Introduction to Econometrics

STAT-S-301

Panel Data (2016/2017)

Lecturer: Yves Dominicy

Teaching Assistant: Elise Petit

Regression with Panel Data

A panel dataset contains observations on multiple entities
(individuals), where each entity is observed at two or more
points in time.
Examples:
Data on 420 California school districts in 1999 and
again in 2000, for 840 observations total.
Data on 50 U.S. states, each state is observed in 3
years, for a total of 150 observations.
Data on 1000 individuals, in four different months, for
4000 observations total.
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Notation for panel data:

A double subscript distinguishes entities (states) and time
periods (years).
i = entity (state), n = number of entities,
so i = 1,,n.
t = time period (year), T = number of time periods
so t =1,,T.
Data: Suppose we have 1 regressor. The data are:
(Xit, Yit), i = 1,,n, t = 1,,T.
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Panel data with k regressors:

(X1it, X2it,,Xkit, Yit), i = 1,,n, t = 1,,T
n = number of entities (states),
T = number of time periods (years).
Some jargon:
Another term for panel data is longitudinal data.
balanced panel: no missing observations.
unbalanced panel: some entities (states) are not
observed for some time periods (years).
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Why are panel data useful?

With panel data we can control for factors that:
vary across entities (states) but do not vary over time,
could cause omitted variable bias if they are omitted,
are unobserved or unmeasured.
Key idea:
If an omitted variable does not change over time, then
any changes in Y over time cannot be caused by the
omitted variable.

Example of a panel data set:

Traffic deaths and alcohol taxes
Observational unit: a year in a U.S. state
48 U.S. states, so n = of entities = 48
7 years (1982,, 1988), so T = # of time periods = 7
Balanced panel, so total # observations = 7 x 48 = 336
Variables:
Traffic fatality rate (# traffic deaths in that state in that
year, per 10,000 state residents).
Tax on a case of beer.
Other (legal driving age, drunk driving laws, etc.).
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Traffic death data for 1982

Policy question: Higher alcohol taxes, more traffic deaths?

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Traffic death data for 1988

Policy question: Higher alcohol taxes, more traffic deaths?

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Why might there be higher more traffic deaths in

states that have higher alcohol taxes?
Other factors that determine traffic fatality rate:
Quality (age) of automobiles,
Quality of roads,
Culture around drinking and driving,
Density of cars on the road.
These omitted factors could cause omitted variable bias.

Example #1: traffic density

Suppose:
(i) High traffic density means more traffic deaths.
(ii) (Western) states with lower traffic density have lower
alcohol taxes.
Then the two conditions for omitted variable bias are
satisfied. Specifically, high taxes could reflect high
traffic density (so the OLS coefficient would be biased
positively high taxes, more deaths).
Panel data lets us eliminate omitted variable bias when the
omitted variables are constant over time within a given
state.
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Example #2: cultural attitudes

Cultural attitudes towards drinking and driving:
(i) arguably are a determinant of traffic deaths; and
(ii) potentially are correlated with the beer tax, so beer
taxes could be picking up cultural differences
(omitted variable bias).
Then the two conditions for omitted variable bias are satisfied.
Specifically, high taxes could reflect cultural attitudes
towards drinking (so the OLS coefficient would be biased).
Panel data lets us eliminate omitted variable bias when the
omitted variables are constant over time within a given state.

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Panel Data with Two Time Periods

Consider the panel data model:
FatalityRateit = 0 + 1BeerTaxit + 2Zi + uit,
Zi is a factor that does not change over time (density), at least
during the years on which we have data.
Suppose Zi is not observed, so its omission could result in
omitted variable bias.
The effect of Zi can be eliminated using T = 2 years.
The key idea: Any change in the fatality rate from 1982 to 1988
cannot be caused by Zi, because Zi (by assumption) does not
change between 1982 and 1988.
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The math: consider fatality rates in 1988 and 1982:

