# 8. Model Specification and Data Problems. 8.1 Functional Form Misspecification

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1 8. Model Specification and Data Problems 8.1 Functional Form Misspecification A functional form misspecification generally means that the model does not account for some important nonlinearities. Recall that omitting important variable is also model misspecification. Generally functional form misspecification causes bias in the remaining parameter estimators 1

2 Example 8.1: Suppose that the correct specification of the wage equation is (1) log(wage) = β 0 + β 1 educ + β 2 exper + β 3 (exper) 2 + u. Then the return for an extra year of experience is (2) log(wage) exper = β 2 + 2β 3 exper. If the second order term is dropped from (1), use of the resulting biased estimate of β 2 can be misleading. 2

3 RESET test Ramsey (1969) proposed a general functional form misspecification test, Regression Specification Error Test (RESET), which has proven to be useful. Estimate first (3) y = β 0 + β 1 x β k x k + u, get ŷ and test in the augmented model y = β 0 + β 1 x β k x k + δ 1 ŷ 2 + δ 2 ŷ 3 + e (4) the null hypothesis (5) H 0 : δ 1 = δ 2 = 0. The test is the F -test with numerator df 1 = 2 and denominator df 2 = n k 3. Ramsey, J.B. (1969). Tests for specification errors in classical linear least-squares analysis, Journal of the Royal Statistical Society, Series B, 71,

4 Example 8.2: Consider the the house price data (Exercise 3.1) and estimate (6) price = β 0 + β 1 lotsize + β 2 sqrft + β 3 bdrms + u. Estimation results are: Dependent Variable: PRICE Method: Least Squares Sample: 1 88 Included observations: 88 ========================================================== Variable Coefficient Std. Error t-statistic Prob C LOTSIZE SQRFT BDRMS ========================================================== R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood F-statistic Durbin-Watson stat Prob(F-statistic) Estimate next (6) augmented with ( price) 2 and ( price) 3 as in (4). The F -statistic for the null hypothesis (5) becomes F = 4.67 with 2 and 82 degrees of freedom. The p-value is 0.012, such that we reject the null hypothesis at the 5% level. Thus, there is some evidence of non-linearity. 4

5 Estimate next (7) log(price) = β 0 + β 1 log(lotsize) Estimation results: +β 2 log(sqrft) + β 3 bdrms + u. Dependent Variable: LOG(PRICE) Method: Least Squares Date: 10/19/06 Time: 00:01 Sample: 1 88 Included observations: 88 Variable Coefficient Std. Error t-statistic Prob. C LOG(LOTSIZE) LOG(SQRFT) BDRMS == R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood F-statistic Durbin-Watson stat Prob(F-statistic) == The F -statistic for the the null hypothesis (5) is now F = 2.56 with p-value Thus (5) is not rejected at the 5% level. Thus overall, on the basis of the RESET test the log-log model (7) is preferred. 5

6 Non-nested alternatives For example if the model choices are (8) y = β 0 + β 1 x 1 + β 2 x 2 + u and (9) y = β 0 + β 1 log(x 1 ) + β 2 log(x 2 ) + u. Because the models are non-nested the usual F -test does not apply. A common approach is to estimate a combined model y = γ 0 + γ 1 x 1 + γ 2 x 2 + γ 3 log(x 1 ) + γ 4 log(x 2 ) + u. (10) H 0 : γ 3 = γ 4 = 0 is a hypothesis for (8) and H 0 : γ 1 = γ 2 = 0 is a hypothesis for (9). The usual F -test applies again here. 6

7 Davidson and MacKinnon (1981) procedure: For example to test (8), estimate first (11) y = β 0 + β 1 x 1 + β 2 x 2 + θ 1 ŷ + v, where ŷ is the fitted value of (9). A significant t value of the θ 1 -estimate is a rejection of (8). Similarly, if ŷ denotes the fitted values of (8), the test of (9) is the t-staistic of the θ 1 -estimate from (12) y = β 0 + β 1 log(x 1 ) + β 2 log(x 2 ) + θ 1 ŷ + v, Davidson, R. and J.G. MacKinnon (1981). Several tests for model specification in the presence of alternative hypotheses, Econometrica 49,

8 Remark 8.1: A clear winner need not emerge. Both models may be rejected or neither may be rejected. In the latter case adjusted R-square can be used to select the better fitting one. If both models are rejected, more work is needed. For more complicated cases, see Wooldridge, J.M. (1994). A simple specification test for the predictive ability of transformation models, Review of Economics and Statistics 76,

9 8.2 Outliers Particularly in small data sets OLS estimates are influenced by one or several observations. Generally such observations are called outliers or influential observations. Loosely, an observation is an outlier if dropping it changes estimation results materially. In detection of outliers a usual practice is to investigate standardized (or studentized ) residuals. If an outlier is an obvious mistake in recording the data, it can be corrected. Usual practice also is to eliminate such observations. Data transformations, like taking logarithms often narrow the range of data and hence may alleviate outlier problems, too. 9

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