http://lipas.uwasa.

fi/~bepa/

2. Pooled Cross Sections and Panels

2.1 Pooled Cross Sections versus Panel Data

Pooled Cross Sections are obtained by col-

lecting random samples from a large polula-
tion independently of each other at different
points in time. The fact that the random
samples are collected independently of each
other implies that they need not be of equal
size and will usually contain different statis-
tical units at different points in time.

Consequently, serial correlation of residuals

is not an issue, when regression analysis is
applied. The data can be pretty much an-
alyzed like ordinary cross-sectional data, ex-
cept that we must use dummies in order to
account for shifts in the distribution between
different points in time.

1
Panel Data or longitudinal data consists of
time series for each statistical unit in the
cross section. In other words, we randomly
select our cross section only once, and once
that is done, we follow each statistical unit
within this cross section over time. Thus all
cross sections are equally large and consist of
the same statistical units.

For panel data we cannot assume that the

observations are independently distributed
across time and serial correlation of regres-
sion residuals becomes an issue. We must
be prepared that unobserved factors, while
acting differently on different cross-sectional
units, may have a lasting effect upon the
same statistical unit when followed through
time. This makes the statistical analysis of
panel data more difficult.

2
2.2 Independent Pooled Cross Sections

Example 1: Women’s fertility over time.

Regressing the number of children born per
woman upon year dummies and controls such
as education, age etc. yields information about
the development of fertility unexplained by
the controls. (Base year 1972)

Dependent Variable: KIDS

Method: Least Squares
Date: 11/23/12 Time: 08:21
Sample: 1 1129
Included observations: 1129

Variable Coefficient Std. Error t-Statistic Prob.

C -7.742457 3.051767 -2.537040 0.0113

EDUC -0.128427 0.018349 -6.999272 0.0000
AGE 0.532135 0.138386 3.845283 0.0001
AGESQ -0.005804 0.001564 -3.710324 0.0002
BLACK 1.075658 0.173536 6.198484 0.0000
EAST 0.217324 0.132788 1.636626 0.1020
NORTHCEN 0.363114 0.120897 3.003501 0.0027
WEST 0.197603 0.166913 1.183867 0.2367
FARM -0.052557 0.147190 -0.357072 0.7211
OTHRURAL -0.162854 0.175442 -0.928248 0.3535
TOWN 0.084353 0.124531 0.677367 0.4983
SMCITY 0.211879 0.160296 1.321799 0.1865
Y74 0.268183 0.172716 1.552737 0.1208
Y76 -0.097379 0.179046 -0.543881 0.5866
Y78 -0.068666 0.181684 -0.377945 0.7055
Y80 -0.071305 0.182771 -0.390136 0.6965
Y82 -0.522484 0.172436 -3.030016 0.0025
Y84 -0.545166 0.174516 -3.123871 0.0018

R-squared 0.129512 Mean dependent var 2.743136

Adjusted R-squared 0.116192 S.D. dependent var 1.653899
S.E. of regression 1.554847 Akaike info criterion 3.736447
Sum squared resid 2685.898 Schwarz criterion 3.816627
Log likelihood -2091.224 Hannan-Quinn criter. 3.766741
F-statistic 9.723282 Durbin-Watson stat 2.010694
Prob(F-statistic) 0.000000

3
We can also interact a time dummy with key
explanatory variables to see if the effect of
that variable has changed over time.

Example 2:
Changes in the return to education and the
gender wage gap between 1978 and 1985.

Dependent Variable: LWAGE

Method: Least Squares
Date: 11/27/12 Time: 17:25
Sample: 1 1084
Included observations: 1084

Variable Coefficient Std. Error t-Statistic Prob.

