Unit 3

Extensions of Regression Models

As pointed out earlier non linearity may be expected in many Economic Relationships. In other
words the relationship between Y and X can be non-linear rather than linear. Thus, once the
independent variables have been identified the next step is to choose the functional form of the
relationship between the dependent and the independent variables. Specification of the functional
form is important, because a correct explanatory variable may well appear to be insignificant or to
have an unexpected sign if an inappropriate functional form is used. Thus the choice of a functional
form for an equation is a vital part of the specification of that equation. The choice of a functional
form almost always should be based on an examination of the underlying economic theory. The
logical form of the relationship between the dependent variable and the independent variable in
question should be compared with the properties of various functional forms, and the one that
comes closest to that underlying theory should be chosen for the equation.
Some Commonly Used Functional Forms
a) The Linear Form: It is based on the assumption that the slope of the relationship between the
independent variable and the dependent variable is constant.
Y
 i i=1, 2...K
X

Y
X => Y
 K
X

In this case elasticity is not constant.

Y / Y Y X X
NY ,X     i
X / X X Y Y
If the hypothesized relationship between Y and X is such that the slope of the relationship can be
expected to be constant and the elasticity can therefore be expected to be variable, then the linear
functional form should be used.
Note: Economic theory frequently predicts only the sign of a relationship and not its functional
form. Under such circumstances, the linear form can be used until strong evidence that it is
inappropriate is found. Thus, unless theory, common sense, or experience justifies using some
other functional form, one should use the linear model.
b) Log-linear, double Log or constant elasticity model

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The most common functional form that is non-linear in the variable (but still linear in the
coefficients) is the log-linear form. A log-linear form is often used, because the elasticities and not
the slopes are constant i.e.,  =  Constant.

Output

Input

Thus, given the assumption of a constant elasticity, the proper form is the exponential (log-linear)
form.

Given: Yi   0 X i i eU i
The log-linear functional form for the above equation can be obtained by a logarithmic
transformation of the equation.

ln Yi  ln  0   i ln X i  U i
The model can be estimated by OLS if the basic assumptions are fulfilled.
demand gd(log f)

ln Yi  ln  0  1 ln X i
 1
Yi   0 X i

price log f price

The model is also called a constant elasticity model because the coefficient of elasticity between
Y and X (1) remains constant.
Y X d ln Y
   1
X Y d ln X
This functional form is used in the estimation of demand and production functions.

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Note: We should make sure that there are no negative or zero observations in the data set before
we decide to use the log-linear model. Thus log-linear models should be run only if all the variables
take on positive values.

c) Semi-log Form
The semi-log functional form is a variant of the log-linear equation in which some but not all of
the variables (dependent and independent) are expressed in terms of their logs. Such models
expressed as:
( i ) Yi   0  1 ln X 1i  U i ( lin-log model ) and ( ii ) ln Yi   0   1 X 1i  U i ( log-lin model
) are called semi-log models. The semi-log functional form, in the case of taking the log of one of
the independent variables, can be used to depict a situation in which the impact of X on Y is
expected to ‘tail off’ as X gets bigger as long as 1 is greater than zero.

1<0
Y=0+1Xi

1>0

Example: The Engel’s curve tends to flatten out, because as incomes get higher, a smaller
percentage of income goes to consumption and a greater percentage goes to saving.
 Consumption thus increases at a decreasing rate.
 Growth models are examples of semi-log forms
d) Polynomial Form
Polynomial functional forms express Y as a function of independent variables some of which are
raised to powers other than one. For example in a second degree polynomial (quadratic)
equation, at least one independent variable is squared.
Y   0   1 X 1i   2 X 1i   3 X 2i  U i
2

Such models produce slopes that change as the independent variables change. Thus the slopes of
Y with respect to the Xs are
Y Y
  1  2  2 X 1 , and  3
X 1 X 2
In most cost functions, the slope of the cost curve changes as output changes.
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 Y Y

A) B)

X
Xi Impact of age on earnings
a typical cost curve

Simple transformation of the polynomial could enable us to use the OLS method to estimate the
parameters of the model
X1  X 3
2
Setting
 Y   0   1 X 1i   2 X 3   3 X 2i  U i
e) Reciprocal Transformation (Inverse Functional Forms)
The inverse functional form expresses Y as a function of the reciprocal (or inverse) of one or more
of the independent variables (in this case X1):
1
Yi   0   1 ( )   2 X 2i  U i
X 1i
Or
1
Yi   0   1 ( )   2 X 2i  U i
X 1i

The reciprocal form should be used when the impact of a particular independent variable is
expected to approach zero as that independent variable increases and eventually approaches
infinity. Thus as X1 gets larger, its impact on Y decreases.

1 0  0
Y  0 
X 1i 1  0

0

1 0  0
Y  0 
X 1i 1  0

An asymptote or limit value is set that the dependent variable will take if the value of the X-
variable increases indefinitely i.e. 0 provides the value in the above case. The function approaches
the asymptote from the top or bottom depending on the sign of 1.

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Example: Phillips curve, a non-linear relationship between the rate of unemployment and the
percentage wage change.
1
Wt   0   1 ( ) Ut
Ut