FatalityRatei1988 = 0 + 1BeerTaxi1988 + 2Zi + ui1988
FatalityRatei1982 = 0 + 1BeerTaxi1982 + 2Zi + ui1982
Suppose E(uit|BeerTaxit, Zi) = 0.
Subtracting 1988 1982 (that is, calculating the change),
eliminates the effect of Zi:
FatalityRatei1988 = 0 + 1BeerTaxi1988 + 2Zi + ui1988
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FatalityRatei1988 FatalityRatei1982 =

1(BeerTaxi1988 BeerTaxi1982) + (ui1988 ui1982)

The new error term, (ui1988 ui1982), is uncorrelated with
either BeerTaxi1988 or BeerTaxi1982.
This difference equation can be estimated by OLS, even
though Zi isnt observed.
The omitted variable Zi doesnt change, so it cannot be a
determinant of the change in Y.
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Example: Traffic deaths and beer taxes

1982 data:
FatalityRate_est= 2.01 + 0.15BeerTax
(0.15) (0.13)
1988 data:
FatalityRate_est = 1.86 + 0.44BeerTax
(0.11) (0.13)

(n = 48)

(n = 48)

Difference regression (n = 48)

FR1988 FR1982= 0.072 1.04(BeerTax1988BeerTax1982)
(0.065) (0.36)
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16

Fixed Effects Regression

What if you have more than 2 time periods (T > 2)?
Yit = 0 + 1Xit + 2Zi + ui, i =1,,n, T = 1,,T
We can rewrite this in two useful ways:
1. n-1 binary regressor regression model
2. Fixed Effects regression model
We first rewrite this in fixed effects form.

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Example:
Suppose we have n = 3 states: California, Texas, Massachusetts.
Yit = 0 + 1Xit + 2Zi + ui, i =1,,n, T = 1,,T
Population regression for California (that is, i = CA):
YCA,t = 0 + 1XCA,t + 2ZCA + uCA,t
= (0 + 2ZCA) + 1XCA,t + uCA,t
= CA + 1XCA,t + uCA,t
CA = 0 + 2ZCA doesnt change over time.
CA is the intercept for CA, and 1 is the slope.
The intercept is unique to CA, but the slope is the same in all
the states: parallel lines.
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Population regression for Texas:

YTX,t = 0 + 1XTX,t + 2ZTX + uTX,t
= (0 + 2ZTX) + 1XTX,t + uTX,t
=TX + 1XTX,t + uTX,t, where TX = 0 + 2ZTX.
Collecting the lines for all three states:
YCA,t = CA + 1XCA,t + uCA,t
YTX,t = TX + 1XTX,t + uTX,t
YMA,t = MA + 1XMA,t + uMA,t
or
Yit = i + 1Xit + uit, i = CA, TX, MA, T = 1,,T.

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The regression lines for each state in a picture

Y = CA + 1X

Y
CA

Y = TX + 1X

CA

Y = MA+ 1X

TX

TX
MA

MA
X

In binary regressor form:

Yit = 0 + CADCAi + TXDTXi + 1Xit + uit
DCAi = 1 if state is CA, = 0 otherwise.
DTXt = 1 if state is TX, = 0 otherwise.
Leave out DMAi (why?).
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Two ways to write the fixed effects model:

n-1 binary regressor form
Yit = 0 + 1Xit + 2D2i + + nDni + ui

1 for i =2 (state #2)

where D2i =
, etc.
0 otherwise
Fixed effects form:
Yit = 1Xit + i + ui
i is called a state fixed effect or state effect it is the constant
(fixed) effect of being in state i.

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Fixed Effects Regression: Estimation

Three estimation methods:
1. n-1 binary regressors OLS regression
2. Entity-demeaned OLS regression
3. Changes specification (only works for T = 2)
These three methods produce identical estimates of the
regression coefficients, and identical standard errors.
We already did the changes specification (1988 minus
1982) but this only works for T = 2 years.
Methods #1 and #2 work for general T.
Method #1 is only practical when n isnt too big.
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1. n-1 binary regressors OLS regression

Yit = 0 + 1Xit + 2D2i + + nDni + ui

where

1 for i =2 (state #2)

D2i =
0 otherwise

(1)

etc.