C 0.458933 0.093449 4.911078 0.0000

EXPER 0.029584 0.003567 8.293165 0.0000
EXPER^2 -0.000399 7.75E-05 -5.151307 0.0000
UNION 0.202132 0.030294 6.672233 0.0000
EDUC 0.074721 0.006676 11.19174 0.0000
FEMALE -0.316709 0.036621 -8.648173 0.0000
Y85 0.117806 0.123782 0.951725 0.3415
Y85*EDUC 0.018461 0.009354 1.973509 0.0487
Y85*FEMALE 0.085052 0.051309 1.657644 0.0977

R-squared 0.426186 Mean dependent var 1.867301

Adjusted R-squared 0.421915 S.D. dependent var 0.542804
S.E. of regression 0.412704 Akaike info criterion 1.076097
Sum squared resid 183.0991 Schwarz criterion 1.117513
Log likelihood -574.2443 Hannan-Quinn criter. 1.091776
F-statistic 99.80353 Durbin-Watson stat 1.918367
Prob(F-statistic) 0.000000

The return to education has risen by about

1.85% and the gender wage gap narrowed by
about 8.5% between 1978 and 1985, other
factors being equal.
4
Policy Analysis with Pooled Cross Sections
Example 3: How does a garbage incinerator’s location
affect housing prices? (Kiel and McClain 1995).
We use data on housing prices from 1978, before any
planning of an incinarator and from 1981, when con-
struction work began. Naively, one might be tempted
to use only 1981 data and to estimate a model like
(1) rprice = γ0 + γ1nearinc + u,
where rprice is the housing price in 1978 dollars and
nearinc is a dummy variable equal to one if the house
is near the incinerator. Estimation yields
(2) \ =101 307.5 − 30 688.27 nearinc,
rprice
(t = 32.75) (t = −5.266)
consistent with the notion that a location near a
garbage incinerator depresses housing prices. How-
ever, another possible interpretation is that incinera-
tors are built in areas with low housing prices. Indeed,
estimating (1) on 1978 data yields
(3) \ =82 517.23 − 18 824.37 nearinc.
rprice
(t = 31.09) (t = −3.968)
To find the price impact of the incinerator, calculate
the so called difference-in-differences estimator
δ̂1 = −30 688.27 − (−18 824.37) = −11 863.9.

So in this sample, vincinity of an incinerator depresses

housing prices by almost $12 000 on average, but we
don’t know yet whether the effect is statistically sig-
nificant.
5
The previous example is called a natural ex-
periment (or a quasi-experiment). It occurs
when some external event (often a policy
change) affects some group, called the treat-
ment group, but leaves another group, called
the control group, unaffected. It differs from
a true experiment in that these groups are
not randomly and explicitely chosen.

Let DT be a dummy variable indicating whether

an observation is from the treatment group
and Dafter be a dummy variable indicating
whether the observation is from after the ex-
ogeneous event. Then the impact of the ex-
ternal event on y is given by δ1 in the model

(4) y =β0 + δ0Dafter + β1DT + δ1Dafter · DT

(+other factors).
If no other factors are included, δ̂1 will be
the difference-in-differences estimator
(5) δ̂1 = (ȳafter,T − ȳbef.,T ) − (ȳafter,C − ȳbef.,C ),
where T and C denote the treatment and
control group, respectively.
6
Example 3: (continued.)

Estimating (4) yields

\ = 82 517 + 18 790 y81 −18 824 nearinc − 11 863 y81 · nearinc
rprice
(t = 30.26) (t = 4.64) (t = −3.86) (t = −1.59)

The p-value on the interaction term is 0.1126, so it

is not yet significant. This changes however, once
additional controls enter (4):

Dependent Variable: RPRICE

Method: Least Squares
Date: 11/29/12 Time: 08:28
Sample: 1 321
Included observations: 321

Variable Coefficient Std. Error t-Statistic Prob.

C 13807.67 11166.59 1.236515 0.2172

Y81 13928.48 2798.747 4.976683 0.0000
NEARINC 3780.337 4453.415 0.848862 0.3966
Y81*NEARINC -14177.93 4987.267 -2.842827 0.0048
AGE -739.4510 131.1272 -5.639189 0.0000
AGE^2 3.452740 0.812821 4.247845 0.0000
INTST -0.538635 0.196336 -2.743437 0.0064
LAND 0.141420 0.031078 4.550529 0.0000
AREA 18.08621 2.306064 7.842891 0.0000
ROOMS 3304.227 1661.248 1.989003 0.0476
BATHS 6977.317 2581.321 2.703002 0.0073

R-squared 0.660048 Mean dependent var 83721.36

Adjusted R-squared 0.649082 S.D. dependent var 33118.79
S.E. of regression 19619.02 Akaike info criterion 22.64005
Sum squared resid 1.19E+11 Schwarz criterion 22.76929
Log likelihood -3622.729 Hannan-Quinn criter. 22.69166
F-statistic 60.18938 Durbin-Watson stat 1.677080
Prob(F-statistic) 0.000000

