During This Course We Will Work With The Three Types of Data Described Above

TYPES OF REGRESSION MODEL AND ASSUMPTIONS FOR MODEL A
Types of data
Cross-sectional: Observations on individuals, households,

enterprises, countries, etc at one moment in
time (Chapters 1–10, Models A and B)
Time series: Observations on income, consumption,
interest rates, etc over a number of time
periods (years, quarters, months, …)
(Chapters 11–13, Model C)
Panel data: Observations on the same cross-section of
individuals, households, etc over a number of
time periods (Chapter 14, Model B)
During this course we will work with the three types of data described above.
1
Types of model
Model A: Cross-sectional data with nonstochastic regressors.

Their values in the observations in a sample do not
have stochastic (random) components.
Model B: Cross-sectional data with stochastic regressors. The
values of the regressors are drawn randomly and
independently from defined populations.
Model C: Time series data. The values of the regressors may
exhibit persistence over time. Regressions with time
series data potentially involve complex technical
issues that are best avoided initially.
Different regression models are appropriate for different types of data. We will consider
three types of regression model, as shown above.
2
Types of model

We will start with Model A. We will do this purely for analytical convenience. It enables us
to conduct the discussion of regression analysis within the relatively straightforward
framework of what is known as the Classical Linear Regression Model.
3
Types of model

We will replace it in Chapter 8 by the weaker and more realistic assumption, appropriate for
regressions with cross-sectional data, that the observations on the regressors are
randomly drawn from defined populations.
4
Assumptions for Model A
A.1: The model is linear in parameters and correctly specified.

Y =  1 + 2 X + u
Examples of models that are not linear in parameters:

Y  1 X 2  u
Y = 1 + 2X2 + 3X3 + 23X4 + u
‘Linear in parameters’ means that each term on the right side includes a  as a simple
factor and there is no built-in relationship among the s. We will defer a discussion of
issues relating to linearity and nonlinearity to Chapter 4.
5
A.2: There is some variation in the regressor in the sample.
There must be some variation in the regressor in the sample. Otherwise it cannot account
for any of the variation in Y.
6
A.2: There is some variation in the regressor in the sample.
  X  X  Y  Y 
i i
b2 
 X  X 
2
i
0
If X i  X for all i , b2  .
0
If we tried to regress Y on X, when X is constant, we would find that we would not be able to
compute the regression coefficients. Both the numerator and the denominator of the
expression for b2 would be equal to zero. We would not be able to obtain b1 either.
7
A.3 The disturbance term has zero expectation

E(ui) = 0 for all i
Suppose Y = 1 +  2X + u
Define vi = ui – u
Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0
We assume that the expected value of the disturbance term in any observation should be zero.
Sometimes the disturbance term will be positive, sometimes negative, but it should not have a
systematic tendency in either direction.
8

E(ui) = 0 for all i
Suppose Yi = 1 + 2Xi + ui
Actually, if an intercept is included in the regression equation, it is usually reasonable to

assume that this condition is satisfied automatically.
9

E(ui) = 0 for all i
Suppose Yi = 1 + 2Xi + ui
The role of the intercept is to pick up any systematic but constant tendency in Y not
accounted for by the regressor(s).
10

E(ui) = 0 for all i
Suppose Yi = 1 + 2Xi + ui E ( ui )   u  0
Suppose that the disturbance term had a nonzero population mean.
11

E(ui) = 0 for all i
Yi   1   2 X i  v i   u
  1*   2 X i  v i where  1*   1   u
Define a new random variable vi = ui – u.
12

E(ui) = 0 for all i
Yi   1   2 X i  v i   u
  1*   2 X i  v i where  1*   1   u
Then we can rewrite the model as shown. vi becomes the new disturbance term and the
intercept has absorbed the constant u.
13

E(ui) = 0 for all i
Yi   1   2 X i  v i   u
  1*   2 X i  v i where  1*   1   u
The disturbance term in the revised model now satisfies Assumption A.3.
14

E(ui) = 0 for all i
Yi   1   2 X i  v i   u
  1*   2 X i  v i where  1*   1   u
The price that we pay is that the interpretation of the intercept has changed. It has
absorbed the nonzero component of the disturbance term in addition to whatever had
previously been responsible for it.
15

