CHAPTER

Exercise Solutions

177

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

EXERCISE 8.1
When i2 = 2
N

( xi x )
i =1

i2

2
N
( xi x )

i =1

( xi x )
i =1

2
N
( xi x )

i =1

2 ( xi x )

i =1

2
N
( xi x )

i =1

2
N

( xi x )
i =1

178

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

179

EXERCISE 8.2
(a)

Multiplying the first normal equation by

1
i
i

) and the second one by ( ) yields

2
i

( x )( ) + ( x ) = ( x ) y
( )( x ) + ( )( x ) = ( ) x y
2
i

1 2
i
i

1
i
i

2
i

2
i

1
i
i
2
i

1
i
i

1
i
i

2
i

*
i i

Subtracting the first of these two equations from the second yields

( 2 )( x 2 ) ( 1 x )2 = ( 2 ) x y* ( 1 x ) 1 y
i i 2 i i i i i i i
i i
Thus,

(
2 =

i2 ) xi yi* ( i1 xi )( i1 yi )

( )( x ) (
2
i

2
i

1 2
i
i

i2 yi xi i2 yi i2 xi

i2
i2 i2

=
2
i2 xi2 i2 xi

i2 i2
In this last expression, the second line is obtained from the first by making the
substitutions yi = i1 yi and xi = i1 xi , and by dividing numerator and denominator by

( )

2 2
i

. Solving the first normal equation

( ) + (
2
i

x ) 2 = i1 yi for 1

1
i
i

and making the substitutions yi = i1 yi and xi = i1 xi , yields

i2 yi i2 xi
1 =

i2 i2
(b)

When i2 = 2 for all i,

and

i2 yi xi = 2 yi xi , i2 yi = 2 yi , i2 xi = 2 xi ,

i2 = N 2 . Making these substitutions into the expression for 2

2 yi xi 2 yi 2 xi

2
2
2
N N =
= N
2
2
2 xi2 2 xi

2
N 2
N

yields

yi xi

yx
N
xi2 x 2
N

and that for 1 becomes

1 =

yi 2 xi

N 2

2
N

= y x 2

These formulas are equal to those for the least squares estimators b1 and b2 . See pages 21
and 42-44 of POE.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

180

Exercise 8.2 (continued)

(c)

The least squares estimators b1 and b2 are functions of the following averages

x=

1
xi
N

y=

1
yi
N

1
xi yi
N

1
xi2

For the generalized least squares estimator for 1 and 2 , these unweighted averages are
replaced by the weighted averages

i2 xi

2
i

i2 yi

2
i

i2 yi xi

2
i

i2 xi2

2
i

In these weighted averages each observation is weighted by the inverse of the error
variance. Reliable observations with small error variances are weighted more heavily than
those with higher error variances that make them more unreliable.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

181

EXERCISE 8.3
For the model yi = 1 + 2 xi + ei where var(ei ) = 2 xi2 , the transformed model that gives a
constant error variance is
yi* = 1 xi* + 2 + ei*
where yi* = yi xi , xi* = 1 xi , and ei* = ei xi . This model can be estimated by least squares
with the usual simple regression formulas, but with 1 and 2 reversed. Thus, the
generalized least squares estimators for 1 and 2 are

N xi* yi* xi* yi*

1 =
2
N ( xi* ) 2 ( xi* )

and 2 = y * 1 x *

Using observations on the transformed variables, we find

yi* = 7 ,

xi* = 37 12 ,

xi* yi* = 47 8 ,

With N = 5 , the generalized least squares estimates are

1 =

5(47 8) (37 12)(7)

= 2.984
5(349 144) (37 12) 2

and
(37 12)
2 = y * 1 x * = (7 5) 2.984
= 0.44
5

( xi* )2 = 349 144

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

182

EXERCISE 8.4
(a)

In the plot of the residuals against income the absolute value of the residuals increases as
income increases, but the same effect is not apparent in the plot of the residuals against
age. In this latter case there is no apparent relationship between the magnitude of the
residuals and age. Thus, the graphs suggest that the error variance depends on income, but
not age.

