Chapter 10

Dummy Variable Models

In general, the explanatory variables in any regression analysis are assumed to be quantitative in nature. For
example, the variables like temperature, distance, age etc. are quantitative in the sense that they are recorded
on a well defined scale.

In many applications, the variables can not be defined on a well defined scale and they are qualitative in
nature.

For example, the variables like sex (male or female), colour (black, white), nationality, employment status
(employed, unemployed) are defined on a nominal scale. Such variables do not have any natural scale of
measurement. Such variables usually indicate the presence or absence of a “quality” or an attribute like
employed or unemployed, graduate or non-graduate, smokers or non- smokers, yes or no, acceptance or
rejection, so they are defined on a nominal scale. Such variables can be quantified by artificially
constructing the variables that take the values, e.g., 1 and 0 where “1” indicates usually the presence of
attribute and “0” indicates usually the absence of attribute. For example, “1” indicates that the person is
male and “0” indicates that the person is female. Similarly, “1” may indicate that the person is employed
and then “0” indicates that the person is unemployed.

Such variables classify the data into mutually exclusive categories. These variables are called indicator
variables or dummy variables.

Usually, the dummy variables take on the values 0 and 1 to identify the mutually exclusive classes of the
explanatory variables. For example,
1 if person is male
D=
0 if person is female,
1 if person is employed
D=
0 if person is unemployed.

Here we use the notation D in place of X to denote the dummy variable. The choice of 1 and 0 to identify
a category is arbitrary. For example, one can also define the dummy variable in above examples as

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 1 if person is female
D=
0 if person is male,
1 if person is unemployed
D=
0 if person is employed.
It is also not necessary to choose only 1 and 0 to denote the category. In fact, any distinct value of D will
serve the purpose. The choices of 1 and 0 are preferred as they make the calculations simple, help in easy
interpretation of the values and usually turn out to be a satisfactory choice.

In a given regression model, the qualitative and quantitative variables may also occur together, i.e., some
variables may be qualitative and others are quantitative.

When all explanatory variables are

- quantitative, then the model is called a regression model,
- qualitative, then the model is called an analysis of variance model and
- quantitative and qualitative both, then the model is called a analysis of covariance model.

Such models can be dealt within the framework of regression analysis. The usual tools of regression analysis
can be used in case of dummy variables.

Example:
Consider the following model with x1 as quantitative and D2 as dummy variable

y =β 0 + β1 x1 + β 2 D2 + ε , E (ε ) =0, Var (ε ) =σ 2
0 if an observation belongs to group A
D2 = 
1 if an observation belongs to group B.
The interpretation of result is important. We proceed as follows:
If D2 = 0, then

y =β 0 + β1 x1 + β 2 .0 + ε
=β 0 + β1 x1 + ε
E ( y D=
2 = β 0 + β1 x1
0)

which is a straight line relationship with intercept β 0 and slope β1 .

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If D2 = 1, then

y =β 0 + β1 x1 + β 2 .1 + ε
= ( β 0 + β 2 ) + β1 x1 + ε
E ( y D2 =1) =( β 0 + β 2 ) + β1 x1

which is a straight line relationship with intercept ( β 0 + β 2 ) and slope β1.

The quantities E ( y D2 = 0) and E ( y D2 = 1) are the average responses when an observation belongs to

group A and group B, respectively. Thus

β2 =
E ( y D2 =
1) − E ( y D2 =
0)

which has an interpretation as the difference between the average values of y =

with D2 0=
and D2 1 .

Graphically, it looks like as in the following figure. It describes two parallel regression lines with same
variances σ 2 .

If there are three explanatory variables in the model with two dummy variables D2 and D3 then they will

describe three levels, e.g., groups A, B and C. The levels of dummy variables are as follows:

1.=
D2 0,=
D3 0 if the observation is from group A

2.=
D2 1,=
D3 0 if the observation is from group B

3.=
D2 0,=
D3 1 if the observation is from group C
The concerned regression model is
y =β 0 + β1 x1 + β 2 D2 + β3 D3 + ε , E (ε ) =0, var(ε ) =σ 2 .

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In general, if a qualitative variable has m levels, then (m − 1) dummy variables are required and each of
them takes value 0 and 1.

Consider the following examples to understand how to define such dummy variables and how they can be
handled.

Example:
Suppose y denotes the monthly salary of a person and D denotes whether the person is graduate or non-
graduate. The model is
y =β 0 + β1 D + ε , E (ε ) =0, var(ε ) =σ 2 .
With n observations, the model is
yi =β 0 + β1 Di + ε i , i =1, 2,..., n
E ( yi D=
i = β0
0)
E ( yi D=
i 1)= β 0 + β1
β1 =
E ( yi Di =
1) − E ( yi Di =
0)

Thus
- β 0 measures the mean salary of a non-graduate.

- β1 measures the difference in the mean salaries of a graduate and non-graduate person.

