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Lecture 6

Indicator variables are used in econometric models to account for qualitative factors. They take only two values, usually zero and one, to indicate the presence or absence of a characteristic. Common uses include modifying the intercept of a regression by including an indicator variable and its parameter, or modifying the slope of a relationship by using an interaction variable of an indicator and another variable. An example uses indicator variables to estimate the effect of proximity to a university on house prices, finding location premiums, different effects of size on price in different locations, and effects of other characteristics.

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46 views

Lecture 6

Indicator variables are used in econometric models to account for qualitative factors. They take only two values, usually zero and one, to indicate the presence or absence of a characteristic. Common uses include modifying the intercept of a regression by including an indicator variable and its parameter, or modifying the slope of a relationship by using an interaction variable of an indicator and another variable. An example uses indicator variables to estimate the effect of proximity to a university on house prices, finding location premiums, different effects of size on price in different locations, and effects of other characteristics.

Uploaded by

Watani Bidami
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Econometrics for Finance

6. Indicator Variables

Siraj M. September, 2023


Indicator Variables

 Indicator variables are used to account for qualitative factors in econometric


models.
 They are often called dummy, binary, or dichotomous variables because they take
just two values, usually one or zero, to indicate the presence or absence of a
characteristic or to indicate whether a condition is true or false.
 They are also called dummy variables, to indicate that we are creating a numeric
variable for a qualitative, nonnumeric characteristic.
 We use the terms indicator variable and dummy variable interchangeably.
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Indicator Variables

 Generally, we define an indicator variable D as:

1 if characteristic is present
𝐷=
0 if characteristic is not present

 For example, for the house price model (Hedonic model), we can define an
indicator variable, to account for a desirable neighborhood, as:

1 if property is in the desirable neighborhood


𝐷=
0 if property is not in the desirable neighborhood

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Intercept Indicator Variables

 The most common use of indicator variables is to modify the regression


model intercept parameter.
 Adding the indicator variable D to a hedonic regression model, along with a
new parameter δ, we obtain:

𝑃𝑅𝐼𝐶𝐸 = 𝛽1 + 𝛿𝐷 + 𝛽2 𝑆𝑄𝐹𝑇 + 𝑒

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Slope Indicator Variables

 Instead of assuming that the effect of location on house price causes a change
in the intercept of the hedonic regression, let us assume that the change is in
the slope of the relationship.
 If we assume that this is one value for homes in the desirable neighborhood,
and another value for homes in other neighborhoods, we can specify:
𝑃𝑅𝐼𝐶𝐸 = 𝛽1 + 𝛽2 𝑆𝑄𝐹𝑇 + 𝛾 𝑆𝑄𝐹𝑇 ∗ 𝐷 + 𝑒
 The new variable (SQFT × D) is the product of house size and the indicator
variable, and is called an interaction variable, as it captures the interaction
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effect of location and size on house price.
Illustration

The University Effect on House Prices


 A real estate economist collects information on 1000 house price sales
from two similar neighborhoods, one called “University Town”
bordering a large state university, and another a neighborhood about
three miles from the university.
 House prices are given in $1000; size (SQFT) is the number of
hundreds of square feet of living area.
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Illustration

The University Effect on House Prices


 Also recorded are the house AGE (in years), location (UTOWN = 1 for
homes near the university, 0 otherwise), whether the house has a pool (POOL
= 1 if a pool is present, 0 otherwise) and whether the house has a fireplace
(FPLACE = 1 if a fireplace is present, 0 otherwise).
 The economist specifies the regression equation as:
𝑃𝑅𝐼𝐶𝐸 = 𝛽1 + 𝛿1 𝑈𝑇𝑂𝑊𝑁 + 𝛽2 𝑆𝑄𝐹𝑇 + 𝛾 𝑆𝑄𝐹𝑇 ∗ 𝑈𝑇𝑂𝑊𝑁 + 𝛽3 𝐴𝐺𝐸
+ 𝛿2 𝑃𝑂𝑂𝐿 + 𝛿3 𝐹𝑃𝐿𝐴𝐶𝐸 + 𝑒
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Illustration

The University Effect on House Prices

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Illustration

The University Effect on House Prices


 The estimated regression function for the houses near the university is:

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Illustration

The University Effect on House Prices


 Based on the regression results, we estimate that:
 The location premium for lots near the university is $27,453.
 The change in expected price per additional square foot is $89.12 for houses
near the university and $76.12 for houses in other areas.
 Houses depreciate $190.10 per year.
 A pool increases the value of a home by $4,377.20.
 A fireplace increases the value of a home by $1,649.20.
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