.6 4053.7
547.5 4379.3
561.2 4840.9
Firm 3
Invest Assets
209.9 1362.4
355.3 1807.1
469.9 2673.3
262.3 1801.9
230.4 1957.3
361.6 2202.9
472.8 2380.5
445.6 2168.6
361.6 1985.1
288.2 1813.9
258.7 1850.2
Firm 4
Invest Assets
12.93 191.5
25.9
516
35.05
729
22.89 560.4
18.84 519.9
28.57 628.5
48.51 537.1
43.34 561.2
37.02 617.2
37.81 626.7
39.27 737.2
We can see the above dataset as 4 separate time series

datasets, one for each firm.
Alternatively, we can see it as 11 separate cross-sectional
datasets, one for each year.
Or we can see it as one big dataset by pooling (combining) the
time series and cross sectional observations. In this case the
pooled data set is called a panel data set.
Slide 5 of 48
1. Introduction
Firm
1
1
1
1
2
2
2
2
3
3
3
3
4
4
4
4
Year
1980
1981
1980
1981
1980
1981
1980
1981
Invest
33.1
45
317.6
391.8
Assets
1170.6
2015.8
3078.5
4661.7
209.9 1362.4
355.3 1807.1
12.93 191.5
25.9
516
If we pool the data, we have one big

dataset.
We can estimate one regression
(y= Invest; X=Assets)
yit = + xit + eit
where i = 1, 2, 3, 4 (firm) and

t= 1980, 1981, 1990(time period)
we now have 44 observations in the
model (4 x 11)
Examples of indexing:
Y3,1981 = 355.3
X1,1980 = 1170.6
If we apply a simple regression
technique (OLS) to the model, we call
this the Pooled Model.
Slide 6 of 48
1. Introduction
Typically panel data consist of observations for the same units

(e.g. firms, countries, or individuals) across time (e.g. yearly or
monthly). This is also referred to as longitudinal data.
However any two or more dimensional data can be treated as
panel data (e.g. universities-courses; regions-firms; farms-plots).
Simple regression analysis using OLS may not always be
adequate for such complicated datasets. Hence we may need
special techniques or estimators.
Two such estimators are especially useful in the context of
linear static panel data models: the fixed effects and the random
effects estimators.
For all intents and purposes one can see linear static panel data
modelling as a three-horse race: For the particular model we propose
to estimate and the specific data in hand, which of the OLS, fixed effects
and random effects estimators is most appropriate?
Slide 7 of 48
1. Introduction
The good news is that there are formal statistical tests that
help identify the winner of this race, and in this lecture we will
discuss the practical implementation of these tests via an
empirical example. A typical panel data model can be written as
= 0 + 1 + + ; i=1,,N;t=1,.T
~ 0, 2
~ 0, 2

e is the usual idiosyncratic random error term which vary with
i and t. The innovation in panel data modelling is the introduction

of the term ui which is time-invariant for each individual unit. It
is the permanent effect associated with individual unit and can
be thought of as capturing unobserved individual heterogeneity.
Slide 8 of 48
1. Introduction
For example if y denotes wages and x is education, ui would

capture the impact of time-invariant individual characteristics
such as ability or family connections that affect earnings.
A three-horse race:
1. There are no individual effects, that is 2 =0 or = 0 for
all i, in which case OLS will be most appropriate .
2. There are individual effects and these are not correlated
with the regressor x. In this case the random effects
estimator will be most appropriate .
3. There are individual effects and these are correlated with
the regressor x. In this case, the fixed effects estimator
is the only appropriate method, and the OLS and random
effects estimators should not be used.
Slide 9 of 48
1. Introduction
Slide 10 of 48
2.
The example dataset
Slide 11 of 48
2. Example
dataset
To fix ideas consider the research question Does advertisement work?

