An Introduction to Modern

Econometrics Using Stata

CHRISTOPHER F. BAUM
Department of Economics
Boston College

A Stata Press Publication

StataCorp LP
College Station, Texas
Stata Press, 4905 Lakeway Drive, College Station, Texas 77845

Copyright c 2006 by StataCorp LP

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Contents
Illustrations xv
Preface xvii
Notation and typography xix

1 Introduction 1
1.1 An overview of Stata’s distinctive features . . . . . . . . . . . . . . . . 1
1.2 Installing the necessary software . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Installing the support materials . . . . . . . . . . . . . . . . . . . . . . 5
2 Working with economic and financial data in Stata 7
2.1 The basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1.1 The use command . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1.2 Variable types . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.3 n and N . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.1.4 generate and replace . . . . . . . . . . . . . . . . . . . . . . . . 10
2.1.5 sort and gsort . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.1.6 if exp and in range . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1.7 Using if exp with indicator variables . . . . . . . . . . . . . . . 13
2.1.8 Using if exp versus by varlist: with statistical commands . . . 15
2.1.9 Labels and notes . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.1.10 The varlist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.1.11 drop and keep . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.1.12 rename and renvars . . . . . . . . . . . . . . . . . . . . . . . . 21
2.1.13 The save command . . . . . . . . . . . . . . . . . . . . . . . . 21
2.1.14 insheet and infile . . . . . . . . . . . . . . . . . . . . . . . . . . 21
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2.2 Common data transformations . . . . . . . . . . . . . . . . . . . . . . . 22

2.2.1 The cond() function . . . . . . . . . . . . . . . . . . . . . . . . 22
2.2.2 Recoding discrete and continuous variables . . . . . . . . . . . 23
2.2.3 Handling missing data . . . . . . . . . . . . . . . . . . . . . . 24
mvdecode and mvencode . . . . . . . . . . . . . . . . . . . . . 25
2.2.4 String-to-numeric conversion and vice versa . . . . . . . . . . . 26
2.2.5 Handling dates . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
2.2.6 Some useful functions for generate or replace . . . . . . . . . . 29
2.2.7 The egen command . . . . . . . . . . . . . . . . . . . . . . . . 30
Official egen functions . . . . . . . . . . . . . . . . . . . . . . . 30
egen functions from the user community . . . . . . . . . . . . 31
2.2.8 Computation for by-groups . . . . . . . . . . . . . . . . . . . . 33
2.2.9 Local macros . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.2.10 Looping over variables: forvalues and foreach . . . . . . . . . . 37
2.2.11 Scalars and matrices . . . . . . . . . . . . . . . . . . . . . . . 39
2.2.12 Command syntax and return values . . . . . . . . . . . . . . . 39
3 Organizing and handling economic data 43
3.1 Cross-sectional data and identifier variables . . . . . . . . . . . . . . . 43
3.2 Time-series data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
3.2.1 Time-series operators . . . . . . . . . . . . . . . . . . . . . . . 45
3.3 Pooled cross-sectional time-series data . . . . . . . . . . . . . . . . . . 45
3.4 Panel data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
3.4.1 Operating on panel data . . . . . . . . . . . . . . . . . . . . . 47
3.5 Tools for manipulating panel data . . . . . . . . . . . . . . . . . . . . . 49
3.5.1 Unbalanced panels and data screening . . . . . . . . . . . . . . 50
3.5.2 Other transforms of panel data . . . . . . . . . . . . . . . . . . 53
3.5.3 Moving-window summary statistics and correlations . . . . . . 53
3.6 Combining cross-sectional and time-series datasets . . . . . . . . . . . . 55
3.7 Creating long-format datasets with append . . . . . . . . . . . . . . . . 56
3.7.1 Using merge to add aggregate characteristics . . . . . . . . . . 57
Contents ix

3.7.2 The dangers of many-to-many merges . . . . . . . . . . . . . . 58

3.8 The reshape command . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.8.1 The xpose command . . . . . . . . . . . . . . . . . . . . . . . 62
3.9 Using Stata for reproducible research . . . . . . . . . . . . . . . . . . . 62
3.9.1 Using do-files . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
3.9.2 Data validation: assert and duplicates . . . . . . . . . . . . . . 63
4 Linear regression 69
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
4.2 Computing linear regression estimates . . . . . . . . . . . . . . . . . . . 70
4.2.1 Regression as a method-of-moments estimator . . . . . . . . . 72
4.2.2 The sampling distribution of regression estimates . . . . . . . 73
4.2.3 Efficiency of the regression estimator . . . . . . . . . . . . . . 74
4.2.4 Numerical identification of the regression estimates . . . . . . 75
4.3 Interpreting regression estimates . . . . . . . . . . . . . . . . . . . . . . 75
4.3.1 Research project: A study of single-family housing prices . . . 76
4.3.2 The ANOVA table: ANOVA F and R-squared . . . . . . . . . 77
4.3.3 Adjusted R-squared . . . . . . . . . . . . . . . . . . . . . . . . 78
4.3.4 The coefficient estimates and beta coefficients . . . . . . . . . 80
4.3.5 Regression without a constant term . . . . . . . . . . . . . . . 81
4.3.6 Recovering estimation results . . . . . . . . . . . . . . . . . . . 82
4.3.7 Detecting collinearity in regression . . . . . . . . . . . . . . . . 84
4.4 Presenting regression estimates . . . . . . . . . . . . . . . . . . . . . . 87
4.4.1 Presenting summary statistics and correlations . . . . . . . . . 90
4.5 Hypothesis tests, linear restrictions, and constrained least squares . . . 91
4.5.1 Wald tests with test . . . . . . . . . . . . . . . . . . . . . . . . 94
4.5.2 Wald tests involving linear combinations of parameters . . . . 96
4.5.3 Joint hypothesis tests . . . . . . . . . . . . . . . . . . . . . . . 98
4.5.4 Testing nonlinear restrictions and forming nonlinear combi-
nations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.5.5 Testing competing (nonnested) models . . . . . . . . . . . . . 100
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4.6 Computing residuals and predicted values . . . . . . . . . . . . . . . . 102