We conclude that vincinity of a garbage incinerator

depresses housing prices by about $14,178 (at 1978
value), when controlling for other valuation-relevant
properties of the house (p = 0.0048).
7
2.3 First-Difference Estimation in Panels

Recall from Econometrics 1 that omitting

important variables in the model may induce
severe bias to all parameter estimates. This
was called the omitted variable bias. Panel
data allows to mitigate, if not eliminate, this
problem.
Example 4.
Crime and unemployment rates for 46 cities in 1982
and 1987. Regressing the crimerate (crimes per 1 000
people) crmte upon the unemployment rate unem (in
percent) yields for the 1987 cross section
\ =
crmrte 128.38 − 4.16unem.
(t = 6.18) (t = −1.22)

Even though unemployment is nonsignificant (p = 0.23),

a causal interpretation would imply that an increase
in unemployment lowers the crime rate, which is hard
to believe. The model probably suffers from omitted
variable bias.

8
With panel data we view the unobserved fac-
tors affecting the dependent variable as con-
sisting of two types: those that are constant
and those that vary over time. Letting i de-
note the cross-sectional unit and t time:
(6) yit = β0 + δ0 D2,t + β1 xit + ai + uit . t = 1, 2

The dummy variable D2,t is zero for t = 1

and one for t = 2. It models the time-varying
part of the unobserved factors. The variable
ai captures all unobserved, time-constant fac-
tors that affect yit. ai is generally called an
unobserved or fixed effect. uit is called the
idiosyncratic error. A model of the form (6)
is called an unobserved effects model or fixed
effects model.

Example 4 (continued). A fixed effects model

for city crime rates in 1982 and 1987 is
(7) crmrteit = β0 + δ0D87,t + β1unemit + ai + uit,

where D87 is dummy variable for 1987.

9
Naively, we might go and estimate a fixed
effects model by pooled OLS. That is, we
write (6) in the form

(8) yit = β0 + δ0D2,t + β1xit + νit, t = 1, 2,

and apply OLS, where νit = ai + uit is called
the composite error.

Such an approach is problematic for two rea-

sons. As a minor complication it turns out
that Cov(νi1, νi2) = V (ai) even though ai and
uit are pairwise uncorrelated, such that the
composite errors become positively correlated
over time. This problem is minor because it
can be solved by using standard errors which
are robust to serial correlation in the residu-
als (HAC (Newey-West) resp. White period
robust standard errors in EViews).

10
The main problem with applying pooled OLS
is that we did very little to solve the omitted
variable bias problem. Only the time-varying
part (assumed to be common for all cross-
sesctional units) has been taken out by in-
troducing the time dummy. The fixed effect
ai, however, is still there; it has just been hid-
den in the composite error νit, and is there-
fore not modeled. That is, the parameter
estimates are still biased, unless ai is uncor-
related with xit.

Example 4 (continued).
Pooled OLS on the crime rate data yields

(9) crmrte
\ = 93.42 + 7.94D87 + 0.427unem.

The (wrong) p-value using OLS standard er-

rors is 0.721, and applying Newey and West
(1987) HAC standard errors p = 0.693. Thus,
while the unemployment rate has now the ex-
pected sign, it is still deemed nonsignificant.

11
The main reason for collecting panel data
is to allow for ai to be correlated with the
explanatory variables. This can be achieved
by first writing down (6) explicitely for both
time points:

yi1 = β0 + β1xi1 + ai + ui1 (t = 1)

yi2 = (β0 + δ0) + β1xi2 + ai + ui2 (t = 2).

Subtract the first equation from the second:

(yi2 − yi1) = δ0 + β1(xi2 − xi1) + (ui2 − ui1),

or

(10) ∆yi = δ0 + β1∆xi + ∆ui.

This is called the first differenced equation.

Note that ai has been “differenced away”,
which implies that estimation of (10) does
not in any way depend upon whether ai is
correlated with xit or not. When we obtain
the OLS estimator of β1 from (10), we call it
the first-difference estimator (FD for short).
12
The parameters of (10) can be consistently
estimated by OLS when the classical assump-
tions for regression analysis hold.