A management consultant was asked to write a report on whether
advertisement expenditure leads to statistically and economically
significant improvements in company profitability.
The consultant decided to use an econometric analysis based on a
panel dataset of 250 companies over the period 2003-2006, and
collected the following variables for this purpose:
1. Log of companys profitability (profits) which is before-tax profits
divided by sales.
2. Log of companys market share (mkshare) in its industry (expected
to have positive effect on profitability).
3. Log of index of industry competition (expected to have negative
effect on profits)
4. Log of advertisement (advert) expenditure divided by sales ( ?).
5. Panel unit identifier is company and time identifier is year
Slide 12 of 48
2. Example
dataset
A screenshot of the dataset (advert.dta)
Slide 13 of 48
2. Example
dataset
Start by declaring which variable identifies panel units

(company) and which one indicates time (year) :
We can see that the panel data span the period 2003 to 2006, and
it is a balanced panel. That is all companies were observed over
the whole period.
In an unbalanced panel data, different panel units have different
number of observations.
- e.g. some companies might be observed from 2003 to
2006, while others are observed for 2004 and 2005 only.
Slide 14 of 48
2. Example
dataset
Summary statistics by year
Slide 15 of 48
2. Example
dataset
Take note of the within versus between companies

variability of the variables
Slide 16 of 48
3.
Time effects
Slide 17 of 48
3. Time effects
If we assume that all companies have the same profitability

function, and this is stable over time, we can use OLS on the
panel data. This is called the pooled regression.
It seems that there is a negative albeit statistically insignificant

relationship between advertisement and profitability.
Slide 18 of 48
3. Time effects
The pooled regression model is simple to estimate as it does

not require the use of any special techniques. But it does not
make full use of the richness of the panel data.
Is the profit function really stable over the time period 2003-2006?
Do all of the companies really have the same profits function?
The pooled model ignores company heterogeneity and time
differences, and this might lead to wrong conclusions. It is
therefore advisable to check whether pooling is appropriate.
One possibility is to test for time effects. For example, business
cycle effects might be important in determining the overall level
of company profitability. We can explore this possibility by reestimating the model with year dummies.
Slide 19 of 48
3. Time effects
Testing for time effects involves three simple steps:

1. Add time dummies to the pooled regression model.
-- In our case, we have yearly data (2003-2006).
-- So we include 3 year dummies ( say from 2004 to 2006)
to avoid the dummy variable trap.
2. Estimate the model using OLS.
3. Test if the time dummies are jointly equal to zero.
If we reject the null hypothesis that the time dummies
are equal to zero, we conclude that there are time effects
in the data and the pooled regression model is not
appropriate.
Next we demonstrate how to implement these steps in
practice.
Slide 20 of 48
3. Time effects
Slide 21 of 48
3. Time effects
Testing the joint significance of the time effects:
No evidence that time (year) effects are significant. This means that
the average level of profits (conditional on the regressors) has not
fluctuated much during the sample period.
Slide 22 of 48
3. Time effects
In the previous regression, the effect of advertisement on profits is

assumed to be stable across the years. But it would be useful to
explore whether the profits-advertisement relationship has changed
over time by interacting the year dummies with advertisement.
Slide 23 of 48
4.
Robust standard errors
Slide 24 of 48
4. Robust
standard
errors
Heteroscedasticity is prevalent in cross sectional data and

serial correlation is widespread in time series data.
Since panel data is a combination of cross sectional and time
series data, both problems are likely to be present.
There are many methods of dealing with these problems in
panel data, some more complicated than others. Here we
consider the simplest but most widely used method.
This method gives standard errors of regression coefficients
that are robust to heteroscedasticity and serial correlation.
These robust standard errors can be used to test hypotheses
about the model parameters and construct confidence
intervals.
Slide 25 of 48
4. Robust
standard
errors
Serial correlation within each panel unit is sometimes referred

to as clustering, and the robust standard errors are also known
as clustered standard errors.
Consider the following pooled panel data model
yit xit e it
i 1,...N ; t 1,..., T .
Given independence over the panel units i, allows for

heteroscedastic errors terms and unrestricted serial
correlation within panel units. That is, for all t and s
Cove it , e is 0
Let ols and eit yit xit ols denote the OLS estimator
and the estimated residual term.
Slide 26 of 48
4. Robust
standard
errors
Assuming finite T and , the panel-robust estimator of the

asymptotic variance covariance matrix is
V ols W WW
Where
W xit xit
i 1 t 1
and
W xit xis eit eis

i 1 t 1 s 1
Note that if we only wanted to correct for heteroscedasicity ( that is

assuming serially uncorrelated errors), the matrix W would simplify to
N
W xit xit e it2

i 1 t 1
Slide 27 of 48
4. Robust
standard
errors
Pooled model with panel robust standard errors.
Slide 28 of 48
5.
The Random Effects Model
Slide 29 of 48
5. Random
effects model
Recall that:
1. A panel data model is called a random effects model if
ui is not correlated with the regressors.
2. By contrast a panel data model where the individual

