# Clustering in the Linear Model

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1 Short Guides to Microeconometrics Fall 2014 Kurt Schmidheiny Universität Basel Clustering in the Linear Model 2 1 Introduction Clustering in the Linear Model This handout extends the handout on The Multiple Linear Regression model and refers to its definitions and assumptions in section 2. It relaxes the homoscedasticity assumption (OLS4a) and allows the error terms to be heteroscedastic and correlated within groups or so-called clusters. It shows in what situations the parameters of the linear model can be consistently estimated by OLS and how the standard errors need to be corrected. The canonical example (Moulton 1986, 1990) for clustering is a regression of individual outcomes (e.g. wages) on explanatory variables of which some are observed on a more aggregate level (e.g. employment growth on the state level). Clustering also arises when the sampling mechanism first draws a random sample of groups (e.g. schools, households, towns) and than surveys all (or a random sample of) observations within that group. Stratified sampling, where some observations are intentionally under- or oversampled asks for more sophisticated techniques. 2 The Econometric Model Consider the multiple linear regression model y gi = x giβ + u gi where observations belong to a cluster g = 1,..., G and observations are indexed by i = 1,..., M within their cluster. G is the number of clusters, M is the number of observations per cluster, and N = g M = GM is the total number of observations. For notational simplicity, M is assumed constant in this handout. It is easily generalized to a cluster specific number M g. y gi is the dependent variable, x gi is a (K + 1)-dimensional row vector of K explanatory variables plus a constant, β is a (K + 1)- dimensional column vector of parameters, and u gi is the error term. Stacking observations within a cluster, we can write y g = X g β + u g where y g is a M 1 vector, X g is a M (K + 1) matrix and u g is is a M 1 vector. Stacking observations cluster by cluster, we can write y = Xβ + u where y = [y 1... y G ] is N 1, X is N (K + 1) and u is N 1. The data generation process (dgp) is fully described by: CL1: Linearity y gi = x gi β + u gi and E(u gi ) = 0 CL2: Independence (X g, y g ) G g=1 i.i.d. (independent and identically distributed) CL2 assumes that the observations in one cluster are independent from the observations in all other clusters. It does not assume independence of the observations within clusters. CL3: Strict Exogeneity a) u gi X g N(0, σ 2 gi ) b) u gi X g (independent) c) E(u gi X g ) = 0 (mean independent) d) cov(x g, u gi ) = 0 (uncorrelated) CL3 assumes that the error term u gi is unrelated to all explanatory variables of all observations within its cluster. Version: , 15:24

2 3 Short Guides to Microeconometrics Clustering in the Linear Model 4 CL4: Clustered Errors V (u g X g ) = σ 2 Ω g = σ 2 Ω(X g ) is p.d. and finite CL4 means that the error terms are allowed to have different variances and to be correlated within clusters conditional on all explanatory variables of all observations within the cluster. Under CL2, CL3c and CL4, the conditional variance-covariance matrix of the vector of error terms in the whole sample is 3 A Special Case: Random Cluster-specific Effects Suppose as Moulton(1986) that the error term u gi consists of a cluster specific random effect c g and an individual effect v gi u gi = c g + v gi Assume that the individual error term is strictly exogenous, homoscedastic and independent across all observations V (u X) = E(uu X) = σ 2 Ω σ 2 Ω σ 2 Ω 2 0 = σ 2 Ω G where the typical diagonal element E(v gi X g ) = 0 V (v gi X g ) = σ 2 v Cov(v gi, v gj X g ) = 0, i j and that the cluster specific effect is exogenous, homoscedastic and uncorrelated with the individual effect E(c g X g ) = 0 σ 2 Ω g = V (u g X) = V (u g X g ) = E(u g u g X g ) = σ 2 Ω(X g ) σg1 2 ρ 12 σ 1g σ g2 ρ g1m σ g1 σ gm ρ g21 σ g2 σ g1 σ 2 g2 ρ g2m σ g2 σ gm = ρ gm1 σ gm σ g1 ρ gm2 σ gm σ g2 σgm 2 is the variance covariance matrix of the error terms within cluster g and all its elements are a function of X g. The decomposition into σ 2 and Ω g is arbitrary but useful. CL5: Identifiability E(X gx g ) = Q is p.d. and finite rank(x) = K + 1 < N CL5 assumes that the regressors have identifying variation (non-zero variance) and are not perfectly collinear. V (c g X g ) = σ 2 c Cov(c g, v gi X g ) = 0 The resulting variance-covariance structure within each cluster g is then 1 ρ u ρ u ρ u 1 ρ u V (u g X g ) = σuω 2 g = σu[ρ 2 u ιι + (1 ρ)i] = σu ρ u ρ u 1 where σ 2 u = σ 2 c + σ 2 v, ρ u = σ 2 c /(σ 2 c + σ 2 v) and ι is a (M 1) column vector of ones. This structure is called equicorrelated errors. In a less restrictive version, σ 2 u and ρ u are allowed to be cluster specific as a function of X g. Note: this structure is formally identical to a random effects model for panel data with many individuals g observed over few time periods i. The cluster specific random effect is also called an unrelated effect.