E(ui) = 0 for all i
Yi   1   2 X i  v i   u
  1*   2 X i  v i where  1*   1   u
This is usually acceptable because the role of the constant is usually to pick up any systematic
tendency in Y not accounted for by the regressor(s).
16
A.4 The disturbance term is homoscedastic
 u2i   u2 for all i
We assume that the disturbance term is homoscedastic, meaning that its value in each
observation is drawn from a distribution with constant population variance.
17
In the language of the section on sampling and estimators in the Review chapter, this is a
‘beforehand’ concept, where we are thinking about the potential behavior of the disturbance
term before the sample is actually generated.
18
Once we have generated the sample, the disturbance term will turn out to be greater in
some observations, and smaller in others, but there should not be any reason for it to be
more erratic in some observations than in others.
19

2
ui  2

  E  ui   u   E  ui2 
E ( ui2 )   u2 for all i
Since E(ui) = 0, by Assumption A.3, the population variance of ui is equal to E(ui2), so the
condition can also be written as shown.
20

2
ui  2

  E  ui   u   E  ui2 
E ( ui2 )   u2 for all i
If Assumption A.4 is not satisfied, the OLS regression coefficients will be inefficient, and
you should be able to obtain more reliable results by using a modification of the regression
technique. This will be discussed in Chapter 7.
21
A.5 The values of the disturbance term have independent

distributions
ui is distributed independently of uj for all j ≠ i
We assume that the disturbance term is not subject to autocorrelation, meaning that there
should be no systematic association between its values in any two observations.
22

distributions
For example, just because the disturbance term is large and positive in one observation,
there should be no tendency for it to be large and positive in the next (or large and
negative, for that matter, or small and positive, or small and negative).
23

distributions
 ui u j  E[(ui   u )( u j   u )]  E ( ui u j )
 E ( ui ) E ( u j )  0
The assumption implies that the population covariance between ui and uj is zero. Note that
the population means of ui and uj are both zero, by virtue of Assumption A.3, and that E(uiuj) can
be decomposed as E(ui)E(uj) if ui and uj are generated independently – see the Review.
24

distributions
 ui u j  E[(ui   u )( u j   u )]  E ( ui u j )
 E ( ui ) E ( u j )  0
If this assumption is not satisfied, OLS will again give inefficient estimates. Chapter 12
discusses the problems that arise and ways of getting around them. Violations of this
assumption are in any case rare with cross-sectional data.
25
A.6 The disturbance term has a normal distribution
We usually assume that the disturbance term has a normal distribution. The justification for
the assumption depends on the Central Limit theorem.
26
In essence, the CLT states that, if a random variable is the composite result of the effects of a
large number of other random variables, it will have an approximately normal distribution even if
its components do not, provided that none of them is dominant.
27
The disturbance term u is composed of a number of factors not appearing explicitly in the
regression equation so, even if we know nothing about the distribution of these factors, we
are usually entitled to assume that the disturbance term is normally distributed.
28
Copyright Christopher Dougherty 1999–2006. This slideshow may be freely copied for
personal use.
21.06.06

During This Course We Will Work With The Three Types of Data Described Above

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TYPES OF REGRESSION MODEL AND ASSUMPTIONS FOR MODEL A

Cross-sectional: Observations on individuals, households,

Model A: Cross-sectional data with nonstochastic regressors.

Model A: Cross-sectional data with nonstochastic regressors.

Model A: Cross-sectional data with nonstochastic regressors.

Assumptions for Model A

A.1: The model is linear in parameters and correctly specified.

Examples of models that are not linear in parameters:

Y = 1 + 2X2 + 3X3 + 23X4 + u

Assumptions for Model A

A.2: There is some variation in the regressor in the sample.

Assumptions for Model A

A.2: There is some variation in the regressor in the sample.

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Actually, if an intercept is included in the regression equation, it is usually reasonable to

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Suppose that the disturbance term had a nonzero population mean.

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Define a new random variable vi = ui – u.

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Assumptions for Model A

A.3 The disturbance term has zero expectation

Then E(vi) = E(ui – u) = E(ui) – E(u) = u – u = 0

Assumptions for Model A

A.4 The disturbance term is homoscedastic

 u2i   u2 for all i

Assumptions for Model A

A.4 The disturbance term is homoscedastic

 u2i   u2 for all i

Assumptions for Model A

A.4 The disturbance term is homoscedastic

 u2i   u2 for all i

Assumptions for Model A

A.4 The disturbance term is homoscedastic

 u2i   u2 for all i

E ( ui2 )   u2 for all i

Assumptions for Model A

A.4 The disturbance term is homoscedastic

 u2i   u2 for all i

E ( ui2 )   u2 for all i

Assumptions for Model A

A.5 The values of the disturbance term have independent