heterogeneity term is correlated with the regressors is
referred to as the fixed effects or correlated effects
model.
3. The most important question in applied static panel data
analysis is to determine which of the three contenders
pooled, random effects and fixed effects models -- is the
most appropriate for the data in hand.
Slide 30 of 48
5. Random
effects model
Consider the following panel data model with the individual specific
effects ui are assumed to be uncorrelated with the regressor, x:
= 0 + 1 + +
~ 0, 2 and ~ 0, 2
i=1, .N; t=1, ,T.
It can be shown that the model is best estimated by Generalised Least
Squares ( GLS). The model is called the random effects model and the GLS
estimator is usually called the random effects estimator. To demonstrate
the mechanics of the random effects estimator, define the time means of
y and x as
T
xit
yi
yit
i 1
and
xi i 1
T
Slide 31 of 48
5. Random
effects model
The random effects GLS estimator is equivalent to estimating the

following transformed model by OLS
( ) = 0 1 + 1 ( ) +
where
=1
2 +2
= 1 + ( )
The above transformation is sometimes called the GLS
transformation.
In unbalanced panel with i=1, .N; t=1, ,Ti, the above
transformation factor will have to be individual specific, i.e.
2
= 1
2 + 2
Slide 32 of 48
5. Random
effects model
Estimating the random effects profitability model
Advertisement doesnt seem to work?

Slide 33 of 48
5. Random
effects model
Testing for individual heterogeneity in random effects models
When there is individual heterogeneity, the random effects model

is more efficient than the pooled model.
But if there is no heterogeneity in the panel data, it is better to
use the pooled model (apply OLS). So it is advisable to test for the
presence of heterogeneity.
The Breusch-Pagan test can be used for this purpose. The null
hypothesis of this test states that there is no heterogeneity.
Rejection of the null hypothesis can be taken as evidence in

favour of the random effects model.
Slide 34 of 48
5. Random
effects model
How to choose between REM vs. Pooled Regression ?

Breusch and Pagan (1980) have devised a Lagrange
Multiplier (LM) test for the REM against the Pooled
Regression based on the OLS residuals.
The hypotheses are:
H0 : 2 = 0 Pooled regression is more appropriate)
Ha: 2 0 ( REM is more appropriate)
The LM test-statistic is based on the OLS (restricted model)

residuals and follows a Chi-Square distribution with 1
degree of freedom :
2
N T
i 1 t 1 it
NT
LM
1
N T
2
2T 1
e
it
i 1i 1
N is the number of cross sections

T is the number of time periods.
Slide 35 of 48
5. Random
effects model
Testing for individual heterogeneity in random effects models.

In practice, use the following command right after estimating the
random effects model
P-value = 0, so reject the null hypothesis of no random effects.

OLS would have been inefficient.
Slide 36 of 48
6.
The Fixed Effects Model
Slide 37 of 48
6. Fixed effects
model
We saw that the random effects model is preferable to the pooled

model if there is individual heterogeneity in the panel data.
But recall that the random effects model assumes that the individual
heterogeneity term is not correlated with the regressors of the
model).
If this assumption is not correct, and the regressors and ui are indeed
correlated, and the random effects model would be inappropriate.
The fixed effects model which allows for correlation between the
regressors and the heterogeneity term should be used.
The fixed effects model is sometimes referred to as the Least Squares
Dummy Variables model.
Slide 38 of 48
6. Fixed effects
model
Consider our panel data model

= 0 + 1 + +
But now assume that ui is correlated with x:
Because of this correlation, OLS will be biased and inconsistent. For

this reason, we first eliminate the effects through the so-called
within transformation of the data and then estimate the transformed
model using OLS:
( ) = 1 ( ) + ( )
The resulting estimator is called the within estimator, and it unbiased
and consistent.
Slide 39 of 48
6. Fixed effects
model
An alternative to the within transformation for dealing with regressorindividual effects correlation is the first-differenced transformation:
( 1 ) = 1 ( 1 ) + ( 1 )
When T=2 , the first-differenced and the within estimators are

algebraically equivalent.
However,
drawback
of
the
within
and
first-differenced
transformations is that they also eliminate all variables that are timeinvariant. For example if the profitability regression model includes the
gender of the manager as an explanatory variable, this variable will
drop out of the transformed model.
Slide 40 of 48
6. Fixed effects
model
Estimating the fixed effects model
For the time being , we are ignoring the