In particular, ∆ui must be uncorrelated with

∆xi, which holds if uit is uncorrelated with
xit in both time periods. That is, we need
strict exogeneity. In particular, this rules out
including lagged dependent variables such as
yi,t−1 as explanatory variables. Lagged in-
dependent variables such as xi,t−1 may be
included without problems.

Another crucial assumption is that there must

be variation in ∆xi. This rules out indepen-
dent variables which do not change over time
or change by the same amount for all cross-
sectional units.

Example 4 (continued).
Estimation of (10) yields
∆crmrte
\ = 15.40 + 2.22∆unem,
(t = 3.28) (t = 2.52)
which now gives a positive, statistically significant
relationship (p = 0.015) between unemployment and
crime rates.
13
Policy Analysis with Two-Period Panel Data

Let yit denote an outcome variable and let

progit be a program participation dummy vari-
able. A simple unobserved effects model is
(11) yit = β0 + δ0D2,t + β1progit + ai + uit.
Differencing yields
(12) ∆yi = δ0 + β1∆progi + ∆ui.
In the special case that program partici-
pation occured only in the second period,
∆progi = progi2, and the OLS estimator of
β1 has the simple interpretation
(13) β̂1 = ∆y Treatment − ∆y Control,
which is the panel data version of the difference-
in-differences estimator (5) in pooled cross
sections.

The advantage of using panel data as op-

posed to pooled cross sections is that there
is no need to include further variables to con-
trol for unit specific characteristics, since by
using the same units at both times, these are
automatically controlled for.
14
Example 5.
Job training program on worker productivity.
Let scrapit denote the scrap rate of firm i
during year t, and let grantit be a dummy
equal to one if firm i received a job training
grant in year t. Pooled OLS yields using data
from the years 1987 and 1988
log(scrapit ) = 0.5974 − 0.1889D88 + 0.0566grant,
(p = 0.005) (p = 0.566) (p = 0.896)
suggesting that grants increase scrap rates.
The preceding model suffers most likely from
omitted variables bias. Estimating the first
differenced equation (12) instead yields
\
∆log( scrap) = − 0.057 − 0.317∆grant.
(p = 0.557) (p = 0.059)
Having a job training grant is estimated to
lower the scrap rate by about 27.2%, since
exp(−0.317) − 1 ≈ −0.272. The effect is sig-
nificant at 10% but not at 5%. The large
difference between β̂1 obtained from pooled
OLS and applying the first differenced esti-
mator suggests that grants were mainly placed
to firms which produce poorer quality.
No further variables (controls) with possible
impact upon scrap rates need to be included
in the model.
15
Differencing with More Than 2 Periods

The fixed effects model in the general case

with k regressors and T time periods is
(14) yit =δ1 + δ2D2,t + · · · + δT DT,t
k
X
+ βj xtij + ai + uit,
j=1
The key assumption is that the idiosyncratic
errors are uncorrelated with the explanatory
variables at all times (strict exogeneity):
(15) Cov(xitj , uis) = 0 for all t, s and j,
which rules out using lagged dependent vari-
ables as regressors. Differencing(14) yields
(16) ∆yit =δ2∆D2,t + · · · + δT ∆DT,t
k
X
+ βj ∆xtij + ∆uit
j=1
for t = 2, . . . , T . Note that both the intercept δ1 and
the unobservable effect ai have disappeared. This im-
plies that while possible correlations between ai and
any of the explanatory variables causes omitted vari-
ables bias in (14), it causes no problem in estimating
the first differenced equation (16).
16
Example 6.
Enterprise Zones and Unemployment Claims

Unemployment claims uclms in 22 cities from 1980 to

1988 as a function of whether the city has an enter-
prise zone (ez = 1) or not:
log(uclmsit ) = θt + β1 ezit + ai + uit ,
where θt shifts the intercept with appropriate year
dummies. FD estimation output:
Dependent Variable: D(LUCLMS)
Method: Panel Least Squares
Date: 11/29/12 Time: 16:45
Sample (adjusted): 1981 1988
Periods included: 8
Cross-sections included: 22
Total panel (balanced) observations: 176

Variable Coefficient Std. Error t-Statistic Prob.