4.6.1 Computing interval predictions . . . . . . . . . . . . . . . . . . 103
4.7 Computing marginal effects . . . . . . . . . . . . . . . . . . . . . . . . 107
4.A Appendix: Regression as a least-squares estimator . . . . . . . . . . . . 112
4.B Appendix: The large-sample VCE for linear regression . . . . . . . . . 113
5 Specifying the functional form 115
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.2 Specification error . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.2.1 Omitting relevant variables from the model . . . . . . . . . . . 116
Specifying dynamics in time-series regression models . . . . . 117
5.2.2 Graphically analyzing regression data . . . . . . . . . . . . . . 117
5.2.3 Added-variable plots . . . . . . . . . . . . . . . . . . . . . . . 119
5.2.4 Including irrelevant variables in the model . . . . . . . . . . . 121
5.2.5 The asymmetry of specification error . . . . . . . . . . . . . . 121
5.2.6 Misspecification of the functional form . . . . . . . . . . . . . 122
5.2.7 Ramsey’s RESET . . . . . . . . . . . . . . . . . . . . . . . . . 122
5.2.8 Specification plots . . . . . . . . . . . . . . . . . . . . . . . . . 124
5.2.9 Specification and interaction terms . . . . . . . . . . . . . . . 125
5.2.10 Outlier statistics and measures of leverage . . . . . . . . . . . 126
The DFITS statistic . . . . . . . . . . . . . . . . . . . . . . . . 128
The DFBETA statistic . . . . . . . . . . . . . . . . . . . . . . 130
5.3 Endogeneity and measurement error . . . . . . . . . . . . . . . . . . . . 132
6 Regression with non-i.i.d. errors 133
6.1 The generalized linear regression model . . . . . . . . . . . . . . . . . . 134
6.1.1 Types of deviations from i.i.d. errors . . . . . . . . . . . . . . 134
6.1.2 The robust estimator of the VCE . . . . . . . . . . . . . . . . 136
6.1.3 The cluster estimator of the VCE . . . . . . . . . . . . . . . . 138
6.1.4 The Newey–West estimator of the VCE . . . . . . . . . . . . . 139
6.1.5 The generalized least-squares estimator . . . . . . . . . . . . . 142
The FGLS estimator . . . . . . . . . . . . . . . . . . . . . . . 143
Contents xi

6.2 Heteroskedasticity in the error distribution . . . . . . . . . . . . . . . . 143

6.2.1 Heteroskedasticity related to scale . . . . . . . . . . . . . . . . 144
Testing for heteroskedasticity related to scale . . . . . . . . . . 145
FGLS estimation . . . . . . . . . . . . . . . . . . . . . . . . . 147
6.2.2 Heteroskedasticity between groups of observations . . . . . . . 149
Testing for heteroskedasticity between groups of observations . 150
FGLS estimation . . . . . . . . . . . . . . . . . . . . . . . . . 151
6.2.3 Heteroskedasticity in grouped data . . . . . . . . . . . . . . . 152
FGLS estimation . . . . . . . . . . . . . . . . . . . . . . . . . 153
6.3 Serial correlation in the error distribution . . . . . . . . . . . . . . . . . 154
6.3.1 Testing for serial correlation . . . . . . . . . . . . . . . . . . . 155
6.3.2 FGLS estimation with serial correlation . . . . . . . . . . . . . 159
7 Regression with indicator variables 161
7.1 Testing for significance of a qualitative factor . . . . . . . . . . . . . . 161
7.1.1 Regression with one qualitative measure . . . . . . . . . . . . 162
7.1.2 Regression with two qualitative measures . . . . . . . . . . . . 165
Interaction effects . . . . . . . . . . . . . . . . . . . . . . . . . 167
7.2 Regression with qualitative and quantitative factors . . . . . . . . . . . 168
Testing for slope differences . . . . . . . . . . . . . . . . . . . 170
7.3 Seasonal adjustment with indicator variables . . . . . . . . . . . . . . . 174
7.4 Testing for structural stability and structural change . . . . . . . . . . 179
7.4.1 Constraints of continuity and differentiability . . . . . . . . . . 179
7.4.2 Structural change in a time-series model . . . . . . . . . . . . 183
8 Instrumental-variables estimators 185
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
8.2 Endogeneity in economic relationships . . . . . . . . . . . . . . . . . . 185
8.3 2SLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
8.4 The ivreg command . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
8.5 Identification and tests of overidentifying restrictions . . . . . . . . . . 190
8.6 Computing IV estimates . . . . . . . . . . . . . . . . . . . . . . . . . . 192
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8.7 ivreg2 and GMM estimation . . . . . . . . . . . . . . . . . . . . . . . . 194

8.7.1 The GMM estimator . . . . . . . . . . . . . . . . . . . . . . . 195
8.7.2 GMM in a homoskedastic context . . . . . . . . . . . . . . . . 196
8.7.3 GMM and heteroskedasticity-consistent standard errors . . . . 197
8.7.4 GMM and clustering . . . . . . . . . . . . . . . . . . . . . . . 198
8.7.5 GMM and HAC standard errors . . . . . . . . . . . . . . . . . 199
8.8 Testing overidentifying restrictions in GMM . . . . . . . . . . . . . . . 200
8.8.1 Testing a subset of the overidentifying restrictions in GMM . . 201
8.9 Testing for heteroskedasticity in the IV context . . . . . . . . . . . . . 205
8.10 Testing the relevance of instruments . . . . . . . . . . . . . . . . . . . . 207
8.11 Durbin–Wu–Hausman tests for endogeneity in IV estimation . . . . . . 211
8.A Appendix: Omitted-variables bias . . . . . . . . . . . . . . . . . . . . . 216
8.B Appendix: Measurement error . . . . . . . . . . . . . . . . . . . . . . . 216
8.B.1 Solving errors-in-variables problems . . . . . . . . . . . . . . . 218
9 Panel-data models 219
9.1 FE and RE models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
9.1.1 One-way FE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
9.1.2 Time effects and two-way FE . . . . . . . . . . . . . . . . . . . 224
9.1.3 The between estimator . . . . . . . . . . . . . . . . . . . . . . 226
9.1.4 One-way RE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
9.1.5 Testing the appropriateness of RE . . . . . . . . . . . . . . . . 230
9.1.6 Prediction from one-way FE and RE . . . . . . . . . . . . . . 231
9.2 IV models for panel data . . . . . . . . . . . . . . . . . . . . . . . . . . 232
9.3 Dynamic panel-data models . . . . . . . . . . . . . . . . . . . . . . . . 232
9.4 Seemingly unrelated regression models . . . . . . . . . . . . . . . . . . 236
9.4.1 SUR with identical regressors . . . . . . . . . . . . . . . . . . 241
9.5 Moving-window regression estimates . . . . . . . . . . . . . . . . . . . . 242
10 Models of discrete and limited dependent variables 247
10.1 Binomial logit and probit models . . . . . . . . . . . . . . . . . . . . . 247
10.1.1 The latent-variable approach . . . . . . . . . . . . . . . . . . . 248
Contents xiii

