Addis Ababa Medical & Business College
INTRODUCTION TO ECONOMETRICS
FOR
DEPARTMENT OF ACCOUNTING & FINANCE AND
BUSINESS MANAGEMENT
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CHAPTER 5: REGRESSION ON
DUMMY
Introduction DEPENDENT VARIABLE
Standard linear regression models are applied when
the behavior of economic agents is approximated by
continuous variables such as income, saving,
expenditure, output, etc.
But there are many situations in which the
dependent variable in a regression equation simply
represents a discrete choice assuming only a limited
number of values.
Models involving dependent variables of this kind are
called limited (discrete) dependent variable models
(also called qualitative response models).
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Cont…
The purpose of this unit is to familiarize
students with the concept of qualitative
dependent variable in a regression model
and the estimating problems associated with
such models.
Conventional regression cannot be used to
analyze a qualitative dependent variable
model.
The models are analyzed in a general
framework of probability models. 1-3
Categories of Qualitative
Response Models (QRM)
Two broad categories of QRM are:
A. Binomial Model
The choice is between two alternatives
B. Multinomial models
The choice is between more than two
alternatives
Example: Y = 1, occupation is farming
= 2, occupation is carpentry
= 3, occupation is fishing 1-4
Definition of some important
terminologies
Binary variables: are variables that have two
categories and are often used to indicate
that an event has occurred or that some
characteristic is present.
Example: - Decision to participate in the labor
force/or not to participate
-Decision to vote or not to vote
Ordinal variables:- these are variables that
have categories that can be ranked.
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Cont……..
Nominal variables: These variables occur when
there are multiple outcomes that cannot be
ordered.
Example: Occupation can be grouped as farming,
fishing, carpentry etc.
Y = 1 farming
= 2 fishing
= 3 carpentry
= 4 Livestock
Count variables: These variables indicate the
number of times some event has occurred. 1-6
Approaches to estimate binary
response models (Type of binomial
models).
1.Linear Probability Models
2.The Logit Model
3.The Probit Model
4.The Tobit (censored regression) Model.
The Linear Probability Model (LPM)
The linear probability model is the regression model
applied to a binary dependent variable.
To fix ideas, consider the following simple model:
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Cont……..
where X = family income
Y = 1 if the family owns a house
= 0 if the family does not own a house
Ui is the disturbance term
The above model expresses the dichotomous Yi as a
linear function of the explanatory variable Xi.
Such kinds of models are called linear probability
models (LPM) since E(Yi/Xi) the conditional
expectation of Yi given Xi, can be interpreted as the
conditional probability that the event will occur
given Xi; that is, Pr(Yi = 1/Xi). 1-8
The justification of the name LPM can be
seen as follows.
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THE LOGIT MODEL
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Cont….
This equation represents what is known as the
(cumulative) logistic distribution function. Since
the above equation is non linear in both the X and
the ’s.
This means we cannot use the familiar OLS
procedure to estimate the parameters.
This can be linear as follows.
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Cont….
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Cont….
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THE PROBIT MODEL
The estimating model that emerges from
the normal CDF is popularly known as the
probit model.
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Cont…
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Cont…
A logit estimate of a parameter multiplied
by 0.625 gives a fairly good approximation of
the probit estimate of the same parameter.
Since Y* is continuous the model avoids the
problems inherent in the LPM model (i.e., the
problem of non-normality of the error term
and heteroscedasticity)
However, since the latent dependent variable is
unobserved the model cannot be estimated
using OLS. Maximum likelihood can be used
instead. 1-17
THE TOBIT MODEL
The Tobit model is an extension of the
probit and is mainly applied when we
have censored data.
The tobit model is:
Y i = X i + i
*
The method of maximum likelihood can be used to
estimate the parameters of such models. 1-18
Friday, July 19, 2024 1-19
