Prof.

Erdin

ECO 310

HOMEWORK #2 SOLUTIONS
Due: October 21, 2010 (5 p.m. in oce 310)

Total: 100 points

Problem 1. (10+5+5+10+5+5=40 points) Consider an equation to explain salaries

of CEOs in terms of annual rm sales ( sales ), return on equity (roe ) and return on
the rm's stock ( ros ) such that

log(salary) = + 1 log(sales) + 2 roe + 3 ros + u

i) Based on the regression output attached, we test the null hypothesis that

none of the variables are signicant for the model such that the model is useless i.e.

H0 : 1 = 2 = 0. We need to use the F test for this test, and it is available in the
output, F = 26.93 and p = 0.0000. Hence we should reject the null and conclude

that there is statistically signicant evidence that at least some of the variables in

this model are signicant and that the model is useful since p = 0.0000 < = 10%.

Also, note that the F = 26.93 > F (3, 205) = 2.08 at 10% signicance and again,

we should reject the null.

log(salary)
ii) Since
ros = 0.0002417 = 3 , then plugging in ros = 50 and mul-

tiplying, we getlog(salary) = 50 0.0002417 = 0.012085 = 1.2085% increase in

salary.
log(salary)
iii) Since
log(sales) = 0.2803149 = 1 , then plugging in log(sales) = 10%
and multiplying, we get log(salary) = 10% 0.2803149 = 0.02803149 = 2.803%
increase in salary.

iv) Test H0 : 1 = 0 (sales has no eect on salary). Since p = 0.000 < =

10%, reject the null and conclude that sales has an individual eect on salary.

Also, note that t = 7.94 > t (0.05, 205) = 1.645 and again, reject the null. Test

H0 : 2 = 0 (roe has no eect on salary). Since p = 0.000 < = 10%, reject

the null and conclude that roe has an individual eect on salary. Also, note that

t = 4.26 > t (0.05, 205) = 1.645 and again, reject the null. Test H0 : 3 = 0
(ros has no eect on salary). Since p = 0.656 > = 10%, Do Not Reject the

null and conclude that ros has no individual eect on salary. Also, note that

t = 0.45 < t (0.05, 205) = 1.645 and again, do not reject the null.

v) All of the estimated coecients are positive and intuitive. These variables

are all relevant for measuring the performance of the CEOs and should raise the

compensation/salary paid to them.

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Homework 2 ECO310, Econometrics Prof. Erdin

vi) Adj. R2 = 0.2722 = 27.22%. It measures that 27.22% of variation in

log(salary) is explained by the regression model including these three variables,

sales, roe and ros.

Problem 2. (7+5+8=20 points)Suppose that the true population model is given

Xi Yi
by Yi = + xi + ui where there is an intercept but you estimate = Xi2
as the

slope coecient.

(Yi Yi )2 = (Yi Xi )2 by choosing . The F OC :

P P
i) Minimize the
(Yi Xi )2
P P P

= 0 i.e. (Yi Xi )(Xi ) = 0, it is easy to show that (Yi Xi ) =
Xi2 gives you the estimator for the model without the intercept as = X i Yi
P
.
Xi2
Xi Yi X i (X i +u i )
ii) Note that we can alternatively write = = = +
Xi2 Xi2
Xi ui Xi ui
then taking the variance,V ar() = V ar( ) since V ar() = 0 as it
Xi2 Xi2
Xi ui
is a constant population parameter. Given V ar(
Xi2
) = (X1 2 )2 V ar(Xi ui ) =
i
1
(X 2 )2
V ar(X1 u1 +X2 u2 +.....+Xn un ) since Xi s are constant/xed, they can be fac-
i
1
 2
tored out. V ar() = (Xi2 )2
X1 V ar(u1 ) + X22 V ar(u2 ) + ..... + Xn2 V ar(un ) .
We know that V ar(ui ) = 2 and Cov(ui uj ) = 0. This means ui s are i.i.d. Hence,
1
X1 2 + X22 2 + ..... + Xn2 2 = (X1 2 )2 2 Xi2 Sim-
 2 
V ar() = (Xi2 )2 i
2
plifying we get V ar() = (Xi2 )
.

iii) If the true model contains an intercept, then the estimator is biased. E() =
E( Xi (+X
X 2
i +ui )
) = + E( X
X 2
i
+ Xi ui
X 2
)= + X
X 2
i
+ XX
i E(ui )
2 ) where E(ui ) = 0
i i i i i
Xi
and E() = + Xi2
is biased unless = 0.

Problem. 3. (10+5+5+10+10=40 points) Using data VOTE1.dta (in folder

Homeworks under ECO 310), estimate the following model to study whether cam-

paign expenditures aect election outcomes.

voteA = + 1 log(expendA) + 2 log(expendB) + 3 prtystrA + 4 shareA + u

wherevoteA is the percentage of the vote received by candidate A, lexpendA

and lexpendB are the logs of the campaign expenditures by candidate A and B

respectively, prtystrA is a measure of party strength for candidate A and shareA is

the share of party A's spending in total campaign spending.

i) At = 10%, there are two variables that are individually insignicant, lex-
pendA and lexpendB. Conducting a Wald test of joint signicance on them, i.e. test-

ing H0 : 1 = 2 = 0 , we get using the p-value approach, p = 0.6671> = 10%.

Hence, we should not reject the null and drop both of these variables.

ii) This question asks you to compute the F statistic based on the UR and

R models to test the joint signicance of the variables, the same hypothesis as
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Homework 2 ECO310, Econometrics Prof. Erdin

above. You need to create a restricted model under the null, setting the coef-
cients of these two variables equal to zero! The restricted model is voteA =
+ 1 prtystrA + 2 shareA + u and run this regression using Stata. Now compute
(SSRR SSRU R )/2
the F statistic =
SSRU R /168 = (6600.916569.18)/2
6569.18/168 = 0.41. Using this long

approach, you should say, since F = 0.41 < F (2, 168) = 2.30 at = 10%. We

again do not reject the null hypothesis.

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iii) Since Adj. RU R = 0.8612 = 86.12% and Adj. RR = 0.862, dropping these

variables improves the t of the model by raising its value in the restricted model.

iv) Test the restriction that 1% increase in party A's spending is oset by a 1%

increase in party B's spending for voteA, i.e. test H0 : 1 = 2 . Using the Wald

test for restrictions, we run the stata command: test lexpendA+lexpendB =0. This

yields F = 0.11 < F (1, 168) = 2.71 at = 10% and we should not reject the null

hypothesis. The restriction is valid and that 1% increase in party A's spending is

really oset by a 1% increase in party B's spending for voteA. Alternatively, using

the p-value approach, p = 0.7366> = 10%. Again, we should not reject the null.

v) You can write your restricted model under H0 : 1 = 2 by plugging this

restriction into your UR model such that you get: voteA = + 1 log(expendA)
1 log(expendB)+3 prtystrA+4 shareA+u or voteA = +1 [log(expendA) log(expendB)]+
3 prtystrA + 4 shareA + u and call this your restricted model. Create a new vari-

able called dif f = log(expendA) log(expendB) by using the generate command

in Stata and run this R model by regressing voteA = + 1 [dif f ] + 3 prtystrA +

4 shareA + u . After this step, you should create your F ratio. This is of course

the long approach.