D81 -0.321632 0.046064 -6.982279 0.0000

D82 0.457128 0.046064 9.923744 0.0000
D83 -0.354751 0.046064 -7.701262 0.0000
D84 -0.338770 0.050760 -6.673948 0.0000
D85 0.001449 0.048208 0.030058 0.9761
D86 -0.029478 0.046064 -0.639934 0.5231
D87 -0.267684 0.046064 -5.811126 0.0000
D88 -0.338684 0.046064 -7.352471 0.0000
D(EZ) -0.181878 0.078186 -2.326211 0.0212

R-squared 0.622997 Mean dependent var -0.159387

Adjusted R-squared 0.604937 S.D. dependent var 0.343748
S.E. of regression 0.216059 Akaike info criterion -0.176744
Sum squared resid 7.795839 Schwarz criterion -0.014617
Log likelihood 24.55348 Hannan-Quinn criter. -0.110986
Durbin-Watson stat 2.441511

The presence of an enterprise zone appears to reduce

unemployment claims by about 18% (p = 0.0212).
Note that we have replaced the change in year dummies ∆D in
(16) with the year dummies themselves. This can be shown to
have no effect on the other parameter estimates (here D(EZ)).

17
2.4 Dummy Variable Regression in Panels

Another way to eliminate possible correla-

tions with the unobservable factors ai in (14)
is to model them explicitly as dummy vari-
ables, where each cross-sectional unit gets
its own dummy. This may be written as
(17) y = Xβ + Zµ + u, where
for N cross sections and T time periods:
y is a (N T × 1) vector of observations on yit,
X is a (N T × k) matrix of regressors xitj ,
β is a (k × 1) vector of slope parameters βj ,
Z is a (N T × N ) matrix of dummies,
µ is a (N × 1) vector of unobservables ai, and
u is a (N T × 1) vector of error terms uit.

It is customs to stack y, X, Z and u such that

the slower index is over cross sections i, and
the faster index is over time points t, e.g.
y 0 = (y11, . . . , y1T , . . . , yN 1, . . . , yN T ).
Note that there is no constant in (17) in or-
der to avoid exact multicollinearity (dummy
variable trap). If you wish to include a con-
stant, use only N −1 dummy variables for the
N cross-sectional units.
18
Example 6. (continued)
Regressing log(uclms) on the year dummies,
22 dummies for the cities in sample and the
enterprise zone dummy ez yields
Dependent Variable: LUCLMS
Method: Panel Least Squares
Date: 12/04/12 Time: 10:39
Sample: 1980 1988
Periods included: 9
Cross-sections included: 22
Total panel (balanced) observations: 198

Variable Coefficient Std. Error t-Statistic Prob.

D81 -0.321632 0.060457 -5.319980 0.0000

D82 0.135496 0.060457 2.241179 0.0263
D83 -0.219255 0.060457 -3.626613 0.0004
D84 -0.579152 0.062318 -9.293490 0.0000
D85 -0.591787 0.065495 -9.035540 0.0000
D86 -0.621265 0.065495 -9.485616 0.0000
D87 -0.888949 0.065495 -13.57268 0.0000
D88 -1.227633 0.065495 -18.74379 0.0000
C1 11.67615 0.080079 145.8073 0.0000
C2 11.48266 0.079105 145.1574 0.0000
C3 11.29721 0.079105 142.8131 0.0000
C4 11.13498 0.079105 140.7621 0.0000
C5 11.68718 0.078930 148.0695 0.0000
C6 12.23073 0.080079 152.7326 0.0000
C7 12.42622 0.080079 155.1738 0.0000
C8 11.61739 0.078930 147.1852 0.0000
C9 12.02958 0.078930 152.4074 0.0000
C10 13.32116 0.079105 168.3987 0.0000
C11 11.54584 0.079105 145.9560 0.0000
C12 11.64117 0.079105 147.1612 0.0000
C13 10.84358 0.079105 137.0784 0.0000
C14 10.80252 0.078930 136.8613 0.0000
C15 11.44073 0.079105 144.6273 0.0000
C16 12.11190 0.079105 153.1118 0.0000
C17 11.23093 0.080079 140.2475 0.0000
C18 11.63326 0.079105 147.0611 0.0000
C19 11.76956 0.079105 148.7842 0.0000
C20 11.32518 0.080079 141.4244 0.0000
C21 12.13394 0.080079 151.5240 0.0000
C22 11.89479 0.079105 150.3673 0.0000
EZ -0.104415 0.055419 -1.884091 0.0613

