# Regression for nonnegative skewed dependent variables

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1 Regression for nonnegative skewed dependent variables July 15, 2010

2 Problem Solutions Link to OLS Alternatives Introduction Nonnegative skewed outcomes y, e.g. labor earnings medical expenditures trade volume often modeled using a regression of ln(y) on X. What about y = 0?

3 Problem Solutions Link to OLS Alternatives Model of the conditional mean Linear regression of ln(y) on X assumes E[ln(y) X ] = Xb but the Poisson quasi-mle (Gourieroux et al. 1984) or GLM with a log link assumes ln(e[y X ]) = Xb Only one of these makes sense when y can be zero. Note that the conditional mean must always be positive, but the actual realized outcome can be zero. GLM with a log link can even accommodate negative outcomes (but poisson exits with an error).

4 Problem Solutions Link to OLS Alternatives When does OLS make sense? If we write y i = exp(x i b + e i ) = exp(x i b)v i and if we happen to have data where y i > 0 for all i, then we can take logs for ln(y i ) = X i b + e i which motivates the OLS specification. With y > 0 always, Manning and Mullahy (2001) provide guidance on when to prefer OLS or GLM (if e is symmetric and homoskedastic, prefer OLS).

5 Problem Solutions Link to OLS Alternatives Tobit typically not a good alternative Other common approaches include tobit and two-part or hurdle models. One tobit approach puts a small number a for every zero (smaller than the smallest observed positive y), takes logs, and then specifies ln(a) as the lower limit. See Cameron and Trivedi (2009, p.532), Setting the censoring point for data in logs, for one example of this advice. But this approach makes no sense. The choice of a is arbitrary, and affects the estimation. Choosing a =.01 results in lny = 4.6 and choosing a = results in lny = 13.8 and there is no obvious reason to prefer one over the other, for example when the smallest positive y is 1. The only time replacing zero with a small positive number a, taking logs, and running a tobit makes sense is when zero represents the result of a known lower detection limit, or rounding, and y is known to actually be positive in these cases. This is not the case in practice, typically.

6 Comparison of OLS and Tobit Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity Graph comparing OLS, Poisson, and Tobit (with a equal to one hundredth or one millionth) Poisson Tobit a=1/100 OLS Tobit a=1/1e x Poisson OLS

7 The simulation model Introduction Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity We specify a data generating process given by y i = exp(x i b)v i with v distributed gamma with moderate or no heteroskedasticity. Choose x = exp(u) with u uniform on (0, 1) for moderate skewness in the predictor. Also tried mixture of gamma, exponential, pareto, mixture of lognormals. Poisson tended to dominate in every case.

8 Objects of interest Introduction Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity We are usually interested not in estimating b, but in the marginal effect E(y X ) X which is straightforward in the Poisson case, and not in the others. Or we might be interested in predictions, or out of sample predictions. Poisson tends to dominate in these cases as well, and sidesteps the pernicious retransformation problem of OLS (Duan 1983, Manning 1988, Mullahy 1998, Ai and Norton 2000, Santos Silva and Tenreyro 2006). Whatever we are interested in estimating, we are presumably looking to minimize the MSE of that so looking for a consistent estimator of ŷ (as in Duan 1983) when we are interested in individual predictions (not the mean of predictions in a large sample) makes no sense we want good small sample performance.

9 Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity Marginal Effects Table: MSE of marginal effect estimates (in percentage terms: No Het. E(y X ) X 1 E(y X ) ) Low Het. Variance N=100 N=1000 N=10000 N=100 N=1000 N=10000 Low % nonzero OLS Poisson Tobit Hurdle (2PM) Med. % nonzero OLS Poisson Tobit Hurdle (2PM) High % nonzero OLS Poisson Tobit Hurdle (2PM)

10 Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity Predictions Table: MSE of predictions No Het. Low Het. Variance N=100 N=1000 N=10000 N=100 N=1000 N=10000 Low % nonzero OLS Poisson Tobit Hurdle (2PM) Med. % nonzero OLS Poisson Tobit Hurdle (2PM) High % nonzero OLS Poisson Tobit Hurdle (2PM)

