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Econ 399 Chapter2c

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2.5 Variances of the OLS Estimators
-We have proven that the sampling distribution of
OLS estimates (B0hat and B1hat) are centered
around the true value
-How FAR are they distributed around the true
values?
-The best estimator will be most narrowly
distributed around the true values
-To determine the best estimator, we must
calculate OLS variance or standard deviation
-recall that standard deviation is the square
root of the variance.
Gauss-Markov Assumption SLR.5
(Homoskedasticity)
The error u has the same variance given
any value of the explanatory variable. In
other words,
Var(u | x)  
2
Gauss-Markov Assumption SLR.5
(Homoskedasticity)
-While variance can be calculated via
assumptions SLR.1 to SLR.4, this is very
complicated
-The traditional simplifying assumption is
homoskedasticity, or that the unobservable
error, u, has a CONSTANT VARIANCE
-Note that SLR.5 has no impact on unbiasness
-SLR.5 simply simplifies variance calculations and
gives OLS certain efficiency properties
Gauss-Markov Assumption SLR.5
(Homoskedasticity)
-While assuming x and u are independent
will also simplify matters, independence is
too strong an assumption
-Note that:
Var(u | x)  E (u | x)  [ E (u | x)]
2
 E(u | x)  0
2
  E(u | x)
2
2
2
Gauss-Markov Assumption SLR.5
(Homoskedasticity)
-if the variance is constant given x, it is
always constant
-Therefore:
  E(u )  Var (u )
2
2
-σ2 is also called the ERROR VARIANCE or
DISTURBANCE VARIANCE
Gauss-Markov Assumption SLR.5
(Homoskedasticity)
-SLR.4 and SLR.5 can be rewritten as
conditions of y (using the fact we expect
the error to be zero and y only varies due
to the error)
E ( y | x)   0  1 x
(2.55)
Var ( y | x)  
(2.56)
2
Heteroskedastistic Example
• Consider the following model:
weighti  130  0.065incomei  u i
(ie)
-here it is assumed that weight is a function of
income
-SLR.5 requires that:
Var ( weighti | income)  
2
(ie)
-but income affects weight range
-rich people can both afford fatty foods and
expensive weight loss
-HETEROSKEDATICITY is present
Theorem 2.2
(Sampling Variances of the OLS
Estimators)
Using assumptions SLR.1 through SLR.5,
Var( ˆ1 ) 
2
 ( x  x)
2

i
2
Var( ˆ0 ) 
x
2
SSTx
(2.57)
2
i
n
2
(
x

x
)
 i
(2.58)
Where these are conditional on sample
values {x1,….,xn}
Theorem 2.2 Proof
From OLS’s unbiasedness we know,
ˆ1  1  (1 / SSTx ) d i u i
(2.52)
-we know that B1 is a constant and SST
and d are non-random, therefore:
2
ˆ
Var( 1 )  (1 / SSTx ) Var ( d i ui )
 d Var(u )
(1 / SST )  d
 (1 / SSTx )

2
2
2
i
i
2
2
x
i
  (1 / SSTx ) SSTx
2
  2 / SSTx
2
Theorem 2.2 Notes
-(2.57) and (2.58) are “standard” ols variances
which are NOT valid if heteroskedasticity is
present
1) Larger error variances increase B1’s variance
-more variance in y’s determinants make B1
harder to estimate
2) Larger x variances decrease B1’s variance
-more variance in x makes OLS easier to
accurately plot
3) Bigger sample size increases x’s variation
-therefore bigger sample size decreases B1’s
variation
Theorem 2.2 Notes
-to get the best estimate of B1, we should choose
x to be as spread out as possible
-this is most easily done by obtaining a large
sample size
-large sample sizes aren’t always possible
-In order to conduct tests and create confidence
intervals, we need the STANDARD DEVIATIONS
of B1hat and B2hat
-these are simply the square roots of the
variances
2.5 Estimating the Error Variance
Unfortunately, we rarely know σ2, although we
can use data to estimate it
-recall that the error term comes from the
population equation:
yi   0  1x i  u i
(2.48)
-recall that residuals come from the estimated
equation:
yi  ˆ0  ˆ1x i  û i
(2.32)
-errors aren’t observable and residuals are
calculated from data
2.5 Estimating the Error Variance
These two formulas combine to give us:
û i  y i - ˆ0 - ˆ1x i
 (    x  u ) - ˆ - ˆ x
0
1
i
i
0
1
 u i - ( ˆ0   0 ) - ( ˆ1 - 1 )x i
i
(2.59)
-Furthermore, an unbiased estimator of σ2 is:
1
2
ui