10.1.2 Marginal effects and predictions . . . . . . . . . . . . . . . . . 250

Binomial probit . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Binomial logit and grouped logit . . . . . . . . . . . . . . . . . 253
10.1.3 Evaluating specification and goodness of fit . . . . . . . . . . . 254
10.2 Ordered logit and probit models . . . . . . . . . . . . . . . . . . . . . . 256
10.3 Truncated regression and tobit models . . . . . . . . . . . . . . . . . . 259
10.3.1 Truncation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
10.3.2 Censoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
10.4 Incidental truncation and sample-selection models . . . . . . . . . . . . 266
10.5 Bivariate probit and probit with selection . . . . . . . . . . . . . . . . . 271
10.5.1 Binomial probit with selection . . . . . . . . . . . . . . . . . . 272

A Getting the data into Stata 277

A.1 Inputting data from ASCII text files and spreadsheets . . . . . . . . . 277
A.1.1 Handling text files . . . . . . . . . . . . . . . . . . . . . . . . . 278
Free format versus fixed format . . . . . . . . . . . . . . . . . 278
The insheet command . . . . . . . . . . . . . . . . . . . . . . . 280
A.1.2 Accessing data stored in spreadsheets . . . . . . . . . . . . . . 281
A.1.3 Fixed-format data files . . . . . . . . . . . . . . . . . . . . . . 281
A.2 Importing data from other package formats . . . . . . . . . . . . . . . . 286

B The basics of Stata programming 289

B.1 Local and global macros . . . . . . . . . . . . . . . . . . . . . . . . . . 290
B.1.1 Global macros . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
B.1.2 Extended macro functions and list functions . . . . . . . . . . 293
B.2 Scalars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
B.3 Loop constructs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
B.3.1 foreach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
B.4 Matrices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
B.5 return and ereturn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
B.5.1 ereturn list . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
xiv Contents

B.6 The program and syntax statements . . . . . . . . . . . . . . . . . . . . 307

B.7 Using Mata functions in Stata programs . . . . . . . . . . . . . . . . . 313

References 321
Author index 329
Subject index 333
Preface
This book is a concise guide for applied researchers in economics and finance to learn
basic econometrics and use Stata with examples using typical datasets analyzed in
economics. Readers should be familiar with applied statistics at the level of a simple
linear regression (ordinary least squares, or OLS) model and its algebraic representation,
equivalent to the level of an undergraduate statistics/econometrics course sequence.1
The book also uses some multivariate calculus (partial derivatives) and linear algebra.
I presume that the reader is familiar with Stata’s windowed interface and with the
basics of data input, data transformation, and descriptive statistics. Readers should
consult the appropriate Getting Started with Stata manual if review is needed. Mean-
while, readers already comfortable interacting with Stata should feel free to skip to
chapter 4, where the discussion of econometrics begins in earnest.
In any research project, a great deal of the effort is involved with the preparation
of the data specified as part of an econometric model. While the primary focus of the
book is placed upon applied econometric practice, we must consider the considerable
challenges that many researchers face in moving from their original data sources to
the form needed in an econometric model—or even that needed to provide appropriate
tabulations and graphs for the project. Accordingly, Chapter 2 focuses on the details
of data management and several tools available in Stata to ensure that the appropriate
transformations are accomplished accurately and efficiently. If you are familiar with
these aspects of Stata usage, you should feel free to skim this material, perhaps returning
to it to refresh your understanding of Stata usage. Likewise, Chapter 3 is devoted to a
discussion of the organization of economic and financial data, and the Stata commands
needed to reorganize data among the several forms of organization (cross section, time
series, pooled, panel/longitudinal, etc.) If you are eager to begin with the econometrics
of linear regression, skim this chapter, noting its content for future reference.
Chapter 4 begins the econometric content of the book and presents the most widely
used tool for econometric analysis: the multiple linear regression model applied to
continuous variables. The chapter also discusses how to interpret and present regression
estimates and discusses the logic of hypothesis tests and linear and nonlinear restrictions.
The last section of the chapter considers residuals, predicted values, and marginal effects.
Applying the regression model depends on some assumptions that real datasets
often violate. Chapter 5 discusses how the crucial zero-conditional-mean assumption
of the errors may be violated in the presence of specification error. The chapter also

1. Two excellent texts at this level are Wooldridge (2006) and Stock and Watson (2006).
xviii Preface

discusses statistical and graphical techniques for detecting specification error. Chapter 6
discusses other assumptions that may be violated, such as the assumption of independent
and identically distributed (i.i.d.) errors, and presents the generalized linear regression
model. It also explains how to diagnose and correct the two most important departures
from i.i.d., heteroskedasticity and serial correlation.
Chapter 7 discusses using indicator variables or dummy variables in the linear re-
gression models containing both quantitative and qualitative factors, models with in-
teraction effects, and models of structural change.
Many regression models in applied economics violate the zero-conditional-mean as-
sumption of the errors because they simultaneously determine the response variable and
one or more regressors or because of measurement error in the regressors. No matter
the cause, OLS techniques will no longer generate unbiased and consistent estimates, so
you must use instrumental-variables (IV) techniques instead. Chapter 8 presents the
IV estimator and its generalized method-of-moments counterpart along with tests for
determining the need for IV techniques.
Chapter 9 applies models to panel or longitudinal data that have both cross-sectional
and time-series dimensions. Extensions of the regression model allow you to take ad-
vantage of the rich information in panel data, accounting for the heterogeneity in both
panel unit and time dimensions.
Many econometric applications model categorical and limited dependent variables:
a binary outcome, such as a purchase decision, or a constrained response such as the
amount spent, which combines the decision whether to purchase with the decision of
how much to spend, conditional on purchasing. Because linear regression techniques
are generally not appropriate for modeling these outcomes, chapter 10 presents several
limited-dependent-variable estimators available in Stata.
The appendices discuss techniques for importing external data into Stata and explain
basic Stata programming. Although you can use Stata without doing any programming,
learning how to program in Stata can help you save a lot of time and effort. You should
also learn to generate reproducible results by using do-files that you can document,
archive, and rerun. Following Stata’s guidelines will make your do-files shorter and
easier to maintain and modify.
 4 Linear regression
This chapter presents the most widely used tool in applied economics: the linear regres-
sion model, which relates a set of continuous variables to a continuous outcome. The
explanatory variables in a regression model often include one or more binary or indica-
tor variables; see chapter 7. Likewise, many models seek to explain a binary response
variable as a function of a set of factors, which linear regression does not handle well.
Chapter 10 discusses several forms of that model, including those in which the response
variable is limited but not binary.