(b)

Since the residual plot shows that the error variance may increase when income increases,
and this is a reasonable outcome since greater income implies greater flexibility in travel,
we set up the null and alternative hypotheses as the one tail test H 0 : 12 = 22 versus
H1 : 12 > 22 , where 12 and 22 are artificial variance parameters for high and low income
households. The value of the test statistic is

F=

12 (2.9471 107 ) (100 4)

=
= 2.8124
22 (1.0479 107 ) (100 4)

The 5% critical value for (96, 96) degrees of freedom is F(0.95,96,96) = 1.401 . Thus, we reject

H 0 and conclude that the error variance depends on income.

Remark: An inspection of the file vacation.dat after the observations have been ordered
according to INCOME reveals 7 middle observations with the same value for INCOME,
namely 62. Thus, when the data are ordered only on the basis of INCOME, there is not one
unique ordering, and the values for SSE1 and SSE2 will depend on the ordering chosen.
Those specified in the question were obtained by ordering first by INCOME and then by
AGE.
(c)

(i)

All three sets of estimates suggest that vacation miles travelled are directly related to
household income and average age of all adults members but inversely related to the
number of kids in the household.

(ii) The White standard errors are slightly larger but very similar in magnitude to the
conventional ones from least squares. Thus, using Whites standard errors leads one
to conclude estimation is less precise, but it does not have a big impact on assessment
of the precision of estimation.
(iii) The generalized least squares standard errors are less than the White standard errors
for least squares, suggesting that generalized least squares is a better estimation
technique.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

183

EXERCISE 8.5
(a)

The table below displays the 95% confidence intervals obtained using the critical t-value
t(0.975,497) = 1.965 and both the least squares standard errors and the Whites standard errors.
After recognizing heteroskedasticity and using Whites standard errors, the confidence
intervals for CRIME, AGE and TAX are narrower while the confidence interval for
ROOMS is wider. However, in terms of the magnitudes of the intervals, there is very little
difference, and the inferences that would be drawn from each case are similar. In
particular, none of the intervals contain zero and so all of the variables have coefficients
that would be judged to be significant no matter what procedure is used.
95% confidence intervals

Least squares standard errors

CRIME
ROOMS
AGE
TAX

Whites standard errors

Lower

Upper

Lower

Upper

0.255
5.600
0.076
0.020

0.112
7.143
0.020
0.005

0.252
5.065
0.070
0.019

0.114
7.679
0.026
0.007

(b)

Most of the standard errors did not change dramatically when Whites procedure was
used. Those which changed the most were for the variables ROOMS, TAX, and PTRATIO.
Thus, heteroskedasticity does not appear to present major problems, but it could lead to
slightly misleading information on the reliability of the estimates for ROOMS, TAX and
PTRATIO.

(c)

As mentioned in parts (a) and (b), the inferences drawn from use of the two sets of
standard errors are likely to be similar. However, keeping in mind that the differences are
not great, we can say that, after recognizing heteroskedasticity and using Whites standard
errors, the standard errors for CRIME, AGE, DIST, TAX and PTRATIO decrease while the
others increase. Therefore, using incorrect standard errors (least squares) understates the
reliability of the estimates for CRIME, AGE, DIST, TAX and PTRATIO and overstates the
reliability of the estimates for the other variables.
Remark: Because the estimates and standard errors are reported to 4 decimal places in
Exercise 5.5 (Table 5.7), but only 3 in this exercise (Table 8.2), there will be some
rounding error differences in the interval estimates in the above table. These differences,
when they occur, are no greater than 0.001.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

184

EXERCISE 8.6
(a)

ROOMS significantly effects the variance of house prices through a relationship that is
quadratic in nature. The coefficients for ROOMS and ROOMS 2 are both significantly
different from zero at a 1% level of significance. Because the coefficient of ROOMS 2 is
positive, the quadratic function has a minimum which occurs at the number of rooms for
which
e 2
= 2 + 2 3 ROOMS = 0
ROOMS
Using the estimated equation, this number of rooms is

ROOMS min =

2
305.311
=
= 6.4
2 3 2 23.822

Thus, for houses of 6 rooms or less the variance of house prices decreases as the number
of rooms increases and for houses of 7 rooms or more the variance of house prices
increases as the number of rooms increases.
The variance of house prices is also a quadratic function of CRIME, but this time the
quadratic function has a maximum. The crime rate for which it is a maximum is
CRIMEmax =