3 5 Short Guides to Microeconometrics Clustering in the Linear Model 6 4 Estimation with OLS The parameter β can be estimated with OLS as β OLS = (X X) 1 X y The OLS estimator of β remains unbiased in small samples under CL1, CL2, CL3c, CL4, and CL5 and normally distributed additionally assuming CL3a. It is consistent and approximately normally distributed under CL1, CL2, CL3d, CL4, and CL5 in samples with a large number of clusters. However, the OLS estimator is not efficient any more. More importantly, the usual standard errors of the OLS estimator and tests (t-, F -, z-, Wald-) based on them are not valid any more. 5 Estimating Correct Standard Errors The small sample covariance matrix of β OLS is under CL3c and CL4 V ( β OLS X) = σ 2 (X X) 1 [X ΩX] (X X) 1 and differs from usual OLS where V ( β OLS X) = σ 2 (X X) 1. Consequently, the usual estimator V ( β OLS X) = σ 2 (X X) 1 is incorrect. Usual small sample test procedures, such as the F - or t-test, based on the usual estimator are therefore not valid. With the number of clusters G and fixed cluster size M = N/G, the OLS estimator is asymptotically normally distributed under CL1, CL2, CL3d, CL4, and CL5 d G( β β) N (0, Σ) where Σ = Q 1 XX E(X gu g u gx g )Q 1 XX and Q XX = E(X gx g ). The OLS estimator is therefore approximately normally distributed in samples with a large number of clusters ( ) β A N β, Avar( β) where Avar( β) = G 1 Σ can be estimated as [ G ] Âvar( β) = (X X) 1 X gû g û gx g (X X) 1 g=1 with û g = y g X g βols under some additional assumptions on higher order moments of X g. This so-called cluster-robust covariance matrix estimator is a generalization of Huber(1967) and White(1980). 1 It does not impose any restrictions on the form of both heteroscedasticity and correlation within clusters (though we assumed independence of the error terms across clusters). We can perform the usual z- and Wald-test for large samples using the cluster-robust covariance estimator. Note: the cluster-robust covariance matrix is consistent when the number of clusters G. In practice we should have at least 50 clusters. Bootstrapping is an alternative method to estimate a cluster-robust covariance matrix under the same assumptions. See the handout on The Bootstrap. Clustering is addressed in the bootstrap by randomly drawing clusters g (rather than individual observations gi) and taking all M observations for each drawn cluster. This so-called block bootstrap preserves all within cluster correlation. 6 Efficient Estimation with GLS In some cases, for example with cluster specific random effects, we can estimate β efficiently using feasible GLS (see the handout on Heteroscedasticity in the Linear Model and the handout on Panel Data ). In practice, we can rarely rule out additional serial correlation beyond the one induced by the random effect. It is therefore advisable to always use cluster-robust standard errors in combination with FGLS estimation of the random effects model. 1 Note: the cluster-robust estimator is not clearly attributed to a specific author.