possibility of non-iid errors.
Advertisement seems to work!
The fixed effects estimator is also called least squares dummy variables
estimator. Here 249 companies dummies are (implicitly) used, and the Ftest shows that these are jointly significant: another evidence that there
are individual specific effects.
Slide 41 of 48
6. Fixed effects
model
Fixed or random effects model?
The choice between the fixed and random effects models is an

important issue in applied panel data analysis.
If the individual effects (heterogeneity) and the regressors are
uncorrelated, use the random effects model as it is the best
(although the fixed effects model is still useful).
If the regressors and the individual effects are correlated, choose
the fixed effects model and never use the random effects model.
The test used to choose between the two models is known as
the Hausman test.
The null hypothesis of this test states that there is no
correlation between regressors and individual effects. So
rejection of the null favours the fixed effects model.
Slide 42 of 48
6. Fixed effects
model
The Hausman test

H0: Regressors and effects ( heterogeneity) are not correlated
H1: They are correlated
Under H0 the Hausman test statistic is distributed as a Chi-Square

random variable with degrees of freedom equal to the number of
regressors.
The formula of the Hausman test statistic is
Where the FEM and REM indices are used to denote the fixed and random
effects estimators respectively, and
Slide 43 of 48
6. Fixed effects
model
Going back to our empirical example, results from the random effects
(RE) estimator appear to suggest that there is no relationship
between advertisement and profitability. By contrast the fixed effect
(FE) estimator would appear to suggest that advertisement works.
Which model should we trust more? Enter the Hausman test!
Reject the null hypothesis that RE model

is best. Discard RE results and base
your analysis on FE model.
Slide 44 of 48
6. Fixed effects
model
Micro panel data are typically characterised by heteroscedasticity and

within units serial correlation. So it is advisable to estimate the random
and fixed effects using robust standard errors.
One important practical implication of doing so is that the standard
Hausman test does not work with non-i.i.d errors ( heteroscedastic and
serially correlated ). For instance when ~ 0, 2 .
Instead a robust version of the Hausman test should be used. This
involves estimating the following model by OLS with robust standard
errors :
= 0 1 + 1 ( ) + 2 ( ) +
where l is as defined on Slide 32.

Testing the null hypothesis 20 is then equivalent to testing the null
hypothesis that the individual effects are not correlated with x.
One way to practically implement this approach is to use the user-written
Stata program xtoverid (you should be able to install this into your machine
by typing ssc install xtoverid , replace from within Stata).
Slide 45 of 48
6. Fixed effects
model
Robust version of Hausman test using xtoverid command, which in

this case is given by the Sargan-Hansen statistic
Thus reject the RE model in favour of the FE model.
Slide 46 of 48
7.
Summary
Slide 47 of 48
7. Summary
The estimation of static linear panel data models boils down to the
choice between three estimators:
1.
The pooled model should be used when there is no individual
heterogeneity in the model.

2.
When there is individual heterogeneity and it is not correlated with the

independent variables of the model, the random effects model should be
preferred.
3.
The Hausman test helps us decide whether this is the case or not. If the
individual heterogeneity is correlated with the independent variables, the
fixed effects model should be used.
THANK YOU!
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L14205 Applied Microeconometrics

Professor Sourafel Girma

Lecture 1: Static panel data modelling

4. Explain the Hausman test for correlated effects.

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

We can see the above dataset as 4 separate time series

Lecture 1: Static panel data modelling

L14025 Applied Microeconometrics

If we pool the data, we have one big

yit = + xit + eit

where i = 1, 2, 3, 4 (firm) and

Lecture 1: Static panel data modelling

Typically panel data consist of observations for the same units

Lecture 1: Static panel data modelling

e is the usual idiosyncratic random error term which vary with

i and t. The innovation in panel data modelling is the introduction

Lecture 1: Static panel data modelling

For example if y denotes wages and x is education, ui would

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

To fix ideas consider the research question Does advertisement work?

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

A screenshot of the dataset (advert.dta)

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

Start by declaring which variable identifies panel units

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

Summary statistics by year

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

Take note of the within versus between companies

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

If we assume that all companies have the same profitability

It seems that there is a negative albeit statistically insignificant

Lecture 1: Static panel data modelling

The pooled regression model is simple to estimate as it does

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

Testing for time effects involves three simple steps:

Lecture 1: Static panel data modelling

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

Testing the joint significance of the time effects:

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling

In the previous regression, the effect of advertisement on profits is

L14025 Applied Microeconometrics

Lecture 1: Static panel data modelling