4
2.285
=
= 29.3

2 5 2 0.039

Thus, the variance of house prices increases with the crime rate up to crime rates of around
30 and then declines. There are very few observations for which CRIME 30 , and so we
can say that, generally, the variance increases as the crime rate increases, but at a
decreasing rate.
The variance of house prices is negatively related to DIST, suggesting that the further the
house is from the employment centre, the smaller the variation in house prices.
(b)

We can test for heteroskedasticity using the White test. The null and alternative
hypotheses are

H 0 : 2 = 3 =

= 6 = 0

H1 : not all s in H 0 are zero

2
2
where (0.95,5)
The test statistic is 2 = N R 2 . We reject H 0 if 2 > (0.95,5)
= 11.07 . The

test value is
2 = N R 2 = 506 0.08467 = 42.84
Since 42.84 > 11.07 , we reject H 0 and conclude that heteroskedasticity exists.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

185

EXERCISE 8.7
(a)

Hand calculations yield

xi = 0

yi = 31.1

x =0

y = 3.8875

xi yi =89.35

xi 2 = 52.34

The least squares estimates are given by

b2 =

N xi yi xi yi
N xi ( xi )
2

8 89.35 0 31.1
8 52.34 ( 0 )

=1.7071

and

b1 = y b2 x = 3.8875 1.7071 0 = 3.8875

(b)

(c)

The least squares residuals ei = yi y i and other information useful for part (c) follow
observation

ln(e 2 )

z ln(e 2 )

1
2
3
4
5
6
7
8

1.933946
0.733822
9.549756
1.714707
3.291665
3.887376
3.484558
3.746079

1.319125
0.618977
4.513031
1.078484
2.382787
2.715469
2.496682
2.641419

4.353113
0.185693
31.591219
5.068875
4.527295
18.465187
5.742369
16.905082

To estimate , we begin by taking logs of both sides of i2 = exp(zi ) , that yields

ln(i2 ) = zi . Then, we replace the unknown i2 with ei2 to give the estimating equation

ln(ei2 ) = zi + vi
Using least squares to estimate from this model is equivalent to a simple linear
regression without a constant term. See, for example, Exercise 2.4. The least squares
estimate for is

( zi ln(ei2 ) )
8

i =1

zi2
i =1

86.4674
= 0.4853
178.17

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

186

Exercise 8.7 (continued)

(d)

Variance estimates are given by the predictions i2 = exp( zi ) = exp(0.4853 zi ) . These

values and those for the transformed variables

y
yi* = i
i

x
xi* = i
i

are given in the following table.

observation
1
2
3
4
5
6
7
8
(e)

i2

4.960560
1.156725
29.879147
9.785981
2.514531
27.115325
3.053260
22.330994

yi*

xi*

0.493887
0.464895
3.457624
0.287700
4.036003
0.345673
2.575316
0.042323

0.224494
2.789371
0.585418
0.575401
2.144126
0.672141
1.373502
0.042323

From Exercise 8.2, the generalized least squares estimate for 2 is

yi xi i2 yi i2 xi

i2 i2 i2
2 =
2
xi2 i2 xi

i2 i2
15.33594
2.193812 (0.383851)
= 2.008623
15.442137
(0.383851) 2
2.008623
=

8.477148
7.540580

= 1.1242
The generalized least squares estimate for 1 is

i2 yi i2 xi
1 =

i2 i2

2 = 2.193812 (0.383851) 1.1242 = 2.6253

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

187

EXERCISE 8.8
(a)

The regression results with standard errors in parenthesis are

PRICE = 5193.15 + 68.3907 SQFT 217.8433 AGE

(se) ( 3586.64 ) ( 2.1687 )
( 35.0976 )
These results tell us that an increase in the house size by one square foot leads to an
increase in house price of $63.39. Also, relative to new houses of the same size, each year
of age of a house reduces its price by $217.84.
(b)