4 7 Short Guides to Microeconometrics Clustering in the Linear Model 8 7 Special Case: Estimating Correct Standard Errors with Random Cluster-specific Effects Moulton (1986, 1990) studies the bias of the usual OLS standard errors for the special case with random cluster-specific effects. Assume clusterspecific random effects in a bivariate regression: y gi = β 0 + β 1 x gi + u gi where u gi = c g + v gi with σ 2 u = σ 2 c + σ 2 v, ρ u = σ 2 c /(σ 2 c + σ 2 v). Then the (cluster-robust) asymptotic variance can be estimated as Âvar cluster ( β 1 ) = σ 2 u G g=1 M i=1 (x gi x) 2 [1 + (M 1) ρ x ρ u ] where σ 2 u is the usual OLS estimator, ρ x is the within cluster correlation of x and [1 + (M 1)ρ x ρ u ] > 1 is called the Moulton factor. σ 2, ρ u and ρ x are consistent estimators of σ 2, ρ u and ρ x, respectively. The robust standard error for the slope coefficient is accordingly ŝe cluster ( β 1 ) = ŝe ols ( β 1 ) 1 + (M 1) ρ x ρ u where ŝe ols ( β 1 ) is the usual OLS standard error. The square root of the Moulton factor measures how much the usual OLS standard errors understate the correct standard errors. For example, with cluster size M = 500 and intracluster correlations ρ u = 0.1 and ρ x = 0.1, the correct standard errors are 2.45 times the usual OLS ones. Lessons from the Moulton factor 1. If either the within cluster correlation of the combined error term u is zero (ρ u = 0) or the within cluster correlation of x is zero (ρ x = 0), then the Moulton factor is 1 and the usual OLS standard errors are correct. Both situations generalize to K explanatory variables. 2. If the variable of interest is an aggregate variable on the level of the cluster (hence ρ x = 1), the Moulton factor is maximal. This case generalizes to K aggregate explanatory variables: Âvar cluster ( β) = σ 2 (X X) 1 [1 + (M 1) ρ] In this situation, we need to correct the standard errors. Alternatively, we could aggregate (average) all variables and run the regression on the collapsed data. 3. If only control variables are aggregated, we better include cluster fixed effects (i.e. dummy variables for the groups) which will take care of the cluster-specific effect. See also the handout on Panel Data: Fixed and Random Effects. 4. If the variable of interest is not aggregated but has an important cluster specific component (large ρ x ), then including cluster fixed effects may destroy valuable information and we better don t include cluster fixed effects. However, we need to correct the standard errors. 5. If only control variables have an important cluster-specific component, it is better to include cluster fixed effects. 6. If the variable of interest has only a small cluster specific component (i.e. a lot of within-cluster variation and very little between-cluster variation), it is better to include cluster fixed effects. Standard errors are in practice most easily corrected using the Eicker- Huber-White cluster-robust covariance from section 5 and not via the Moulton factor. Note that we should have at least G = 50 clusters to justify the asymptotic approximation. In the context of panel and time series data, serial correlation beyond the ones from a random effect becomes very important. See the handout on Panel Data: Fixed and Random Effects. In this case standard errors need to be corrected even when including fixed effects.

5 9 Short Guides to Microeconometrics Clustering in the Linear Model 10 8 Implementation in Stata 11.0 Load example data webuse auto7.dta Stata reports the cluster-robust covariance estimator with the vce(cluster) option, e.g. 2 regress price weight, vce(cluster manufacturer) matrix list e(v) Note: Stata multiplies V with (N 1)/(N K) G/(G 1) to correct for degrees of freedom in small samples. This practice is ad-hoc and not based on asymptotic theory; it is practically irrelevant with large G. Stata reports t- and F -statistics with G 1 degrees of freedom. We can also estimate a cluster robust covariance using a nonparametric block bootstrap. For example with either of the following, regress price weight, vce(bootstrap, reps(100) cluster(manufacturer)) bootstrap, reps(100) cluster(manufacturer): regress price weight The cluster specific random effects model is efficiently estimated by FGLS. For example, xtset manufacturer_grp xtreg price weight, re 9 Implementation in R 2.13 Load example data library(foreign) auto <- read.dta(" The cluster-robust covariance estimator can be estimated in R with the package rms. First, we use an alternative regression command (ols) which stores the covariance matrix library(rms) fm <- ols(price~weight, data=auto, x=true, y=true) print(fm) Second, the cluster-robust covariance is called by 3 cov <- robcov(fm, cluster=auto\$manufacturer) print(cov) print(cov\$var) Note: R reports t-statistics with N K 1 degrees of freedom. We can also estimate a cluster robust covariance using a nonparametric block bootstrap cov <- bootcov(fm, cluster=auto\$manufacturer, B=100) print(cov) In addition, cluster-robust standard errors are reported with xtreg price weight, re vce(cluster manufacturer) 2 There are only 23 clusters in this example dataset used by the Stata manual. This is not enough to justify using large sample approximations. 3 There are only 23 clusters in this example dataset used by the Stata manual. This is not enough to justify using large sample approximations.

6 11 Short Guides to Microeconometrics References Advanced textbooks Cameron, A. Colin and Pravin K. Trivedi (2005), Microeconometrics: Methods and Applications, Cambridge University Press. Sections Wooldridge, Jeffrey M. (2002), Econometric Analysis of Cross Section and Panel Data, MIT Press. Sections 7.8 and Companion textbooks Angrist, Joshua D. and Jörn-Steffen Pischke (2009), Mostly Harmless Econometrics: An Empiricist s Companion, Princeton University Press. Chapter 8. Articles Cameron, A. Colin and Douglas L. Miller (2015), A Practitioner s Guide to Cluster-Robust Inference, Journal of Human Resources, forthcoming. Moulton, B. R. (1986), Random Group Effects and the Precision of Regression Estimates, Journal of Econometrics, 32(3), Moulton, B. R. (1990), An Illustration of a Pitfall in Estimating the Effects of Aggregate Variables on Micro Units, The Review of Economics and Statistics, 72,

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