# ols assumptions

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• 8/8/2019 OLS Assumptions

1/41

The Simple Regression Model

y = F0 +F1x +u

• 8/8/2019 OLS Assumptions

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Some Terminology

In the simple linear regression model,

wherey = F0 +F1x +u, we typically refer

to y as the

Dependent Variable, or

Left-Hand Side Variable, or

Explained Variable, or Regressand

• 8/8/2019 OLS Assumptions

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Some Terminology, cont.

In the simple linear regression of y on x,we typically refer to x as the

Independent Variable, or Right-Hand Side Variable, or

Explanatory Variable, or

Regressor, or

Covariate, or

Control Variables

• 8/8/2019 OLS Assumptions

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A Simple Assumption

The average value ofu, the error term, in

the population is 0. That is,

E(u) = 0

This is not a restrictive assumption, since

we can always use F0 to normalize E(u) to 0

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Zero Conditional Mean

We need to make a crucial assumptionabout how u andx are related

We want it to be the case that knowingsomething about x does not give us anyinformation about u, so that they arecompletely unrelated. That is, that

E(u|x) = E(u) = 0, which implies

E(y|x) = F0 +F1x

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.

.

x1

x2

E(y|x) as a linear function ofx, where for anyx

the distribution ofy is centered about E(y|x)

E(y|x) = F0 + F1x

y

f(y)

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Ordinary Least Squares

Basic idea of regression is to estimate the

population parameters from a sample

Let {(xi,yi): i=1, ,n} denote a random

sample of size n from the population

For each observation in this sample, it will

be the case that

yi = F0 + F1xi + ui

• 8/8/2019 OLS Assumptions

8/41

.

.

.

.

y4

y1

y2

y3

x1 x2 x3 x4

}

}

{

{

u1

u2

u3

u4

x

y

Population regression line, sample data points

and the associated error terms

E(y|x) =F0 + F1x

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Deriving OLS Estimates

To derive the OLS estimates we need torealize that our main assumption of E(u|x) =

E(u) = 0 also implies that

Cov(x,u) = E(xu) = 0

Why? Remember from basic probabilitythat Cov(X,Y) = E(XY) E(X)E(Y)

• 8/8/2019 OLS Assumptions

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Deriving OLS continued

We can write our2 restrictions just in terms

ofx,y, F0 and F , since u =y F0 F1x

E(y F0 F1x) = 0

E[x(y F0 F1x)] = 0

These are called moment restrictions

• 8/8/2019 OLS Assumptions

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Deriving OLS using M.O.M.

The method of moments approach toestimation implies imposing the population

moment restrictions on the sample moments

What does this mean? Recall that for E(X),the mean of a population distribution, asample estimator of E(X) is simply thearithmetic mean of the sample

• 8/8/2019 OLS Assumptions

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More Derivation ofOLS

We want to choose values of the parameters that

will ensure that the sample versions of our

moment restrictions are trueThe sample versions are as follows:

1

1

1

1

1

1

!

!

!

!

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iii

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ii

xyxn

xyn

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• 8/8/2019 OLS Assumptions

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More Derivation ofOLS

Given the definition of a sample mean, and

properties of summation, we can rewrite the first

condition as follows

xy

xy

10

10

or

,

FF

FF

!

!

• 8/8/2019 OLS Assumptions

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More Derivation ofOLS

!!

!!

!

!

!

!

n

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n

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n

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xxxyyx

xxyyx

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2

1

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• 8/8/2019 OLS Assumptions

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So the OLS estimated slope is

0thatprovided

1

2

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"

!

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!

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i

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• 8/8/2019 OLS Assumptions

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Summary ofOLS slope estimate

The slope estimate is the sample covariancebetweenx andy divided by the sample

variance ofxIfx andy are positively correlated, theslope will be positive

Ifx andy are negatively correlated, theslope will be negative

Only needx to vary in our sample

• 8/8/2019 OLS Assumptions

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More OLS

Intuitively, OLS is fitting a line through the

sample points such that the sum of squared

residuals is as small as possible, hence theterm least squares

The residual, , is an estimate of the error

term, u, and is the difference between thefitted line (sample regression function) and

the sample point

• 8/8/2019 OLS Assumptions

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.

.

.

.

y4

y1

y2

y3

x1 x2 x3 x4

}

}

{

{

1

2

3

4

x

y

Sample regression line, sample data points

and the associated estimated error terms

xy1

0

FF !

• 8/8/2019 OLS Assumptions

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Alternate approach to derivation

Given the intuitive idea of fitting a line, we can

set up a formal minimization problem

That is, we want to choose our parameters suchthat we minimize the following:

!! !n

i

ii

n

i

i xyu1

2

10

1

FF

• 8/8/2019 OLS Assumptions

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Alternate approach, continued

If one uses calculus to solve the minimization

problem for the two parameters you obtain the

following first order conditions, which are thesame as we obtained before, multiplied by n

0

0

1

10

1

10

!