For SQFT = 1400 and AGE = 20

PRICE = 5193.15 + 68.3907 1400 217.8433 20 = 96,583

The estimated price for a 1400 square foot house, which is 20 years old, is $96,583. For
SQFT = 1800 and AGE = 20

PRICE = 5193.15 + 68.3907 1800 217.8433 20 = 123,940

The estimated price for a 1800 square foot house, which is 20 years old, is $123,940.
(c)

For the White test we estimate the equation

ei2 = 1 + 2 SQFT + 3 AGE + 4 SQFT 2 + 5 AGE 2 + 6 SQFT AGE + vi
and test the null hypothesis H 0 : 2 = 3 =

= 6 = 0 . The value of the test statistic is

2 = N R 2 = 940 0.0375 = 35.25

2
Since (0.95,5)
= 11.07 , the calculated value is larger than the critical value. That is,
2
2 > (0.95,5)
. Thus, we reject the null hypothesis and conclude that heteroskedasticity

exists.
(d)

Estimating the regression log(ei2 ) = 1 + 2 SQFT + vi gives the results

1 = 16.3786,

2 = 0.001414

With these results we can estimate i2 as

i2 = exp(16.3786 + 0.001414 SQFT )

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

188

Exercise 8.8 (continued)

(e)

Generalized least squares requires us to estimate the equation

PRICEi

1
= 1

SQFTi
+ 2

AGEi
+ 2

ei
+
i

When estimating this model, we replace the unknown i with the estimated standard
deviations i . The regression results, with standard errors in parenthesis, are

PRICE = 8491.14 + 65.3269 SQFT 187.6587 AGE

(se)

( 3109.43) ( 2.0825)

( 29.2844 )

These results tell us that an increase in the house size by one square foot leads to an
increase in house price of $65.33. Also, relative to new houses of the same size, each year
of age of a house reduces its price by $187.66.
(f)

For SQFT = 1400 and AGE = 20

PRICE = 8491.14 + 65.3269 1400 187.6587 20 = 96,196

The estimated price for a 1400 square foot house, which is 20 years old, is $96,196. For
SQFT = 1800 and AGE = 20

PRICE = 8491.14 + 65.3269 1800 187.6587 20 = 122,326

The estimated price for a 1800 square foot house, which is 20 years old, is $122,326.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

189

EXERCISE 8.9
(a)

(i)

Under the assumptions of Exercise 8.8 part (a), the mean and variance of house prices
for houses of size SQFT = 1400 and AGE = 20 are

E ( PRICE ) = 1 + 1400 2 + 20 3

var( PRICE ) = 2

Replacing the parameters with their estimates gives

E ( PRICE ) = 96583

var( PRICE ) = 22539.632

Assuming the errors are normally distributed,

115000 96583

P ( PRICE > 115000 ) = P Z >

22539.6

= P ( Z > 0.8171)
= 0.207
where Z is the standard normal random variable Z N (0,1) . The probability is
depicted as an area under the standard normal density in the following diagram.

The probability that your 1400 square feet house sells for more than $115,000 is
0.207.
(ii) For houses of size SQFT = 1800 and AGE = 20 , the mean and variance of house
prices from Exercise 8.8(a) are

E ( PRICE ) = 123940

var( PRICE ) = 22539.632

The required probability is

110000 123940

P ( PRICE < 110000 ) = P Z <

22539.6

= P ( Z < 0.6185 )
= 0.268
The probability that your 1800 square feet house sells for less than $110,000 is
0.268.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

190

Exercise 8.9 (continued)

(b)

(i)

Using the generalized least squares estimates as the values for 1 , 2 and 3 , the
mean of house prices for houses of size SQFT = 1400 and AGE = 20 is, from
Exercise 8.8(f), E ( PRICE ) = 96196 . Using estimates of 1 and 2 from Exercise
8.8(d), the variance of these house types is

var( PRICE ) = exp(1 + 1.2704 + 2 1400)

= exp(16.378549 + 1.2704 + 0.00141417691 1400)
= 3.347172 108
= (18295.3) 2
Thus,

115000 96196

P ( PRICE > 115000 ) = P Z >

18295.3

= P ( Z > 1.0278 )
= 0.152
The probability that your 1400 square feet house sells for more than $115,000 is
0.152.
(ii) For your larger house where SQFT = 1800 , we find that E ( PRICE ) = 122326 and

var( PRICE ) = exp(1 + 1.2704 + 2 1800)

