Econ 3720, Introduction to Regression Analysis

Professor Ariell Reshef

University of Virginia
Lecture 11 Non-Linear Models
1
In this lecture we will see how you can transform non-linear models into linear ones, so that we can estimate
them using OLS. All the assumptions that are required for OLS to be unbiased, BLUE and consistent will
have to hold in the transformed model. However, you do need to pay more attention to the interpretation
of the coecients.
Please review the Chapter 8 in Stock and Watson for more non-linear models and interpretations, and
some illuminating examples.
1 Polynomials
These are models of the type
1
I
= ,
0
+,
1
A
I
+,
2
A
2
I
+... +,
|
A
|
I
+-
I
.
Estimating this kind of model requires transforming it into a linear model. You must generate new variables
A
2I
= A
2
I
A
3I
= A
3
I
.
.
.
A
|I
= A
|
I
and estimate
1
I
= ,
0
+,
1
A
I
+,
2
A
2I
+... +,
|
A
|I
+-
I
,
which is just a multiple linear regression model.
When evaluating the eect of changing A
I
you must remember that the eect is
01
I
0A
I
= ,
1
+ 2 ,
2
A
I
+... +/ ,
|
A
|1
I
,
so you need to decide at which value of A
I
to evaluate the derivative. In other words, your statements on
the marginal eect of A
I
on 1
I
will depend on the value of A
I
around which you are making changes.
1
See also Chapter 8 in Stock and Watson.
1
Example: returns to experience. Many economic outcomes exhibit diminishing returns with respect
to some factor. It turns out that the relationship between wages and experience (or age) exhibit
diminishing returns that are well captured by a hyperbola
\
I
= ,
0
+,
1
A
I
+,
2
A
2
I
+-
I
,
where \
I
is wages and A
I
is experience.
2
So you would expect ,
1
to be positive and ,
2
to be negative.
Estimating this model requires computing A
2I
= A
2
I
and estimating
\
I
= ,
0
+,
1
A
I
+,
2
A
2I
+-
I
.
Just remember that the eect of one more year of experience is not ,
1
but changes with experience:
,
1
+ 2 ,
2
A
I
.
2 The log-log model
Suppose that you want to estimate a Cobb-Douglas production function:
1 = 1
o

1o
.
This is a non linear model, but by taking logs on both sides you get
ln(1 ) = ln() +cln(1) + (1 c) ln() ,
which is linear in the log variables. Estimating this model requires transforming it into a linear model. You
must generate new variables
j = ln(1 )
/ = ln(1)
: = ln()
and estimate
j
I
= ,
0
+,
1
/
I
+,
2
:
I
+-
I
,
which is just a multiple linear regression model. In this case, ,
0
= ln(), ,
1
= c and ,
2
= 1 c.
Notice that in this way you can test whether some production function exhibits constant returns to scale by
H
0
: ,
1
+,
2
= 1.
If we want to estimate the parameters of the model without bias and in a consistent way using OLS,
then we require that 1 (-
I
j/
I
, :
I
) = 0. This means that in the original Cobb-Douglas production function
2
In the data this relationship does not hold well in levels, but if you replace W
i
with ln (W
i
), then the relationship is very
tight. In one of the following subsections you will see how to tackle such a model.
2
1 = 1
o

1o
, there is actually an additional multiplicative term c
:i
such that 1 = 1
o

1o
c
:
. It is
useful to think about what might justify this additional term. Usually it is assumed to be a technological
shock. It is also important to notice that given 1 (-
I
j/
I
, :
I
) = 0, 1 (c
:
j1, ) is not c
0
= 1. The reason is that
a zero mean error inside a convex function (the exponential) has a level eect. If - is normally distributed
around zero, i.e. -

0, o
2
:

, then 1 (c
:
j1, ) = c
1
2
c
2
"
1.
The interpretation of the coecients in the log-log model is that of elasticities. After all, the elasticity
of 1 with respect to 1 is dened as
j
,|
=
01
01

1
1
=
d ln(1 )
d ln(1)

ln(1 )
ln(1)
.
Remember: log dierences are approximately percent changes
ln(1 ) = ln(1
2
) ln(1
1
)
1
2
1
1
1
1
=
1
1
.
So in our Cobb-Douglas model increasing 1 by 1 percent will increase 1 by ,
1
percent.
3 Half-log models
These are models of the type
1
I
= c
o
0
+o
1
i+:i
.
This is a non linear model, but by taking logs on both sides you get
ln(1
I
) = ,
0
+,
1
A
I
+-
I
. (1)
As with the log-log models, you need to create the log variables from the original ones, j = ln(1 ), and
estimate
j
I
= ,
0
+,
1
A
I
+-
I
The interpretation of the coecients again depends on the point at which the marginal eects are eval-
uated. The eect of A on 1 in 1 is a "half elasticity":
,
1
=
0 ln(1 )
0A

ln(1 )
A
.
This means that a change in one unit of A will result in a change of ,
1
percent in 1 . But the level eect is
going to be
01
0A
= ,
1
c
o
0
+o
1
i
,
which depends on A. I conveniently assumed that -
I
= 0. In practice, you will need to assume something
about what is -
I
, but let us not get into this right now.
When making expectations about levels we must take into account the fact that the zero mean error has
non-zero eects on the level of the left hand side variable, in a similar way to what we saw above in the
log-log model.
3
Example: The Mincer model of human capital accumulation and wages. This model gives rise to a
wage equation that is half log:
\
I
= c
o
0
+o
1
i+o
2

2
i
+o
3
Si+:i
,
where \
I
are wages, A
I
is experience and o
I
is years of schooling (what labor economists call "invest-
ment in human capital"). Taking logs we obtain
ln\
I
= ,
0
+,
1
A
I
+,
2
A
2
I
+,
3
o
I
+-
I
.
This model combines both the half log and polynomial.
Another form of half-log models is
1
I
= ,
0
+,
1
ln(A
I
) +-
I
. (2)
You need to create the log variables from the original ones, r = ln(A), and estimate
1
I
= ,
0
+,
1
r
I
+-
I
.
The interpretation of ,
1
depends on the point at which the marginal eect are evaluated. The eect of
A on 1 is
,
1
=
01
0 ln(A)

1
ln(A)
.
This means that a change of 1 percent of A will result in a change in ,
1
units of 1 . But the level eect is
going to be
d1
dA
= ,
1
1
A
.
4 Models with dummy variables and interactions
Models with dummy variables and interactions are also non-linear models. See Lecture 12.
4