11 Hurdle Models Introduction Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity Hurdle or two-part models (2PM), described by Mullahy (1986) among others, appear in the prior comparison. Why are they popular? Due to the RAND Health Insurance Experiment (Duan et al. 1983, Manning et al. 1987, Newhouse et al. 1993), primarily. Idea is: a person decides whether to go to the doctor, and then the doctor decides expenditure conditional on y > 0. Also easy to run likelihood is separable, so just run a probit (or logit or cloglog or what have you) using 1(y > 0) as a dummy outcome, then run OLS regression of ln(y) on X or a truncated regression (ztp or ztnb or truncreg) of y on X. See McDowell (2003) but replace commands with those appropriate in newer Stata.

12 Two-part assumption Introduction Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity Not all that realistic in reality-you may find yourself getting medical care without any decision on your part; you can also end your medical care if you decide to (in most cases). Now we need several pieces of the model to be correctly specified, or all estimates are inconsistent. Also hard to include endogenous explanatory variables in a hurdle model without some unpleasantly strong ML assumptions. Not so with Poisson/GLM: simply adopt a GMM framework.

13 Comparison of estimators dgp Estimands MSE Hurdle Models Endogeneity GMM framework easily accommodates instruments GMM version of Poisson assumes: y i exp(x i b) 1 is orthogonal to X i (uncorrelated in the population, or dgp). If X is endogenous, we can instead assume it is orthogonal to Z where Z is a set of instruments: [ ( ) y i E Z] exp(x i b) 1 = 0 ivpois for Stata 10, on SSC, gmm in Stata 11. Manual entry on gmm has many examples.

14 Introduction Prices Results The RAND HIE Suppose we want to measure the effect of a one percent reduction in the price of health care on health expenditures. In health plans, prices fall as expenditures increase, so regressing spending on price is a bad idea. In the RAND Health Insurance Experiment (HIE), participants were randomly assigned first-dollar prices; not prices more generally, because every case had a stoploss.

15 Introduction Prices Results HIE price structure Out of pocket Total spending FDP 95 FDP 50

16 Introduction Prices Results Expected prices The price changes during the course of the year; in fact, in the RAND HIE the price is the first dollar price up until the stoploss and then drops to zero; but the shadow price of a bit more health care also has to take into account the chance that you want a lot more later in the year, and spending now lowers the effective price of care later in the year. Ellis (1986) shows that using expected end-of-year price as a proxy for the actual marginal price (at each point during the plan year) performs very well. But the expected end-of-year price is endogenously determined by spending behavior. I compute expected price over all other individuals in an individual s randomly assigned group and use first dollar price as an instrument for the expected price.

17 Introduction Prices Results Graph comparing expenditures by first-dollar price.4.3 Fraction ,000 10,000 Medical expenditures Coinsurance rate = 0 Coinsurance rate = 25 Coinsurance rate = 50 Coinsurance rate = 95

18 Introduction Prices Results Results Table: Regressions of medical spending on prices (1) (2) (3) (4) (5) Poisson Poisson using Ep Poisson using lnep GMM-IV using Ep GMM-IV using lnep FDP (-1.48) FDP (0.42) FDP (-3.71) Expected price (-2.29) (-3.23) ln(expected price) (-1.37) (-1.65) Good health (1.98) (1.98) (1.18) (2.29) (2.44) Fair health (3.93) (3.95) (3.20) (3.03) (2.76) Poor health (4.92) (4.97) (2.33) (4.62) (2.49) Child (-0.29) (-0.28) (-0.82) (-0.67) (-0.05) Female child (-0.86) (-0.87) (0.34) (-2.57) (-1.57) Female (3.27) (3.27) (1.96) (3.94) (2.94) Black (-3.82) (-3.80) (-2.16) (-3.23) (-2.26) Age (2.14) (2.16) (1.68) (2.88) (2.57) Constant (19.66) (20.03) (9.85) (23.18) (11.33) Observations t statistics in parentheses