= exp(16.378549 + 1.2704 + 0.00141417691 1800)
= 5.893127 108
= (24275.8) 2
Thus,

110000 122326

P ( PRICE < 110000 ) = P Z <

24275.8

= P ( Z < 0.5077 )
= 0.306
The probability that your 1800 square feet house sells for less than $110,000 is 0.306.
(c)

In part (a) where the heteroskedastic nature of the error term was not recognized, the same
standard deviation of prices was used to compute the probabilities for both house types. In
part (b) recognition of the heteroskedasticity has led to a standard deviation of prices that
is smaller than that in part (a) for the case of the smaller house, and larger than that in part
(a) for the case of the larger house. These differences have in turn led to a smaller
probability for part (i) where the distribution is less spread out and a larger probability for
part (ii) where the distribution has more spread.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

191

EXERCISE 8.10
(a)

The transformed model corresponding to the variance assumption i2 = 2 xi is

1
= 1
+ x + ei
x 2 i
xi
i

e
where ei = i
x
i

yi

We obtain the residuals from this model, square them, and regress the squares on xi to
obtain

e 2 = 123.79 + 23.35 x

R 2 = 0.13977

To test for heteroskedasticity, we compute a value of the 2 test statistic as

2 = N R 2 = 40 0.13977 = 5.59
A null hypothesis of no heteroskedasticity is rejected because 5.59 is greater than the 5%
2
critical value (0.95,1)
= 3.84 . Thus, the variance assumption i2 = 2 xi was not adequate to
eliminate heteroskedasticity.
(b)

The transformed model used to obtain the estimates in (8.27) is

1
yi
= 1
i
i

xi

+ 2 + ei
i

e
where ei = i
i

and

i = exp(0.93779596 + 2.32923872 ln( xi )

We obtain the residuals from this model, square them, and regress the squares on xi to
obtain
e 2 = 1.117 + 0.05896 x

R 2 = 0.02724

To test for heteroskedasticity, we compute a value of the 2 test statistic as

2 = N R 2 = 40 0.02724 = 1.09
A null hypothesis of no heteroskedasticity is not rejected because 1.09 is less than the 5%
2
critical value (0.95,1)
= 3.84 . Thus, the variance assumption i2 = 2 xi is adequate to
eliminate heteroskedasticity.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

192

EXERCISE 8.11
The results are summarized in the following table and discussed below.
part (a)

part (b)

part (c)

81.000

76.270

81.009

se( 1 )

32.822

12.004

33.806

10.328

10.612

10.323

1.706

1.024

1.733

6.641

2.665

6.955

se( 2 )
= NR
2

The transformed models used to obtain the generalized estimates are as follows.
(a)

yi
1
xi
0.25 = 1 0.25 + 2 0.25 + ei
xi
xi
xi

where ei =

ei
xi0.25

(b)

yi

xi

where ei =

ei
xi

(c)

yi
1
xi

= 1
+ 2
+ e
ln( x )
ln( x )
ln( x ) i
i
i
i

1
= 1

xi

xi
+ 2

xi

+ ei

where ei =

ei
ln( xi )

In each case the residuals from the transformed model were squared and regressed on
income and income squared to obtain the R 2 values used to compute the 2 values. These
equations were of the form

e 2 = 1 + 2 x + 3 x 2 + v
For the White test we are testing the hypothesis H 0 : 2 = 3 = 0 against the alternative
hypothesis H1 : 2 0 and/or 3 0. The critical chi-squared value for the White test at a
2
5% level of significance is (0.95,2)
= 5.991 . After comparing the critical value with our test

statistic values, we reject the null hypothesis for parts (a) and (c) because, in these cases,
2
. The assumptions var(ei ) = 2 xi and var(ei ) = 2 ln( xi ) do not eliminate
2 > (0.95,2)
heteroskedasticity in the food expenditure model. On the other hand, we do not reject the
2
. Heteroskedasticity has been eliminated
null hypothesis in part (b) because 2 < (0.95,2)
with the assumption that var(ei ) = 2 xi2 .
In the two cases where heteroskedasticity has not been eliminated (parts (a) and (c)), the
coefficient estimates and their standard errors are almost identical. The two
transformations have similar effects. The results are substantially different for part (b),
however, particularly the standard errors. Thus, the results can be sensitive to the
assumption made about the heteroskedasticity, and, importantly, whether that assumption
is adequate to eliminate heteroskedasticity.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