!

!

!

n

i

iii

n

i

ii

xyx

xy

FF

FF

• 8/8/2019 OLS Assumptions

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Algebraic Properties ofOLS

The sum of the OLS residuals is zero

Thus, the sample average of the OLS

residuals is zero as well

The sample covariance between the

regressors and the OLS residuals is zero

The OLS regression line always goes

through the mean of the sample

• 8/8/2019 OLS Assumptions

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Algebraic Properties (precise)

xy

ux

n

u

u

n

iii

n

i

in

i

i

10

1

1

1

0

0

thus,and0

FF !

!

!!

!

!

!

• 8/8/2019 OLS Assumptions

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More terminology

TThen

( )squaresosumresidualtheis

( )squaresosumexplainedtheis

( T)squaresosumtotaltheis

:ollo ingthede inethenWe

part,dunexplaineanandpart,explainedanoup

2

2

2

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!

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iii

u

yy

yy

uyy

• 8/8/2019 OLS Assumptions

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Proof that SST = SSE + SSR

? A

? A

!!

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!

!

0thatknoeand

SSE2SSR

2

22

2

22

yyu

yyu

yyyyuu

yyu

yyyyyy

ii

ii

iiii

ii

iiii

• 8/8/2019 OLS Assumptions

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Goodness-of-Fit

How do we think about how well oursample regression line fits our sample data?

Can compute the fraction of the total sumof squares (SST) that is explained by themodel, call this the R-squared of regression

R2 = SSE/SST = 1 SSR/SST

• 8/8/2019 OLS Assumptions

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Using Stata forOLS regressions

Now that weve derived the formula for

calculating the OLS estimates of our

parameters, youll be happy to know youdont have to compute them by hand

Regressions in Stata are very simple, to run

the regression of y on x, just typereg y x

• 8/8/2019 OLS Assumptions

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Unbiasedness ofOLS

Assume the population model is linear inparameters asy = F0 + F1x + u

Assume we can use a random sample ofsize n, {(xi, yi): i=1, 2, , n}, from thepopulation model. Thus we can write thesample modelyi = F0 + F1xi + uiAssume E(u|x) = 0 and thus E(ui|xi) = 0

Assume there is variation in thexi

• 8/8/2019 OLS Assumptions

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Unbiasedness ofOLS (cont)

In order to think about unbiasedness, we need to

rewrite our estimator in terms of the population

|

!22

2 where,

xxs

s

yxx

ix

x

ii

F

• 8/8/2019 OLS Assumptions

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Unbiasedness ofOLS (cont)

ii

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iiiii

uxxxxxxx

uxx

xxxxx

uxxxyxx

!

!!

10

10

10

FF

FF

FF

• 8/8/2019 OLS Assumptions

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Unbiasedness ofOLS (cont)

211

2

1

2

thusand,

asrewrittenbecannumeratorthe,so

,0

x

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iix

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• 8/8/2019 OLS Assumptions

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Unbiasedness ofOLS (cont)

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then,1

thatso,let

FFF

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!

iix

iix

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xxd

• 8/8/2019 OLS Assumptions

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Unbiasedness Summary

The OLS estimates ofF1 and F0 areunbiased

Proof of unbiasedness depends on our 4assumptions if any assumption fails, thenOLS is not necessarily unbiased

Remember unbiasedness is a description ofthe estimator in a given sample we may benear or far from the true parameter

• 8/8/2019 OLS Assumptions

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Variance of the OLS Estimators

Now we know that the samplingdistribution of our estimate is centered

around the true parameterWant to think about how spread out thisdistribution is

Assume Var(u|x) = W2 (Homoskedasticity)

• 8/8/2019 OLS Assumptions

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• 8/8/2019 OLS Assumptions

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.

.

x1

x2

Homoskedastic Case

E(y|x) = F0 + F1x

y

f(y|x)

• 8/8/2019 OLS Assumptions

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.

xx1 x2

f(y|x)

Heteroskedastic Case

x3

.

.

E(y|x) = F0 + F1x

• 8/8/2019 OLS Assumptions

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Variance ofOLS (cont)

12

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222

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• 8/8/2019 OLS Assumptions

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Variance ofOLS Summary

The larger the error variance, W2, the larger

the variance of the slope estimate

The larger the variability in thexi, thesmaller the variance of the slope estimate

As a result, a larger sample size should

decrease the variance of the slope estimateProblem that the error variance is unknown

• 8/8/2019 OLS Assumptions

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Estimating the Error Variance

We dont know what the error variance, W2,

is, because we dont observe the errors, ui

What we observe are the residuals, i

We can use the residuals to form anestimate of the error variance

• 8/8/2019 OLS Assumptions

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Error Variance Estimate (cont)

2/

2

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isofestimatorunbiasedanThen,

22

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• 8/8/2019 OLS Assumptions

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Error Variance Estimate (cont)

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oerrorstandardthe

havethen eorsubstituteei

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regressiontheoerrortandard

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