R-squared 0.933188 Mean dependent var 11.19078

Adjusted R-squared 0.921185 S.D. dependent var 0.714236
S.E. of regression 0.200514 Akaike info criterion -0.233004
Sum squared resid 6.714401 Schwarz criterion 0.281826
Log likelihood 54.06741 Hannan-Quinn criter. -0.024618
Durbin-Watson stat 1.306450

(marginally significant decrease by 10%.)

19
2.5 Fixed Effects (FE) Estimation in Panels

Dummy variable regressions become imprac-

tical when the number of cross-sections gets
large. An alternative method, which turns
out to yield identical results, is called the
fixed effects method.

As an example consider the simple model

(18) yit = β1xit + ai + uit,

i = 1, . . . , N , t = 1, . . . , T .
Thus there are altogether N × T observations.

Define means over the T time periods

T T T
1X 1X 1X
(19) ȳi = yit , x̄i = xit , ūi = uit .
T t=1 T t=1 T t=1

Then averaging over T yields

(20) ȳi = β1x̄i + ai + ūi,

since
T
1 X 1
ai = T ai = ai.
T t=1 T

20
Thus, subtracting (20) from (18) eliminates
ai and gives
(21) yit − ȳi = β1(xit − x̄i) + (uit − ūi)
or
(22) ẏit = β1ẋit + u̇it,
where e.g., ẏit = yit − ȳi is the time demeaned
data on y.

This transformation is also called the within

transformation and resulting (OLS) estima-
tors of the regression parameters applied to
(22) are called fixed effect estimators or within
estimators. It generalizes to k regressors as
(23) ẏit = β1ẋit1 + . . . + βk ẋitk + u̇it.

Remark. The slope coefficient β1 estimated

from (20) (including a constant) is called the
between estimator. vi = ai + ūi is the error
term. This estimator is biased, however, if
the unobserved component ai is correlated
with x.
21
Example 6. (continued)
Regressing the differences of log(uclms) from
their means upon the differences of the year
dummies from their means and the differ-
ences of the enterprize zone dummy ez from
its means yields
Dependent Variable: LUCLMS-MLUCLMS
Method: Panel Least Squares
Date: 12/04/12 Time: 13:09
Sample: 1980 1988
Periods included: 9
Cross-sections included: 22
Total panel (balanced) observations: 198

Variable Coefficient Std. Error t-Statistic Prob.

D81-MD81 -0.321632 0.056830 -5.659560 0.0000

D82-MD82 0.135496 0.056830 2.384236 0.0181
D83-MD83 -0.219255 0.056830 -3.858104 0.0002
D84-MD84 -0.579152 0.058579 -9.886703 0.0000
D85-MD85 -0.591787 0.061566 -9.612288 0.0000
D86-MD86 -0.621265 0.061566 -10.09109 0.0000
D87-MD87 -0.888949 0.061566 -14.43903 0.0000
D88-MD88 -1.227633 0.061566 -19.94022 0.0000
EZ-MEZ -0.104415 0.052094 -2.004355 0.0465

R-squared 0.841596 Mean dependent var -1.27E-16

Adjusted R-squared 0.834892 S.D. dependent var 0.463861
S.E. of regression 0.188483 Akaike info criterion -0.455226
Sum squared resid 6.714401 Schwarz criterion -0.305760
Log likelihood 54.06741 Hannan-Quinn criter. -0.394727
Durbin-Watson stat 1.306450

We recover the parameter estimates of the

dummy variable regression, however not the
standard errors. For example, the within esti-
mator for the enterprise zone is -0.1044, the
same as previously, but its standard error has
decreased from 0.0554 to 0.0521 with a cor-
responding decrease in p-values from 0.0613
to 0.0465 now.
22
In order to understand the discrepancy in
standard errors recall from STAT1010 (see
also equations (18) and (22) of chapter 1)
that the standard error of a slope coefficient
is inverse proportional to the square root of
the number of observations minus the num-
ber of regressors (including the constant).