193

EXERCISE 8.12
(a)

This suspicion might be reasonable because richer countries, countries with a higher GDP
per capita, have more money to distribute, and thus they have greater flexibility in terms
of how much they can spend on education. In comparison, a country with a smaller GDP
will have fewer budget options, and therefore the amount they spend on education is likely
to vary less.

(b)

The regression results, with the standard errors in parentheses are

EE
i
Pi
(se)

GDPi
= 0.1246 + 0.0732

Pi

( 0.0485) ( 0.0052 )

The fitted regression line and data points appear in the following figure. There is evidence
of heteroskedasticity. The plotted values are more dispersed about the fitted regression
line for larger values of GDP per capita. This suggests that heteroskedasticity exists and
that the variance of the error terms is increasing with GDP per capita.
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
0

10

12

14

16

18

GDP per capita

(c)

For the White test we estimate the equation

GDPi
ei2 = 1 + 2
Pi

GDPi
+ 3
+ vi

Pi

This regression returns an R2 value of 0.29298. For the White test we are testing the
hypothesis H 0 : 2 = 3 = 0 against the alternative hypothesis H1 : 2 0 and/or 3 0.
The White test statistic is

2 = N R 2 = 34 0.29298 = 9.961
The critical chi-squared value for the White test at a 5% level of significance is
2
(0.95,2)
= 5.991 . Since 9.961 is greater than 5.991, we reject the null hypothesis and
conclude that heteroskedasticity exists.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

194

Exercise 8.12 (continued)

(d)

Using Whites formula:

se ( b1 ) = 0.040414,

se ( b2 ) = 0.006212

The 95% confidence interval for 2 using the conventional least squares standard errors is

b2 t(0.975,32) se(b2 ) = 0.073173 2.0369 0.00517947 = (0.0626,0.0837)

The 95% confidence interval for 2 using Whites standard errors is

b2 t(0.975,32) se(b2 ) = 0.073173 2.0369 0.00621162 = (0.0605,0.0858)

In this case, ignoring heteroskedasticity tends to overstate the precision of least squares
estimation. The confidence interval from Whites standard errors is wider.
(e)

Re-estimating the equation under the assumption that var(ei ) = 2 xi , we obtain

EE
i
Pi
(se)

GDPi
= 0.0929 + 0.0693

Pi

( 0.0289 ) ( 0.0044 )

Using these estimates, the 95% confidence interval for 2 is

b2 t(0.975,32) se(b2 ) = 0.069321 2.0369 0.00441171 = (0.0603,0.0783)

The width of this confidence interval is less than both confidence intervals calculated in
part (d). Given the assumption var(ei ) = 2 xi is true, we expect the generalized least
squares confidence interval to be narrower than that obtained from Whites standard
errors, reflecting that generalized least squares is more precise than least squares when
heteroskedasticity is present. A direct comparison of the generalized least squares interval
with that obtained using the conventional least squares standard errors is not meaningful,
however, because the least squares standard errors are biased in the presence of
heteroskedasticity.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

195

EXERCISE 8.13
(a)

For the model C1t = 1 + 2 Q1t + 3Q12t + 4 Q13t + e1t , where var ( e1t ) = 2Q1t , the generalized
least squares estimates of 1, 2, 3 and 4 are:
estimated
coefficient

standard
error

93.595
68.592
10.744
1.0086

23.422
17.484
3.774
0.2425

1
2
3
4
(b)

The calculated F value for testing the hypothesis that 1 = 4 = 0 is 108.4. The 5% critical
value from the F(2,24) distribution is 3.40. Since the calculated F is greater than the critical
F, we reject the null hypothesis that 1 = 4 = 0. The F value can be calculated from
F=

(c)

( SSER SSEU )
( SSEU ) 24

( 61317.65 6111.134 )
( 6111.134 ) 24

= 108.4

The average cost function is given by

1
C1t
= 1
Q1t
Q1t

et
2
+ 2 + 3Q1t + 4 Q1t +
Q1t

Thus, if 1 = 4 = 0 , average cost is a linear function of output.