4.1 Introduction
This chapter discusses multiple regression in the context of a prototype economic re-
search project. To carry out such a research project, we must

1. lay out a research framework—or economic model—that lets us specify the ques-
tions of interest and defines how we will interpret the empirical results;
2. find a dataset containing empirical counterparts to the quantities specified in the
economic model;
3. use exploratory data analysis to familiarize ourselves with the data and identify
outliers, extreme values, and the like;
4. fit the model and use specification analysis to determine the adequacy of the
explanatory factors and their functional form;
5. conduct statistical inference (given satisfactory findings from specification analy-
sis) on the research questions posed by the model; and
6. analyze the findings from hypothesis testing and the success of the model in terms
of predictions and marginal effects. On the basis of these findings, we may have
to return to one of the earlier stages to reevaluate the dataset and its specification
and functional form.

Section 2 reviews the basic regression analysis theory on which regression point and
interval estimates are based. Section 3 introduces a prototype economic research project
studying the determinants of communities’ single-family housing prices and discusses the
various components of Stata’s results from fitting a regression model of housing prices.
Section 4 discusses how to transform Stata’s estimation results into publication-quality
tables. Section 5 discusses hypothesis testing and estimation subject to constraints on

69
 70 Chapter 4 Linear regression

the parameters. Section 6 deals with computing residuals and predicted values. The
last section discusses computing marginal effects. In the following chapters, we take up
violations of the assumptions on which regression estimates are based.

4.2 Computing linear regression estimates

The linear regression model is the most widely used econometric model and the baseline
against which all others are compared. It specifies the conditional mean of a response
variable y as a linear function of k independent variables
E [y | x1 , x2 , . . . , xk ] = β1 x1 + β2 x2 + · · · + βk xk
Given values for the βs, which are fixed parameters, the linear regression model predicts
the average value of y in the population for different values of x1 , x2 , . . . , xk .
Suppose that the mean value of single-family home prices in Boston-area communi-
ties, conditional on the student–teacher ratios, is given by
E [price | stratio] = β1 + β2 stratio
where price is the mean value of single-family home prices and stratio is the student–
teacher ratio. This relationship reflects the hypothesis that the quality of communities’
school systems is capitalized into housing prices. Here the population is the set of com-
munities in the Commonwealth of Massachusetts. Each town or city in Massachusetts
is generally responsible for its own school system.

Average single−family house price

40000
30000
20000
10000
0

12 14 16 18 20 22
Student−−teacher ratio

Figure 4.1: Conditional mean of single-family house price

Figure 4.1 shows average single-family housing prices for 100 Boston-area communi-
ties, along with the linear fit of housing prices to student–teacher ratios. The conditional
4.2 Computing linear regression estimates 71

mean of price for each value of stratio is shown by the appropriate point on the line.
As theory predicts, the mean house price conditional on the student–teacher ratio is
inversely related to that ratio. Communities with more crowded schools are considered
less desirable. Of course, this relationship between house price and the student–teacher
ratio must be considered ceteris paribus: all other factors that might affect the price
of the house are held constant when we evaluate the effect of a measure of community
schools’ quality on the house price.
In working with economic data, we do not know the population values of β1 , β2 , . . . ,
βk . We work with a sample of N observations of data from that population. Using the
information in this sample, we must

1. obtain good estimates of the coefficients (β1 , β2 , . . . , βk );

2. determine how much our coefficient estimates would change if we were given an-
other sample from the same population;
3. decide whether there is enough evidence to rule out some values for some of the
coefficients (β1 , β2 , . . . , βk ); and
4. use our estimated (β1 , β2 , . . . , βk ) to interpret the model.

To obtain estimates of the coefficients, some assumptions must be made about the
process that generated the data. I discuss those assumptions below and describe what I
mean by good estimates. Before performing steps 2–4, I check whether the data support
these assumptions by using a process known as specification analysis.
If we have a cross-sectional sample from the population, the linear regression model
for each observation in the sample has the form

yi = β1 + β2 xi,2 + β3 xi,3 + · · · + βk xi,k + ui

for each observation in the sample i = 1, 2, . . . , N . The u process is a stochastic distur-

bance, representing the net effect of all other unobservable factors that might influence
y. The variance of its distribution, σu2 , is an unknown population parameter to be
estimated along with the β parameters. We assume that N > k: to conduct statis-
tical inference, there must be more observations in the sample than parameters to be
estimated. In practice, N must be much larger than k.
We can write the linear regression model in matrix form as

y = Xβ + u (4.1)

where X is an N × k matrix of sample values.1

This population regression function specifies that a set of k regressors in X and the
stochastic disturbance u are the determinants of the response variable (or regressand)
1. Some textbooks use k in this context to refer to the number of slope parameters rather than the
number of columns of X. That will explain the deviations in the formulas given below; where I write
k some authors write (k + 1).
 72 Chapter 4 Linear regression

y. We usually assume that the model contains a constant term, so x1 is understood to

equal one for each observation.
The key assumption in the linear regression model involves the relationship in the
population between the regressors x and u.2 We may rewrite (4.1) as

u = y − xβ

We assume that
E [u | x] = 0 (4.2)
i.e., that the u process has a zero-conditional mean. This assumption is that the un-
observed factors involved in the regression function are not related systematically to
the observed factors. This approach to the regression model lets us consider both non-
stochastic and stochastic regressors in X without distinction, as long as they satisfy the
assumption of (4.2).3