19 Conclusions Use a model that could possibly fit your data seems like simple and obvious advice, and has been offered many times before, sometimes forcefully (e.g. Mullahy 1988, Santos Silva and Tenreyro 2006), but still has not permeated the awareness of many researchers. See e.g. Rutledge (2009) regresses ln spending on X, dropping zeros! GLM or GMM is the better alternative. Kowalski (2009) compares her method to ivtobit instead of a more reasonable GMM. These are both common errors, and easily avoided. There are many other models, zero-inflated or not, for nonnegative outcomes, but few have the robustness of Poisson. Note in particular we need no assumption about conditional variance for consistency, contrary to occasional claims about Poisson.

20 Practical Guidance For a specific application, you should run your own simulation. You can run several candidate models on half the data, and see the MSE of the quantity of interest (the other half of the data serves for out of sample predictions), or resample errors to simulate new data in which to estimate (with known coefficients and marginal effects). If you choose half-sample cross-validation, it is easy to run 100 times or so, and get very reliable estimates of MSE for half-samples. GLM or the equivalent poisson, both with a log link, will often win this contest. Note: If you decide on a log link, you may want to call your model GLM with a log link, rather than a Poisson QMLE some older reviewers believe Poisson regression is only for counts.

21 Ai, Chunrong and Edward C. Norton Standard errors for the retransformation problem with heteroscedasticity. Journal of Health Economics, 19(5): Cameron, A. Colin and Pravin K. Trivedi Regression Analysis of Count Data. Cambridge University Press, Cambridge. Cameron, A. Colin and Pravin K. Trivedi The role of income and health risk in the choice of health insurance: Evidence from Australia. Journal of Public Economics, 45(1): Cameron, A. Colin and Pravin K. Trivedi Microeconometrics Using Stata. Stata Press, College Station TX. Duan, Naihua Smearing estimate: a nonparametric retransformation method. Journal of the American Statistical Association, 78, Duan, Naihua, Willard G. Manning, Carl N. Morris, and Joseph P. Newhouse A comparison of alternative models for the demand for medical care. Journal of Business and Economics Statistics, 1(2): Ellis, Randall P Rational Behavior in the Presence of Coverage Ceilings and Deductibles. The RAND Journal of Economics, 17(2): Gourieroux, C., Montfort, A., Trognon, A., Pseudo-maximum likelihood methods: applications to Poisson models. Econometrica, 52, Kowalski, Amanda E Censored Quantile Instrumental Variable Estimates of the Price Elasticity of Expenditure on Medical Care. NBER Working Paper Manning, Willard G. and John Mullahy Estimating Log Models: To Transform Or Not To Transform? Journal of Health Economics, 20(4):

22 Manning, Willard G The logged dependent variable, heteroscedasticity, and the retransformation problem. Journal of Health Economics, 17, Manning, Willard G., Joseph P. Newhouse, Naihua Duan, Emmett B. Keeler, Arleen Liebowitz, and M. Susan Marquis Health insurance and the demand for medical care: evidence from a randomized experiment. American Economic Review, 77(3): McDowell, Allen From the help desk: hurdle models. Stata Journal, 3(2): Mullahy, J., Specification and testing of some modified count data models. Journal of Econometrics, 33(3): Mullahy, J., Much ado about two: reconsidering retransformation and the two-part model in health econometrics. Journal of Health Economics, 17, Newhouse, Joseph P. and the Insurance Experiment Group Free for all? Lessons from the RAND Health Insurance Experiment. Harvard University Press, Cambridge. Rutledge, Matthew S Asymmetric Information and the Generosity of Employer-Sponsored Health Insurance. University of Michigan Working [Job Market] Paper. Santos Silva, João M. C. and Silvana Tenreyro The Log of Gravity. Review of Economics and Statistics, 88(4): Wooldridge, J.M., On the application of robust, regression-based diagnostics to models of conditional means and conditional variances. Journal of Econometrics, 47, Wooldridge, J.M Econometric Analysis of Cross Section and Panel Data. Cambridge, MA: MIT Press. Available from Stata.com.

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