(d)

The average cost function is an appropriate transformed model for estimation when
heteroskedasticity is of the form var ( e1t ) = 2Q12t .

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

196

EXERCISE 8.14
(a)

The least squares estimated equations are

C1 = 72.774 + 83.659 Q1 13.796 Q12 + 1.1911Q13

(se)
( 23.655) ( 4.597 ) ( 0.2721)

12 = 324.85
SSE1 = 7796.49

C 2 = 51.185 + 108.29 Q2 20.015 Q22 + 1.6131Q23

(se)
( 28.933) ( 6.156 ) ( 0.3802 )

22 = 847.66
SSE2 = 20343.83

To see whether the estimated coefficients have the expected signs consider the marginal
cost function
dC
MC =
= 2 + 23Q + 34 Q 2
dQ
We expect MC > 0 when Q = 0; thus, we expect 2 > 0. Also, we expect the quadratic MC
function to have a minimum, for which we require 4 > 0. The slope of the MC function is
d ( MC ) dQ = 23 + 64 Q . For this slope to be negative for small Q (decreasing MC), and
positive for large Q (increasing MC), we require 3 < 0. Both our least-squares estimated
equations have these expected signs. Furthermore, the standard errors of all the
coefficients except the constants are quite small indicating reliable estimates. Comparing
the two estimated equations, we see that the estimated coefficients and their standard
errors are of similar magnitudes, but the estimated error variances are quite different.
(b)

Testing H 0 : 12 = 22 against H1 : 12 22 is a two-tail test. The critical values for

performing a two-tail test at the 10% significance level are F(0.05,24,24) = 0.0504 and

F(0.95,24,24) = 1.984 . The value of the F statistic is

F=

22 847.66
=
= 2.61
12 324.85

Since F > F(0.95,24,24) , we reject H0 and conclude that the data do not support the
proposition that 12 = 22 .
(c)

Since the test outcome in (b) suggests 12 22 , but we are assuming both firms have the
same coefficients, we apply generalized least squares to the combined set of data, with the
observations transformed using 1 and 2 . The estimated equation is

C = 67.270 + 89.920 Q 15.408 Q 2 + 1.3026 Q3

(se)
(16.973) ( 3.415 ) ( 0.2065)
Remark: Some automatic software commands will produce slightly different results if the
transformed error variance is restricted to be unity or if the variables are transformed using
variance estimates from a pooled regression instead of those from part (a).

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

197

Exercise 8.14 (continued)

(d)

Although we have established that 12 22 , it is instructive to first carry out the test for

H 0 : 1 = 1 , 2 = 2 , 3 = 3 , 4 = 4
under the assumption that 12 = 22 , and then under the assumption that 12 22 .
Assuming that 12 = 22 , the test is equivalent to the Chow test discussed on pages 179-181
of POE. The test statistic is

F=

( SSER SSEU ) J
SSEU ( N K )

where SSEU is the sum of squared errors from the full dummy variable model. The
dummy variable model does not have to be estimated, however. We can also calculate
SSEU as the sum of the SSE from separate least squares estimation of each equation. In
this case

SSEU = SSE1 + SSE2 = 7796.49 + 20343.83 = 28140.32

The restricted model has not yet been estimated under the assumption that 12 = 22 . Doing
so by combining all 56 observations yields SSER = 28874.34 . The F-value is given by
F=

( SSER SSEU ) J
SSEU ( N K )

(28874.34 28140.32) 4
= 0.313
28140.32 (56 8)

The corresponding 2 -value is 2 = 4 F = 1.252 . These values are both much less than
2
their respective 5% critical values F(0.95, 4, 48) = 2.565 and (0.95,4)
= 9.488 . There is no

evidence to suggest that the firms have different coefficients. In the formula for F, note
that the number of observations N is the total number from both firms, and K is the
number of coefficients from both firms.
The above test is not valid in the presence of heteroskedasticity. It could give misleading
results. To perform the test under the assumption that 12 22 , we follow the same steps,
but we use values for SSE computed from transformed residuals. For restricted estimation
from part (c) the result is SSER = 49.2412 . For unrestricted estimation, we have the
interesting result