4.2.1 Regression as a method-of-moments estimator

We may use the zero-conditional-mean assumption shown in (4.2) to define a method-
of-moments estimator of the regression function. Method-of-moments estimators are
defined by moment conditions that are assumed to hold for the population moments.
When we replace the unobservable population moments by their sample counterparts,
we derive feasible estimators of the model’s parameters. The zero-conditional-mean
assumption gives rise to a set of k moment conditions, one for each x. In particular, the
zero-conditional-mean assumption implies that each regressor is uncorrelated with u.4

E[x′ u] = 0
′
E[x (y − xβ)] = 0 (4.3)

Substituting calculated moments from our sample into the expression and replacing the
b in (4.3) yields the ordinary least squares
unknown coefficients β with estimated values β
(OLS) estimator

b
X ′ y − X ′ Xβ = 0
b
β = (X′ X)−1 X′ y (4.4)

b to calculate the regression residuals:

We may use β

u b
b = y − Xβ
2. x is a vector of random variables and u is scalar random variable. In (4.1), X is a matrix of
realizations of the random vector x, u and y are vectors of realizations of the scalar random variables
u and y.
3. Chapter 8 discusses how to use the instrumental-variables estimator when the zero-conditional-
mean assumption is encountered.
4. The assumption of zero-conditional mean is stronger than that of a zero covariance, because co-
variance considers only linear relationships between the random variables.
 4.2.2 The sampling distribution of regression estimates 73

Given the solution for the vector β,b the additional parameter of the regression prob-
lem σu2 —the population variance of the stochastic disturbance—may be estimated as a
function of the regression residuals u
bi
PN
2 b2i
u
i=1 b′u
u b
s = = (4.5)
N −k N −k
where (N −k) are the residual degrees of freedom of the regression problem. The positive
square root of s2 is often termed the standard error of regression, or root mean squared
error. Stata uses the latter term and displays s as Root MSE.
The method of moments is not the only approach for deriving the linear regression
estimator of (4.4), which is the well-known formula from which the OLS estimator is
derived.5

4.2.2 The sampling distribution of regression estimates

The OLS estimator β b is a vector of random variables because it is a function of the
random variable y, which in turn is a function of the stochastic disturbance u. The OLS
estimator takes on different values for each sample of N observations drawn from the
population. Because we often have only one sample to work with, we may be unsure of
the usefulness of the estimates from that sample. The estimates are the realizations of
the random vector β b from the sampling distribution of the OLS estimator. To evaluate
b we use the sampling distribution of the
the precision of a given vector of estimates β,
regression estimator.
To learn more about the sampling distribution of the OLS estimator, we must make
further assumptions about the distribution of the stochastic disturbance ui . In clas-
sical statistics, the ui were assumed to be independent draws from the same normal
distribution. The modern approach to econometrics drops the normality assumption
and simply assumes that the ui are independent draws from an identical distribution
(i.i.d.).6
Using the normality assumption, we were able to derive the exact finite-sample
distribution of the OLS estimator. In contrast, under the i.i.d. assumption, we must use
large-sample theory to derive the sampling distribution of the OLS estimator. Basically,
large-sample theory supposes that the sample size N becomes infinitely large. Since no
real sample is infinitely large, these methods only approximate the sampling distribution
of the OLS estimator in finite samples. With a few hundred observations or more,
the large-sample approximation works well, so these methods work well with applied
economic datasets.

5. The treatment here is similar to that of Wooldridge (2006). See Stock and Watson (2006) and
appendix 4.A for a derivation based on minimizing the squared-prediction errors.
6. Both frameworks also assume that the (constant) variance of the u process is finite. Formally, i.i.d.
stands for independently and identically distributed.
 74 Chapter 4 Linear regression

Although large-sample theory is more abstract than finite-sample methods, it im-

poses weaker assumptions on the data-generating process. We will use large-sample
theory to define “good” estimators and to evaluate the precision of the estimates pro-
duced from a given sample.
In large samples, consistency means that as N goes to ∞, the estimates will converge
to their respective population parameters. Roughly speaking, if the probability that the
estimator produces estimates arbitrarily close to the population values goes to one as
the sample size increases to infinity, the estimator is said to be consistent.
The sampling distribution of an estimator describes the set of estimates produced
when that estimator is applied to repeated samples from the underlying population.
You can use the sampling distribution of an estimator to evaluate the precision of a
given set of estimates and to statistically test whether the population parameters take
on certain values.
Large-sample theory shows that the sampling distribution of the OLS estimator is
approximately normal.7 Specifically, when the ui are i.i.d. with finite variance σu2 , the
OLS estimator β b has a large-sample normal distribution with mean β and variance
σu Q , where Q−1 is the variance–covariance matrix of X in the population. The
2 −1

variance–covariance of the estimator, σu2 Q−1 , is also referred to as a VCE. Because it

is unknown, we need a consistent estimator of the VCE. Although neither σu2 nor Q−1
is actually known, we can use consistent estimators of them to construct a consistent
estimator of σu2 Q−1 . Given that s2 consistently estimates σu2 and 1/N (X′ X) consistently
estimates Q, s2 (X′ X)−1 is a VCE of the OLS estimator.8

4.2.3 Efficiency of the regression estimator

Under the assumption of i.i.d. errors, the Gauss–Markov theorem holds. Among linear,
unbiased estimators, the OLS estimator has the smallest sampling variance, or the great-
est precision.9 In that sense, it is best, so that “ordinary least squares is BLUE” (the
best linear unbiased estimator) for the parameters of the regression model. If we con-
sider only unbiased estimators that are linear in the parameters, we cannot find a more
efficient estimator. The property of efficiency refers to the precision of the estimator. If
estimator A has a smaller sampling variance than estimator B, estimator A is said to
be relatively efficient. The Gauss–Markov theorem states that OLS is relatively efficient

7. More precisely, the distribution of the OLS estimator converges to a normal distribution. Although
appendix B provides some details, in the text I will simply refer to the “approximate” or “large-sample”
normal distribution. See Wooldridge (2006) for an introduction to large-sample theory.
8. At first glance, you might think that the expression for the VCE should be multiplied by 1/N , but
this assumption is incorrect. As discussed in appendix B, because the OLS estimator
√ is consistent, it
is converging to the constant vector of population parameters at the rate 1/ N , implying that the
variance of the OLS estimator is going to zero as the sample size gets larger. Large-sample theory
compensates for this effect in how it standardizes the estimator. The loss of the 1/N term in the
estimator of the VCE is a product of this standardization.
9. For a formal presentation of the Gauss–Markov theorem, see any econometrics text, e.g., Wooldridge
(2006, 108–109). The OLS estimator is said to be “unbiased” because E[β] b = β.
 4.3 Interpreting regression estimates 75

versus all other linear, unbiased estimators of the parameterization model. However,
this statement rests upon the hypotheses of an appropriately specified model and an
i.i.d. disturbance process with a zero-conditional mean, as specified in (4.2).