First create the binary variables D2i,,Dni.

Then estimate (1) by OLS.
Inference (hypothesis tests, confidence intervals) is as
usual (using heteroskedasticity-robust standard errors).
This is impractical when n is very large (for example if
n = 1000 workers).
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2. Entity-demeaned OLS regression

The fixed effects regression model:
Yit = 1Xit + i + ui
The state averages satisfy:
1 T
1 T
1 T
Yit = i + 1 X it + uit

T t 1
T t 1
T t 1

Deviation from state averages:

1 T
1 T
1 T

Yit Yit = 1 X it X it + uit uit

T t 1
T t 1
T t 1

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1 T
1 T
1 T

Yit Yit = 1 X it X it + uit uit

T t 1
T t 1
T t 1

or
Yit = 1 X it + uit
1 T
1 T
where Yit = Yit Yit and X it = Xit X it
T t 1
T t 1

For i=1 and t = 1982, Yit is the difference between the

fatality rate in Alabama in 1982, and its average value
in Alabama averaged over all 7 years.
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Yit = 1 X it + uit

(2)

1 T
where Yit = Yit Yit , etc.
T t 1
First construct the demeaned variables Yit and X it .
Then estimate (2) by regressing Yit on X it using OLS.
Inference (hypothesis tests, confidence intervals) is as usual
(using heteroskedasticity-robust standard errors).
This is like the changes approach, but instead Yit is deviated
from the state average instead of Yi1.
This can be done in a single command in STATA.

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Example: Traffic deaths and beer taxes in STATA

. areg vfrall beertax, absorb(state) r;
Regression with robust standard errors

Number of obs
F( 1,
287)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

336
10.41
0.0014
0.9050
0.8891
.18986

-----------------------------------------------------------------------------|
Robust
vfrall |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------beertax | -.6558736
.2032797
-3.23
0.001
-1.055982
-.2557655
_cons |
2.377075
.1051515
22.61
0.000
2.170109
2.584041
-------------+---------------------------------------------------------------state |
absorbed
(48 categories)

areg automatically de-means the data,

this is especially useful when n is large,
the reported intercept is arbitrary.
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For n = 48, T = 7:
FatalityRate_est = 0.66BeerTax + State fixed effects
(0.20)
Should you report the intercept?
How many binary regressors would you include to
estimate this using the binary regressor method?
Compare slope, standard error to the estimate for the
1988 v. 1982 changes specification (T = 2, n = 48):
FR1988-FR1982 = 0.072 1.04(BeerTax1988BeerTax1982).
(0.065) (0.36)
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Regression with Time Fixed Effects

An omitted variable might vary over time but not across states:
Safer cars (air bags, etc.); changes in national laws.
These produce intercepts that change over time.
Let these changes (safer cars) be denoted by the variable St,
which changes over time but not states.
The resulting population regression model is:
Yit = 0 + 1Xit + 2Zi + 3St + uit.
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Time fixed effects only

Yit = 0 + 1Xit + 3St + uit
In effect, the intercept varies from one year to the next:
Yi,1982 = 0 + 1Xi,1982 + 3S1982 + ui,1982
= (0 + 3S1982) + 1Xi,1982 + ui,1982
or
Yi,1982 = 1982 + 1Xi,1982 + ui,1982,

1982 = 0 + 3S1982

Similarly,
Yi,1983 = 1983 + 1Xi,1983 + ui,1983,

1983 = 0 + 3S1983

etc.
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Two formulations for time fixed effects

1. Binary regressor formulation:
Yit = 0 + 1Xit + 2B2t + TBTt + uit
1 when t =2 (year #2)
where B2t =
, etc.
0 otherwise

2. Time effects formulation:

Yit = 1Xit + t + uit
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Time fixed effects: estimation methods