In the dummy variable regression there are

N T observations and k + N regressors (k orig-
inal regressors and N cross-sectional dum-
mies). The degrees of freedom are therefore
df = N T − (k + N ) = N (T − 1) − k.
The demeaned regression sees only k regres-
sors on the same N T observations, and there-
fore calculates the degrees of freedom (incor-
rectly, for our purpose) as dfdemeaned = N T −k.

In order to correct for this, multiply the wrong

standard errors of the demeaned regression
by the square root of N T − k and divide this
with the square root of N (T −1) − k:
s
NT − k
(24) SE = SEdemeaned.
N (T −1) − k

23
Example 6. (continued)
We have N = 22 cross-sectional units and
T = 9 time periods for a total of N T = 198
observations. There is one dummy for the
enterprize zone and eight year dummies for
a total of k = 9 regressors. The correction
factor for the standard errors is therefore
s r r
NT − k 22 · 9 − 9 189
= = ≈ 1.063831.
N (T −1) − k 22 · 8 − 9 167

For example, multiplying the demeaned stan-

dard error of 0.052094 for the enterprise zone
dummy with the correction factor yields

1.063831 · 0.052094 = 0.055419,

which is the correct standard error that we
found from the dummy regression earlier.

Taken together with its coefficient estimate

of -0.1044 it will hence correctly reproduce
the t-statistic of -1.884 with p-value 0.0613,
however without the need to define 22 dummy
variables!

24
EViews can do the degrees of freedom ad-
justment automatically, if you tell it that you
have got panel data. In order to do that,
choose

Structure/Resize Current Page. . .

from the Proc Menue. In the Workfile Struc-

ture Window, choose ’Dated Panel’ and pro-
vide two identifyers: one for the cross section
and one for time.

This will provide you with a ’Panel Options’

tab in the estimation window. In order to ap-
ply the fixed effects estimator, (which, as we
discussed, is equivalent to a dummy variable
regression), change the effects specification
for the cross-section into ’Fixed’.

Note that EViews reports a constant C, even

though the demeaned regression shouldn’t
have any. C is to be interpreted as the aver-
age unobservable effect āi, or cross-sectional
average intercept.
25
Example 6. (continued)

Applying the Fixed Effects option in Eviews

yields
Dependent Variable: LUCLMS
Method: Panel Least Squares
Date: 12/05/12 Time: 11:47
Sample: 1980 1988
Periods included: 9
Cross-sections included: 22
Total panel (balanced) observations: 198

Variable Coefficient Std. Error t-Statistic Prob.

C 11.69439 0.042750 273.5544 0.0000

D81 -0.321632 0.060457 -5.319980 0.0000
D82 0.135496 0.060457 2.241179 0.0263
D83 -0.219255 0.060457 -3.626613 0.0004
D84 -0.579152 0.062318 -9.293490 0.0000
D85 -0.591787 0.065495 -9.035540 0.0000
D86 -0.621265 0.065495 -9.485616 0.0000
D87 -0.888949 0.065495 -13.57268 0.0000
D88 -1.227633 0.065495 -18.74379 0.0000
EZ -0.104415 0.055419 -1.884091 0.0613

Effects Specification

Cross-section fixed (dummy variables)

R-squared 0.933188 Mean dependent var 11.19078

Adjusted R-squared 0.921185 S.D. dependent var 0.714236
S.E. of regression 0.200514 Akaike info criterion -0.233004
Sum squared resid 6.714401 Schwarz criterion 0.281826
Log likelihood 54.06741 Hannan-Quinn criter. -0.024618
F-statistic 77.75116 Durbin-Watson stat 1.306450
Prob(F-statistic) 0.000000

The output coincides with that obtained from

the dummy variable regression. C is the av-
erage of the cross-sectional city dummies C1
to C22.

26
R2 in Fixed Effects Estimation

Note from the preceding example that while

both the dummy regression and the fixed ef-
fects estimation yield an identical coefficient
of determination of R2 = 0.933188, it dif-
fers from R2 = 0.841596, which we obtained
when calculating the FE estimator by hand.
Both ways of calculating R2 are used.

The lower R2 obtained from estimating (23)

has the more intuitive interpretation as the
amount of variation in yit explained by the
time variation in the explanatory variables.