4.2.4 Numerical identification of the regression estimates

As in (4.4) above, the solution to the regression problem involves a set of k moment
conditions, or equations to be jointly solved for the k parameter estimates βb1 , βb2 , . . . , βbk .
When will these k parameter estimates be uniquely determined, or numerically iden-
tified? We must have more sample observations than parameters to be estimated, or
N > k. That condition is not sufficient, though. For the simple “two-variable” regres-
sion model yi = β1 + β2 xi,2 + ui , Var[x2 ] must be greater than 0. If there is no variation
in x2 , the data do not provide sufficient information to determine estimates of β1 and
β2 .
In multiple regression with many regressors, XN ×k must be a matrix of full column
rank k, which implies two things. First, only one column of X can take on a constant
value, so each of the other regressors must have a positive sample variance. Second,
there are no exact linear dependencies among the columns of the matrix X. The as-
sumption that X is of full column rank is often stated as “(X′ X) is of full rank” or
“(X′ X) is nonsingular (or invertible).” If the matrix of regressors X contains k linearly
independent columns, the cross-product matrix (X′ X) will have rank k, its inverse will
exist, and the parameters β1 , . . . , βk in (4.4) will be numerically identified.10 If nu-
merical identification fails, the sample does not contain enough information for us to
use the regression estimator on the model as it is specified. That model may be valid
as a description of the data-generating process, but the particular sample may lack
the necessary information to generate a regressor matrix of full column rank. Then we
must either respecify the model or acquire another sample that contains the information
needed to uniquely determine the regression estimates.

4.3 Interpreting regression estimates

This section illustrates using regression by an example from a prototype research project
and discusses how Stata presents regression estimates. We then discuss how to recover
the information displayed in Stata’s estimation results for further computations within
your program and how to combine this information with other estimates to present
them in a table. The last subsection considers problems of numerical identification, or
collinearity, that may appear when you are estimating the regression equation.

10. When computing infinite precision, we must be concerned with numerical singularity and a com-
puter program’s ability to reliably invert a matrix regardless of whether it is analytically invertible. As
we discuss in section 4.3.7, computationally near-linear dependencies among the columns of X should
be avoided.
 76 Chapter 4 Linear regression

4.3.1 Research project: A study of single-family housing prices

As an illustration, we present regression estimates from a model fitted to 506 Boston-
area communities’ housing price data, in which the response variable is the logarithm of
the median price of a single-family home in each community. The dataset (hprice2a)
contains an attribute of each community’s housing stock that we would expect to in-
fluence price: rooms, the average number of rooms per house. Our research question
relates to the influences on price exerted by several external factors. These factors,
measured at the community level, include a measure of air pollution (lnox, the log
of nitrous oxide in parts per 100m), the distance from the community to employment
centers (ldist, the log of the weighted distance to five employment centers), and the
average student–teacher ratio in local schools (stratio). From economic theory, we
would expect the average number of rooms to increase the price, ceteris paribus. Each
of the external factors is expected to decrease the median housing price in the commu-
nity. More polluted communities, those less conveniently situated to available jobs, and
those with poorly staffed schools should all have less expensive housing, given the forces
of supply and demand.
We present the descriptive statistics with summarize and then fit a regression equa-
tion.

. use http://www.stata-press.com/data/imeus/hprice2a, clear

(Housing price data for Boston-area communities)
. summarize price lprice lnox ldist stratio, sep(0)
Variable Obs Mean Std. Dev. Min Max

price 506 22511.51 9208.856 5000 50001

lprice 506 9.941057 .409255 8.517193 10.8198
lnox 506 1.693091 .2014102 1.348073 2.164472
ldist 506 1.188233 .539501 .1222176 2.495682
stratio 506 18.45929 2.16582 12.6 22

The regress command, like other Stata estimation commands, requires us to specify
the response variable followed by a varlist of the explanatory variables.

. regress lprice lnox ldist rooms stratio

Source SS df MS Number of obs = 506
F( 4, 501) = 175.86
Model 49.3987735 4 12.3496934 Prob > F = 0.0000
Residual 35.1834974 501 .070226542 R-squared = 0.5840
Adj R-squared = 0.5807
Total 84.5822709 505 .167489645 Root MSE = .265

lprice Coef. Std. Err. t P>|t| [95% Conf. Interval]

lnox -.95354 .1167418 -8.17 0.000 -1.182904 -.7241762

ldist -.1343401 .0431032 -3.12 0.002 -.2190255 -.0496548
rooms .2545271 .0185303 13.74 0.000 .2181203 .2909338
stratio -.0524512 .0058971 -8.89 0.000 -.0640373 -.0408651
_cons 11.08387 .3181115 34.84 0.000 10.45887 11.70886
 4.3.2 The ANOVA table: ANOVA F and R-squared 77

The header of the regression output describes the overall model estimates, whereas
the table presents the point estimates, their precision, and their interval estimates.