1. T-1 binary regressors OLS regression:
Yit = 0 + 1Xit + 2B2it + TBTit + uit.
Create binary variables B2,,BT
B2 = 1 if t = year #2, = 0 otherwise.
Regress Y on X, B2,,BT using OLS.
Wheres B1?
2. Year-demeaned OLS regression:
Deviate Yit, Xit from year (not state) averages.
Estimate by OLS using year-demeaned data.
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State and Time Fixed Effects

Yit = 0 + 1Xit + 2Zi + 3St + uit
1. Binary regressor formulation:
Yit = 0 + 1Xit + 2D2i + + nDni
+ 2B2t + TBTt + uit
2. State and time effects formulation:
Yit = 1Xit + i + t + uit
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State and time effects: estimation methods

1. n-1 and T-1 binary regressors OLS regression:
Create binary variables D2,,Dn.
Create binary variables B2,,BT.
Regress Y on X, D2,,Dn, B2,,BT using OLS.
What about D1 and B1?
2. State- and year-demeaned OLS regression:
Deviate Yit, Xit from year and state averages.
Estimate by OLS using year- and statedemeaned data.
These two methods can be combined too.
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STATA example: Traffic deaths

. gen y83=(year==1983);
. gen y88=(year==1988);
. areg vfrall beertax y83 y84 y85 y86 y87 y88, absorb(state) r;
Regression with robust standard errors

Number of obs =
336
F( 7,
281) =
3.70
Prob > F
= 0.0008
R-squared
= 0.9089
Adj R-squared = 0.8914
Root MSE
= .18788
-----------------------------------------------------------------------------|
Robust
vfrall |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------beertax | -.6399799
.2547149
-2.51
0.013
-1.141371
-.1385884
y83 | -.0799029
.0502708
-1.59
0.113
-.1788579
.0190522
y84 | -.0724206
.0452466
-1.60
0.111
-.161486
.0166448
y85 | -.1239763
.0460017
-2.70
0.007
-.214528
-.0334246
y86 | -.0378645
.0486527
-0.78
0.437
-.1336344
.0579055
y87 | -.0509021
.0516113
-0.99
0.325
-.1524958
.0506917
y88 | -.0518038
.05387
-0.96
0.337
-.1578438
.0542361
_cons |
2.42847
.1468565
16.54
0.000
2.139392
2.717549
-------------+---------------------------------------------------------------state |
absorbed
(48 categories)

Go to section for other ways to do this in STATA!

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The Fixed Effects Regression Assumptions

For a single X:
Yit = 1Xit + i + uit, i = 1,,n, t = 1,, T
1. E(uit|Xi1,,XiT,i) = 0.
2. (Xi1,,XiT,Yi1,,YiT), i =1,,n, are i.i.d. draws from
their joint distribution.
3. (Xit, uit) have finite fourth moments.
4. There is no perfect multicollinearity (multiple Xs).
5. corr(uit,uis|Xit,Xis,i) = 0 for t s.
Assumptions 3 and 4 are identical; 1 and 2 differ; and 5 is
new.
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Assumption #1:
E(uit|Xi1,,XiT,i) = 0
uit has mean zero, given the state fixed effect and the
entire history of the Xs for that state.
This is an extension of the previous multiple regression
Assumption #1.
This means there are no omitted lagged effects (any
lagged effects of X must enter explicitly).
Also, there is not feedback from u to future X:
o Whether a state has a particularly high fatality rate this
year doesnt subsequently affect whether it increases
the beer tax.
o Well return to this when we take up time series data.
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Assumption #2:
(Xi1,,XiT,Yi1,,YiT), i =1,,n, are i.i.d.
This is an extension of Assumption #2 for multiple
regression with cross-section data.
This is satisfied if entities (states, individuals) are
randomly sampled from their population by simple
random sampling, then data for those entities are collected
over time.
This does not require observations to be i.i.d. over time for
the same entity that would be unrealistic (whether a state
has a mandatory DWI sentencing law this year is strongly
related to whether it will have that law next year).
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Assumption #5:
corr(uit,uis|Xit,Xis,i) = 0 for t s
This is new.
This says that (given X), the error terms are uncorrelated
over time within a state.
For example, uCA,1982 and uCA,1983 are uncorrelated..
Is this plausible? What enters the error term?
o Especially snowy winter.
o Opening major new divided highway.
o Fluctuations in traffic density from local economic
conditions.
Assumption #5 requires these omitted factors entering uit
to be uncorrelated over time, within a state.
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What if Assumption #5 fails?