SSEU* =

SSE1 SSE2 ( N1 K1 ) 12 ( N 2 K 2 ) 22
+ 2 =
+
= N1 K1 + N 2 K 2 = 48
12
2
12
22

Thus,

F=

(49.2412 48) 4
= 0.3103
48 48

and

2 = 1.241

The same conclusion is reached. There is no evidence to suggest that the firms have
different coefficients.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

198

EXERCISE 8.15
(a)

To estimate the two variances using the variance model specified, we first estimate the
equation

WAGEi = 1 + 2 EDUCi + 3 EXPERi + 4 METROi + ei

From this equation we use the squared residuals to estimate the equation
ln(ei2 ) = 1 + 2 METROi + vi
The estimated parameters from this regression are 1 = 1.508448 and 2 = 0.338041 .
Using these estimates, we have
METRO = 0

2R = exp(1.508448 + 0.338041 0) = 4.519711

METRO = 1,

2M = exp(1.508448 + 0.338041 1) = 6.337529

These error variance estimates are much smaller than those obtained from separate subsamples ( 2M = 31.824 and 2R = 15.243 ). One reason is the bias factor from the
exponential function see page 206 of POE. Multiplying 2M = 6.3375 and 2R = 4.5197
by the bias factor exp(1.2704) yields 2M = 22.576 and 2R = 16.100 . These values are
closer, but still different from those obtained using separate sub-samples. The differences
occur because the residuals from the combined model are different from those from the
separate sub-samples.
(b)

To use generalized least squares, we use the estimated variances above to transform the
model in the same way as in (8.32). After doing so the regression results are, with standard
errors in parentheses
WAGEi = 9.7052 + 1.2185EDUCi + 0.1328EDUCi + 1.5301METROi
(se)

(1.0485) ( 0.0694 )

( 0.0150 )

( 0.3858 )

The magnitudes of these estimates and their standard errors are almost identical to those in
equation (8.33). Thus, although the variance estimates can be sensitive to the estimation
technique, the resulting generalized least squares estimates of the mean function are much
less sensitive.
(c)

The regression output using White standard errors is

WAGEi = 9.9140 + 1.2340EDUCi + 0.1332EDUCi + 1.5241METROi

(se)

(1.2124 ) ( 0.0835)

( 0.0158)

( 0.3445)

With the exception of that for METRO, these standard errors are larger than those in part
(b), reflecting the lower precision of least squares estimation.

Chapter 8, Exercise Solutions, Principles of Econometrics, 3e

199

EXERCISE 8.16
(a)

Separate least squares estimation gives the error variance estimates G2 = 2.899215 104
and 2A = 15.36132 10-4 .

(b)

The critical values for testing the hypothesis H 0 : G2 = 2A against the alternative
H1 : G2 2A at a 5% level of significance are F(0.025,15,15) = 0.349 and F(0.975,15,15) = 2.862 .
The value of the F-statistic is

2A 15.36132 10-4
=
= 5.298
G2 2.899215 10-4
Since 5.298 > 2.862, we reject the null hypothesis and conclude that the error variances of
the two countries, Austria and Germany, are not the same.

F=

(c)

The estimates of the coefficients using generalized least squares are

1
2
3
4
(d)

[const]
[ln(INC)]
[ln(PRICE)]
[ln(CARS)]

estimated
coefficient

standard
error

2.0268
0.4466
0.2954
0.1039

0.4005
0.1838
0.1262
0.1138

Testing the null hypothesis that demand is price inelastic, i.e., H 0 : 3 1 against the
alternative H1 : 3 < 1 , is a one-tail t test. The value of our test statistic is

t=

0.2954 (1)
= 5.58
0.1262

The critical t value for a one-tail test and 34 degrees of freedom is t(0.05,34) = 1.691 . Since

5.58 > 1.691 , we do not reject the null hypothesis and conclude that there is not enough
evidence to suggest that demand is elastic.