n
-But we don’t have data on ui, we only have data
on uihat
2.5 Estimating the Error Variance
A true estimator of σ2 using uihat is:
1
SSR
2
û i 

n
n
-Unfortunately this estimator is biased as it
doesn’t account for two OLS restrictions:
1
û i  0,

n
 x û
i
i
0
(2.60)
2.5 Estimating the Error Variance
-Since we have two different OLS restrictions, if
we have n-2 of the residuals, we can then
calculate the remaining 2 residuals that satisfy
the restrictions
-While the errors have n degrees of freedom,
residuals have n-2 degrees of freedom
-an unbiased estimator of σ2 takes this into
account:
1
2
ˆ 
û i

(n - 2)
SSR

(2.61)
(n  2)
2
Theorem 2.3
(Unbiased Estimation of σ2)
Using assumptions SLR.1 through SLR.5,
E (ˆ )  
2
2
Theorem 2.3 Proof
If we average (2.59) and remember that
OLS residuals average to zero we get:
ˆ
ˆ
0  u  (0  0 )  (1  1 ) xi
Subtracting this from (2.59) we get:
uˆi  (ui  u)  (ˆ1  1 )( xi  xi )
Theorem 2.3 Proof
Squaring, we get:
2
2
ˆ
uˆi  (ui  u )  ( 1  1 ) ( xi  x)
 2(u  u )( ˆ   )( x  x)
2
2
i
1
Summing, we get:
1
i
2
2
ˆ
 uˆi   (ui  u)  (1  1 )  ( xi  x)
2
2
 2( ˆ1  1 ) ui ( xi  x)
Theorem 2.3 Proof
Expectations and statistics give us:
E ( uˆi )  (n  1)  ( / s x ) s x  2
2
2
2
2
2
2
SSR

(n - 2)
Given (2.61), we now prove the theorem
since
SSR
2
E(
) 
(n  2)
E (ˆ )  
2
2
2.5 Standard Error
-Given (2.57) and (2.58) we now have
unbiased estimators of the variance of B1hat
and B0hat
-furthermore, we can estimate σ as
ˆ  ˆ
2
(2.62)
-which is called the STANDARD ERROR OF THE
REGRESSION (SER) or the STANDARD ERROR
OF THE ESTIMATE (Shazam)
-although σhat is not an unbiased estimator, it
is consistent and appropriate to our needs
2.5 Standard Error
-since σhat estimates u’s standard deviation, it
in turn estimates y’s standard deviation when x
is factored out
-the natural estimator of sd(B1hat) is:
se( ˆ1 )  ˆ / SSTx  ˆ /
 ( x  x)
2
i
-which is called the STANDARD ERROR of
B1hat (se(B1hat))
-note that this is a random variable as σhat
varies across samples
-replacing σ with σhat creates se(B0hat)
2.6 Regression through the Origin
-sometimes it makes sense to impose the
restriction that when x=0, we also expect y=0
Examples:
-Calorie intake and weight gain
-Credit card debt and monthly payments
-Amount of House watched and how cool you
are
-Number of classes attended and number of
notes taken
2.6 Regression through the Origin
-this restriction sets our typical B0hat equal to
zero and creates the following line:
~
~
y  1 x
(2.63)
-where the tilde’s distinguish this problem from
the typical OLS estimation
-since this line passes through (0,0), it is called a
REGRESSION THROUGH THE ORIGIN
-since the line is forced to go through a point,
B1tilde is a BIASED estimator of B1
2.6 Regression through the Origin
-our estimate of B1tilde comes from minimizing
the sum of our new squared residuals:
~
 ( y  x )
i
2
1 i
(2.64)
-through the First Order Condition, we get:
~
 x ( y  x )  0
i
i
1 i
(2.65)
-which solves to
~
1
xy


x
i
i
2
(2.66)
i
-note that all x cannot equal zero and if xbar
equals zero, B1tide equals B1hat
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