A useful analogy is heteroskedasticity.
OLS panel data estimators of 1 are unbiased, consistent.
The OLS standard errors will be wrong usually the OLS
standard errors understate the true uncertainty.
Intuition: if uit is correlated over time, you dont have as much
information (as much random variation) as you would were uit
uncorrelated.
This problem is solved by using heteroskedasticity and
autocorrelation-consistent standard errors we return to this
when we focus on time series regression.

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Drunk Driving Laws and Traffic Deaths

Some facts:
Approx. 40,000 traffic fatalities annually in the U.S.
1/3 of traffic fatalities involve a drinking driver.
25% of drivers on the road between 1am and 3am
have been drinking (estimate).
A drunk driver is 13 times as likely to cause a fatal
crash as a non-drinking driver (estimate).
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Public policy issues:

Drunk driving causes massive externalities (sober
drivers are killed, etc. etc.) there is ample
justification for governmental intervention.
Are there any effective ways to reduce drunk driving?
If so, what?
What are effects of specific laws:
o mandatory punishment,
o minimum legal drinking age,
o economic interventions (alcohol taxes).
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The drunk driving panel data set

n = 48 U.S. states, T = 7 years (1982,,1988) (balanced)
Variables
Traffic fatality rate (deaths per 10,000 residents).
Tax on a case of beer (Beertax).
Minimum legal drinking age.
Minimum sentencing laws for first DWI violation:
o Mandatory Jail,
o Manditory Community Service,
o otherwise, sentence will just be a monetary fine.
Vehicle miles per driver (US DOT).
State economic data (real per capita income, etc.).
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Why might panel data help?

Potential omitted variable bias from variables that vary across
states but are constant over time:
o culture of drinking and driving
o quality of roads
o vintage of autos on the road
use state fixed effects
Potential omitted variable bias from variables that vary over time
but are constant across states:
o improvements in auto safety over time
o changing national attitudes towards drunk driving
use time fixed effects
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45

46

Empirical Analysis: Main Results

Sign of beer tax coefficient changes when fixed state
effects are included.
Fixed time effects are statistically significant but do not
have big impact on the estimated coefficients.
Estimated effect of beer tax drops when other laws are
included as regressor.
The only policy variable that seems to have an impact is
the tax on beer not minimum drinking age, not
mandatory sentencing, etc.
The other economic variables have plausibly large
coefficients: more income, more driving, more deaths.
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Extensions of the n-1 binary regressor approach

The idea of using many binary indicators to eliminate omitted
variable bias can be extended to non-panel data the key is that
the omitted variable is constant for a group of observations, so that
in effect it means that each group has its own intercept.
Example: Class size problem.
Suppose funding and curricular issues are determined at the county
level, and each county has several districts. Resulting omitted
variable bias could be addressed by including binary indicators,
one for each county (omit one to avoid perfect multicollinearity).

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Summary: Regression with Panel Data

You can control for unobserved variables that:
o vary across states but not over time, and/or
o vary over time but not across states.
More observations give you more information.
Estimation involves relatively straightforward extensions
of multiple regression.
Fixed effects estimation can be done three ways:
1. Changes method when T = 2
2. n-1 binary regressors method when n is small
3. Entity-demeaned regression.

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 Similar methods apply to regression with time fixed

effects and to both time and state fixed effects.
Statistical inference: like multiple regression.
Limitations/challenges:
Need variation in X over time within states.
Time lag effects can be important.
Standard errors might be too low (errors might be
correlated over time).

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