4.3.2 The ANOVA table: ANOVA F and R-squared

The regression output for this model includes the analysis of variance (ANOVA) table in
the upper left, where the two sources of variation are displayed as Model and Residual.
The SS are the sums of squares, with the Residual SS corresponding to u b′u
b and the
′
total Total SS to y e y e in (4.6) below. The next column of the table reports the df:
the degrees of freedom associated with each sum of squares. The degrees of freedom for
total SS are (N −1) since the total SS have been computed by using one sample statistic,
y. The degrees of freedom for the model are (k − 1), equal to the number of slopes (or
explanatory variables), or one fewer than the number of estimated coefficients due to the
constant term. The model SS refer to the ability of the four regressors to jointly explain
a fraction of the variation of y about its mean (the total SS). The residual degrees of
freedom are (N −k), indicating that (N −k) residuals may be freely determined and still
satisfy the constraint from the first normal equation of least squares that the regression
surface passes through the multivariate point of means (y, x2 , . . . , xk ):

y = βb1 + βb2 x2 + βb3 x3 + · · · + βbk xk

In the presence of the constant term βb1 , the first normal equation implies that
u b must be identically zero.11 This is not an assumption but is an algebraic
b = y − Σi xi β i
implication of the least-squares technique, which guarantees that the sum of least-
squares residuals (and their mean) will be very close to zero.12
The last column of the ANOVA table reports the MS, the mean squares due to regres-
sion and error, or the SS divided by the df. The ratio of the Model MS to Residual
MS is reported as the ANOVA F statistic, with numerator and denominator degrees of
freedom equal to the respective df values. This ANOVA F statistic is a test of the null
hypothesis13 that the slope coefficients in the model are jointly zero: that is, the null
model of yi = µ + ui is as successful in describing y as the regression alternative. The
Prob > F is the tail probability or p-value of the F statistic. Here we can reject the
null hypothesis at any conventional level of significance. Also the Root MSE for the
regression of 0.265, which is in the units of the response variable y, is small relative to
the mean of that variable, 9.94.
The upper-right section of the regress output contains several goodness-of-fit statis-
tics, which measure the degree to which a fitted model can explain the variation of the
response variable y. All else equal, we should prefer a model with a better fit to the
data. For the sake of parsimony, we also prefer a simpler model. The mechanics of
11. Recall that the first column of X = ι, an N -element unit vector.
12. Since computers use finite arithmetic, the sum will differ from zero. A well-written computer
program should result in a difference similar to machine precision. For this regression, Stata reports
a mean residual of −1.4 × 10−15 , comparable to the epsdouble() value of 2.2 × 10−16 , which is the
smallest number distinguishable by Stata.
13. I discuss hypothesis testing in detail in section 4.5.
 78 Chapter 4 Linear regression

regression imply that a model with a great many regressors can explain y arbitrarily
well. Given the least-squares residuals, the most common measure of goodness of fit,
regression R2 , may be calculated (given a constant term in the regression function) as
b′u
u b
R2 = 1 − (4.6)
e′ y
y e
where ye = y − y: the regressand with its sample mean removed. This calculation
emphasizes that the object of regression is not to explain y′ y, the raw sum of squares of
the response variable y, which would merely explain why E[y] 6= 0—not an interesting
question. Rather, the object is to explain the variations in the response variable.
With a constant term in the model, the least-squares approach seeks to explain
the largest possible fraction of the sample variation of y about its mean (and not the
associated variance). The null model with which (4.1) is contrasted is y = µ + ui ,
where µ is the population mean of y. In estimating a regression, we want to determine
whether the information in the regressors x is useful. Is the conditional expectation
E[y|x] more informative than the unconditional expectation E[y] = µ? The null model
above has an R2 = 0, whereas virtually any set of regressors will explain some fraction
of the variation of y around y, the sample estimate of µ. R2 is that fraction in the unit
interval, the proportion of the variation in y about y explained by x.

4.3.3 Adjusted R-squared

What about the Adj R-squared? The algebra of least squares dictates that adding a
2
(k + 1)st column to X will result in a regression estimate with Rk+1 ≥ Rk2 . R2 cannot
fall with the addition of xk+1 to the regression equation, as long as the observations
on the marginal regressor are linearly independent of the previous k columns from
a numerical standpoint.14 Indeed, we know that RN 2
(that is, R2 calculated from a
regression in which there are N linearly independent columns of X and N observations
in the sample) must equal 1.0. As we add regressors to x, R2 cannot fall and is likely
to rise, even when the marginal regressor is irrelevant econometrically.
What if we have a competing model that cannot be expressed as nested within
this model, and this model does not nest within the competing model? A nonstatistical
approach to this problem, especially where the two models differ widely in their numbers
2
of regressors (or Model df), is to consider their R values, the statistic Stata labels
2
as Adj R-squared.15 The R considers the explained variance of y, rather than the
explained variation, as does ordinary R2 . That is, rather than merely considering ub′u
b,
2
the residual sum of squares, R takes into account the degrees of freedom lost in fitting
14. In this sense, the limitations of finite arithmetic using the binary number system intrude: since
0.100 cannot be exactly expressed in a finite number of digits in the binary system, even a column that
should be perfectly collinear with the columns of Xk may not be so computationally. The researcher
should know her data and recognize when a candidate regressor cannot logically add information to an
existing regressor matrix, whether or not the resulting regressor matrix is judged to possess full column
rank by Stata.
15. A formal statistical approach to the nonnested models problem is presented below in section 4.5.5.
4.3.3 Adjusted R-squared 79

2
b′u
the model and scales u b by (N −k) rather than N .16 R can be expressed as a corrected
2
version of R in which the degrees-of-freedom adjustments are made, penalizing a model
with more regressors for its loss of parsimony:

2 b′u
u b /(N − k) N −1
R =1− ′
= 1 − (1 − R2 )
e y
y e /(N − 1) N −k

If an irrelevant regressor is added to a model, R2 cannot fall and will probably

2
rise, but R will rise if the benefit of that regressor (reduced variance of the residuals)
2
exceeds the cost of including it in the model: 1 degree of freedom.17 Therefore, R
can fall when a more elaborate model is considered, and indeed it is not bounded by
2
zero. Algebraically, R must be less than R2 since (N − 1)/(N − k) > 1 for any X
matrix and cannot be interpreted as the “proportion of variation of y”, as can R2 in the
2
presence of a constant term. Nevertheless, you can use R to informally compare models
with the same response variable but differing specifications. You can also compare the
equations’ s2 values (labeled Root MSE in Stata’s output) in units of the dependent
variable to judge nonnested specifications.
Two other measures commonly used to compare competing regression models are
the Akaike information criterion (AIC; Akaike [1974]) and Bayesian information crite-
rion (BIC; often referred to as the Schwarz criterion: Schwarz [1978]). These measures
also account for both the goodness of fit of the model and its parsimony. Each mea-
sure penalizes a larger model for using additional degrees of freedom while rewarding
improvements in goodness of fit. The BIC places a higher penalty on using degrees of
freedom. You can calculate the AIC and BIC after a regression model with the estat
ic command. estat ic will display the log likelihood of the null model (that with only
a constant term), the log likelihood of the fitted model, the model degrees of freedom,
and the AIC and BIC values. For the regression above, we would type
. estat ic

