Christopher Dougherty

EC220 - Introduction to econometrics

(chapter 14)
Slideshow: fixed effects regressions: LSDV method
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FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

In the third version of the fixed effects approach, known as the least squares dummy
variable (LSDV) method, the unobserved effect is brought explicitly into the model.
1

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

If we define a set of dummy variables Ai, where Ai is equal to 1 in the case of an observation
relating to individual i and 0 otherwise, the model can be rewritten as shown.
2

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

Formally, the unobserved effect is now being treated as the coefficient of the individualspecific dummy variable, the iAi term representing a fixed effect on the dependent variable
Yi for individual i (this accounts for the name given to the fixed effects approach).
3

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

Having re-specified the model in this way, it can be fitted using OLS.

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

Note that if we include a dummy variable for every individual in the sample as well as an
intercept, we will fall into the dummy variable trap.
5

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

To avoid this, we can define one individual to be the reference category, so that 1 is its
intercept, and then treat the i as the shifts in the intercept for the other individuals.
6

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

However, the choice of reference category is often arbitrary and accordingly the
interpretation of the i not particularly illuminating.
7

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

Alternatively, we can drop the 1 intercept and define dummy variables for all of the
individuals, as has been done here. The i now become the intercepts for each of the
individuals.
8

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

Note that, in common with the first two versions of the fixed effects approach, the LSDV
method requires panel data.
9

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

With cross-sectional data, one would be defining a dummy variable for every observation,
exhausting the degrees of freedom. The dummy variables on their own would give a perfect
but meaningless fit.
10

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it

If there are a large number of individuals, using the LSDV method directly is not a practical
proposition, given the need for a large number of dummy variables.
11

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it
Equivalent to within-groups method:
k

Yit Yi j ( X jit X ji ) ( t t ) it i
j2

However, it can be shown mathematically that the approach is equivalent to the withingroups method and therefore yields precisely the same estimates.
12

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it
Equivalent to within-groups method:
k

Yit Yi j ( X jit X ji ) ( t t ) it i
j2

Thus in practice we always use the within-groups method rather than the LSDV method.
But it may be useful to know that the within-groups method is equivalent to modelling the
fixed effects with dummy variables.
13

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it
Equivalent to within-groups method:
k

Yit Yi j ( X jit X ji ) ( t t ) it i
j2

The only apparent difference between the LSDV and within-groups methods is in the
number of degrees of freedom. It is easy to see from the LSDV specification that there are
nT k n degrees of freedom if the panel is balanced.
14

FIXED EFFECTS REGRESSIONS: LSDV METHOD

Fixed effects estimation (least squares dummy variable method)
k

Yit 1 j X jit t i it
j 2

j2

i 1

Yit j X jit t i Ai it
Equivalent to within-groups method:
k

Yit Yi j ( X jit X ji ) ( t t ) it i
j2

In the within-groups approach, it seemed at first that there were nT k. However n degrees
of freedom are consumed in the manipulation that eliminate the i, so the number of
degrees of freedom is really nT k n.
15

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

To illustrate the use of a fixed effects model, we return to the example in Section 1 and use
all the available data from 1980 to 1996, 20,343 observations in all.
16

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

The table shows the extra hourly earnings of married men and of men who are single but
married within the next four years. The omitted category in the first two columns is single
men who are still single four years later.
17

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

The controls (not shown) are the same as in the example in the first slideshow on panel
data.
18

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

The first column gives the estimates obtained by simply pooling the observations and using
OLS with robust standard errors. The estimates are very similar to those in the wage
equation for 1988 in the example in the first slideshow on panel data.
19

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

The second column gives the fixed effects estimates, using the within-groups method, with
single men as the reference category. The third gives the fixed effects estimates with
married men as the reference category.
20

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

The fixed effects estimates are considerably lower than the OLS estimates, suggesting that
the OLS estimates were inflated by unobserved heterogeneity. Nevertheless the pattern is the
same.
21

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

Our findings confirm that married men earn more than single men. Part of the differential
appears to be attributable to the characteristics of married men, since men who are soonto-marry but still single also enjoy a significant earnings premium.
22

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

However if we make married men the omitted category, as in the third column, we find that
soon-to-be-married men earn significantly less than married men. Thus part of the
marriage premium appears to be attributable to the effect of marriage itself.
23

FIXED EFFECTS REGRESSIONS: LSDV METHOD

NLSY 19801996
Dependent variable logarithm of hourly earnings
OLS

Fixed effects

Married

0.184
(0.007)

0.106
(0.012)

Soon-to-bemarried

0.096
(0.009)

0.045
(0.010)

0.061
(0.008)

Single

0.106
(0.012)

R2

0.358

0.268

0.268

20,343

20,343

20,343

Hence both hypotheses relating to the marriage premium appear to be partly true.

24

Copyright Christopher Dougherty 2011.

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The content of this slideshow comes from Section 14.2 of C. Dougherty,
Introduction to Econometrics, fourth edition 2011, Oxford University Press.
Additional (free) resources for both students and instructors may be
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Individuals studying econometrics on their own and who feel that they might
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of Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
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11.07.25