Now consider the same model with two dummy variables defined in the following way:
1 if person is graduate
Di1 = 
0 if person is nongraduate,
1 if person is nongraduate
Di 2 = 
0 if person is graduate.
The model with n observations is
yi =β 0 + β1 Di1 + β 2 Di 2 + ε i , E (ε i ) =
0, Var (ε i ) =
σ 2,i =
1, 2,..., n.
Then we have
1. E  yi Di1 = 0, Di 2 = 1 = β 0 + β 2 : Average salary of non-graduate

2. E  yi Di1 = 1, Di 2 = 0  = β 0 + β1 : Average salary of graduate

3. E  yi Di1 = 0, Di 2 = 0  = β 0 : cannot exist

4. E  yi Di1 = 1, Di 2 = 1 = β 0 + β1 + β 2 : cannot exist.

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Notice that in this case
Di1 + Di 2 =
1 for all i
which is an exact constraint and indicates the contradiction as follows:
Di1 + Di 2 =
1 ⇒ person is graduate

Di1 + Di 2 =
1 ⇒ person is non-graduate

So multicollinearity is present in such cases. Hence the rank of matrix of explanatory variables falls short by
1. So β 0 , β1 and β 2 are indeterminate and least squares method breaks down. So the proposition of
introducing two dummy variables is useful but they lead to serious consequences. This is known as dummy
variable trap.

If the intercept term is ignored, then the model becomes

yi =β1 Di1 + β 2 Di 2 + ε i , E (ε i ) =0, Var (ε i ) =σ 2 , i =1, 2,..., n
then
E ( yi Di=
1 1, Di=
2 = β1 ⇒ Average salary of a graduate.
0)
E ( yi Di1 =
0, Di 2 = β 2 ⇒ Average salary of a non − graduate.
1) =

So when intercept term is dropped , then β1 and β 2 have proper interpretations as the average salaries of a
graduate and non-graduate persons, respectively.

Now the parameters can be estimated using ordinary least squares principle and standard procedures for
drawing inferences can be used.

Rule: When the explanatory variable leads to m mutually exclusive categories classification, then use
(m − 1) dummy variables for its representation. Alternatively, use m dummy variables but drop the intercept
term.

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Interaction term:
Suppose a model has two explanatory variables – one quantitative variable and other an dummy variable.
Suppose both interact and an explanatory variable as the interaction of them is added to the model.
yi =β 0 + β1 xi1 + β 2 Di 2 + β3 xi1 Di 2 + ε i , E (ε i ) =0, Var (ε i ) =σ 2,i =1, 2,..., n.

To interpret the model parameters, we proceed as follows:

Suppose the dummy variables are given by
1 if i th person belongs to group A
Di 2 = 
0 if i th person belongs to group B

yi = salary of i th person.
Then
E ( yi Di 2 =0 ) =β 0 + β1 xi1 + β 2 .0 + β3 xi1.0
= β 0 + β1 xi1.

This is a straight line with intercept β 0 and slope β1 . Next

E ( yi Di 2 =
1) =β 0 + β1 xi1 + β 2 .1 + β3 xi1.1
= ( β 0 + β 2 ) + ( β1 + β3 ) xi1.

This is a straight line with intercept term ( β 0 + β 2 ) and slope ( β1 + β3 ).

The model
E ( yi ) =β 0 + β1 xi1 + β 2 Di 2 + β3 xi1 Di 2
has different slopes and different intercept terms.

Thus
β 2 reflects the change in intercept term associated with the change in the group of person i.e., when group
changes from A to B.
β3 reflects the change in slope associated with the change in the group of person, i.e., when group changes
from A to B.

Fitting of the model

yi =β 0 + β1 xi1 + β 2 Di 2 + β3 xi1 Di 2 + ε i
is equivalent to fitting two separate regression models corresponding to Di 2 = 1 and Di 2 = 0 , i.e.

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 yi =β 0 + β1 xi1 + β 2 .1 + β3 xi1.1 + ε i
yi = ( β 0 + β 2 ) + ( β1 + β3 ) xi1 Di 2 + ε i
and
yi =β 0 + β1 xi1 + β 2 .0 + β3 xi1.0 + ε i
yi =β 0 + β1 xi1 + ε i
respectively.

The test of hypothesis becomes convenient by using an dummy variable. For example, if we want to test
whether the two regression models are identical, the test of hypothesis involves testing
H 0 : β=
2 β=
3 0
H1 : β 2 ≠ 0 and/or β3 ≠ 0.

Acceptance of H 0 indicates that only single model is necessary to explain the relationship.
In another example, if the objective is to test that the two models differ with respect to intercepts only and
they have same slopes, then the test of hypothesis involves testing
H 0 : β3 = 0
H1 : β3 ≠ 0.

Dummy variables versus quantitative explanatory variable

The quantitative explanatory variables can be converted into dummy variables. For example, if the ages of
persons are grouped as follows:
Group 1: 1 day to 3 years
Group 2: 3 years to 8 years
Group 3: 8 years to 12 years
Group 4: 12 years to 17 years
Group 5: 17 years to 25 years
then the variable “age” can be represented by four different dummy variables.

Since it is difficult to collect the data on individual ages, so this will help in easy collection of data. A
disadvantage is that some loss of information occurs. For example, if the ages in years are 2, 3, 4, 5, 6, 7 and
suppose the dummy variable is defined as

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 1 if age of i person is > 5 years
th

Di = 
0 if age of i person is ≤ 5 years.
th

Then these values become 0, 0, 0, 1, 1, 1. Now looking at the value 1, one can not determine if it
corresponds to age 5, 6 or 7 years.

Moreover, if a quantitative explanatory variable is grouped into m categories , then (m − 1) parameters are
required whereas if the original variable is used as such, then only one parameter is required.

Treating a quantitative variable as qualitative variable increases the complexity of the model. The degrees
of freedom for error are also reduced. This can effect the inferences if data set is small. In large data sets,
such effect may be small.

The use of dummy variables does not require any assumption about the functional form of the relationship
between study and explanatory variables.

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