Model Obs ll(null) ll(model) df AIC BIC

. 506 -265.4135 -43.49514 5 96.99028 118.123

Least-squares regression can also be considered a maximum likelihood estimator

of the vector β and ancillary parameter σu2 .18 The degree to which our fitted model
improves upon the null model in explaining the variation of the response variable is
measured by the (algebraically) larger magnitude of ll(model) than that of ll(null).19
16. For comparison you may write (4.6), dividing both numerator and denominator by N .
2 2
17. This is not a statistical judgment, as Rk+1 can exceed Rk if the t statistic on the added regressor
exceeds 1.0 in absolute value.
18. The maximum likelihood estimator requires the normality assumption. See Johnston and DiNardo
(1997).
19. A likelihood-ratio test formally compares these two magnitudes under the null hypothesis that the
null model is adequate. I discuss likelihood-ratio tests in chapter 10.
 80 Chapter 4 Linear regression

4.3.4 The coefficient estimates and beta coefficients

Below the ANOVA table and summary statistics, Stata reports the β b coefficient esti-
mates, along with their estimated standard errors, t statistics, and the associated p-
values labeled P>|t|: that is, the tail probability for a two-tailed test on the hypothesis
H0: βbj = 0.20 The last two columns display an estimated confidence interval, with limits
defined by the current setting of level. You can use the level() option on regress
(or other estimation commands) to specify a particular level. After performing the esti-
mation (e.g., with the default 95% level), you can redisplay the regression results with,
for instance, regress, level(90). You can change  the default level
 (see [R] level)
for the session or permanently with set level # , permanently .
Economic researchers often express regressors or response variables in logarithms.21
A model in which the response variable is the log of the original series and the regressors
are in levels is termed a log-linear (or single-log) model. The rough approximation that
log(1 + x) ≃ x for reasonably small x is used to interpret the regression coefficients.
These coefficients are also the semielasticities of y with respect to x, measuring the
response of y in percentage terms to a unit change in x. When logarithms are used
for both the response variable and regressors, we have the double-log model. In this
model, the coefficients are themselves elasticities of y with respect to each x. The most
celebrated example of a double-log model is the Cobb–Douglas production function,
q = alα k β eǫ , which we can estimate by linear regression by taking logs of q, l, and k.
In other social science disciplines, linear regression results are often reported as
estimated beta coefficients. This terminology is somewhat confusing for economists,
given their common practice of writing the regression model in terms of βs. The beta
coefficient is defined as ∂y ∗ /∂x∗j , where the starred quantities are z-transformed or
standardized variables; for instance, y ∗ = (yi − y)/sy , where y is the sample mean and
sy is the sample standard deviation of the response variable. Thus the beta coefficient
for the jth regressor tells us how many standard deviations y would change given a
1–standard deviation change in xj . This measure is useful in disciplines where many
empirical quantities are indices lacking a natural scale. We can then rank regressors by
the magnitudes of their beta coefficients because the absolute magnitude of the beta
coefficient for xj indicates the strength of the effect of that variable. For the regression
model above, we can merely redisplay the regression by using the beta option:

20. We discuss hypothesis testing in detail in section 4.5.

21. Economists use natural logs exclusively; references to log should be taken as the natural log, or ln.
 4.3.5 Regression without a constant term 81

. regress, beta
Source SS df MS Number of obs = 506
F( 4, 501) = 175.86
Model 49.3987735 4 12.3496934 Prob > F = 0.0000
Residual 35.1834974 501 .070226542 R-squared = 0.5840
Adj R-squared = 0.5807
Total 84.5822709 505 .167489645 Root MSE = .265

lprice Coef. Std. Err. t P>|t| Beta

lnox -.95354 .1167418 -8.17 0.000 -.4692738

ldist -.1343401 .0431032 -3.12 0.002 -.1770941
rooms .2545271 .0185303 13.74 0.000 .4369626
stratio -.0524512 .0058971 -8.89 0.000 -.2775771
_cons 11.08387 .3181115 34.84 0.000 .

The output indicates that lnox has the largest beta coefficient, in absolute terms, fol-
lowed by rooms. In economic and financial applications, where most regressors have
a natural scale, it is more common to compute marginal effects such as elasticities or
semielasticities (see section 4.7).

4.3.5 Regression without a constant term

With Stata, you can estimate a regression equation without a constant term by using
the noconstant option, but I do not recommend doing so. Such a model makes little
sense if the mean of the response variable is nonzero and all regressors’ coefficients are
insignificant.22 Estimating a constant term in a model that does not have one causes a
small loss in the efficiency of the parameter estimates. In contrast, incorrectly omitting
a constant term produces inconsistent estimates. The tradeoff should be clear: include
a constant term, and let the data indicate whether its estimate can be distinguished
from zero.
What if we want to estimate a homogeneous relationship between y and the regres-
sors x, where economic theory posits y ∝ x? We can test the hypothesis of propor-
tionality by estimating the relationship with a constant term and testing H0 : β1 = 0.
If the data reject that hypothesis, we should not fit the model with the constant term
removed. Many of the common attributes of a linear regression are altered in a model
that truly lacks a constant term. For instance, the least-squares residuals are not con-
strained to have zero sum or mean, and R2 measured conventionally will be negative
when the null model yi = µ + ui is not only preferable but strictly dominates the model
yi = β2 xi,2 + ui . Therefore, unless we have a good reason to fit a model without a
constant term, we should retain the constant. An estimated βb1 not significantly differ-
ent from zero does not harm the model, and it renders the model’s summary statistics
comparable to those of other models of the response variable y.
22. If we provide the equivalent of a constant term by including a set of regressors that add up to a
constant value for each observation, we should specify the hascons option as well as noconstant. Using
the hascons option will alter the Model SS and Total SS, affecting the ANOVA F and R2 measures;
it does not affect the Root MSE or the t statistics for individual coefficients.