The higher R2 obtained in fixed effects esti-

mation and dummy variable regressions should
be used in F-tests when for example test-
ing for joint significance of the unobservables
ai, that is the cross-sectional dummies in
dummy variable regression.

27
Limitations

As with first differencing, the fact that we

eliminated the unobservables ai in estimation
of (23) implies that any explanatory variable
that is constant over time gets swept away by
the fixed effects transformation. Therefore
we cannot include dummies such as gender
or race.

If we furthermore include a full set of time

dummies, then, in order to avoid exact mul-
ticollinearity, we may neither include variables
which change by a constant amount through
time, such as working experience. Their ef-
fect will be absorbed by the year dummies in
the same way as the effect of time-constant
cross-sectional dummies is absorbed by the
unobservables.

28
Example 7
Data set wagepan.xls (Wooldridge): n = 545, T = 8.
Is there a wage premium in belonging to labor union?
log(wageit ) = β0 + β1 educit + β3 exprit + β4 expr2it
+β5 marriedit + β6 unionit + ai + uit
Year (d81 to d87) and race dummies (black and hisp)
are also included. Pooled OLS with νit = ai +uit yields
Dependent Variable: LWAGE
Method: Panel Least Squares
Date: 12/11/12 Time: 12:32
Sample: 1980 1987
Periods included: 8
Cross-sections included: 545
Total panel (balanced) observations: 4360
White period standard errors & covariance (d.f. corrected)

Variable Coefficient Std. Error t-Statistic Prob.

C 0.092056 0.160807 0.572460 0.5670

EDUC 0.091350 0.011073 8.249575 0.0000
BLACK -0.139234 0.050483 -2.758032 0.0058
HISP 0.016020 0.039047 0.410265 0.6816
EXPER 0.067234 0.019580 3.433820 0.0006
EXPERSQ -0.002412 0.001024 -2.354312 0.0186
MARRIED 0.108253 0.026013 4.161480 0.0000
UNION 0.182461 0.027421 6.653964 0.0000
D81 0.058320 0.028205 2.067692 0.0387
D82 0.062774 0.036944 1.699189 0.0894
D83 0.062012 0.046211 1.341930 0.1797
D84 0.090467 0.057941 1.561356 0.1185
D85 0.109246 0.066794 1.635577 0.1020
D86 0.141960 0.076174 1.863633 0.0624
D87 0.173833 0.085137 2.041805 0.0412

R-squared 0.189278 Mean dependent var 1.649147

Adjusted R-squared 0.186666 S.D. dependent var 0.532609
S.E. of regression 0.480334 Akaike info criterion 1.374764
Sum squared resid 1002.481 Schwarz criterion 1.396714
Log likelihood -2981.986 Hannan-Quinn criter. 1.382511
F-statistic 72.45876 Durbin-Watson stat 0.864696
Prob(F-statistic) 0.000000

The serial correlation in the residuals has been ac-

counted for by using White period standard errors.
But the parameter estimates are biased if ai is corre-
lated with any of the explanatory variables.
29
Example 7 (continued.)
Fixed Effects estimation yields
Dependent Variable: LWAGE
Method: Panel Least Squares
Date: 11/26/12 Time: 12:31
Sample: 1980 1987
Periods included: 8
Cross-sections included: 545
Total panel (balanced) observations: 4360

Variable Coefficient Std. Error t-Statistic Prob.

C 1.426019 0.018341 77.74835 0.0000

EXPERSQ -0.005185 0.000704 -7.361196 0.0000
MARRIED 0.046680 0.018310 2.549385 0.0108
UNION 0.080002 0.019310 4.142962 0.0000
D81 0.151191 0.021949 6.888319 0.0000
D82 0.252971 0.024418 10.35982 0.0000
D83 0.354444 0.029242 12.12111 0.0000
D84 0.490115 0.036227 13.52914 0.0000
D85 0.617482 0.045244 13.64797 0.0000
D86 0.765497 0.056128 13.63847 0.0000
D87 0.925025 0.068773 13.45039 0.0000

Effects Specification

Cross-section fixed (dummy variables)

R-squared 0.620912 Mean dependent var 1.649147

Adjusted R-squared 0.565718 S.D. dependent var 0.532609
S.E. of regression 0.350990 Akaike info criterion 0.862313
Sum squared resid 468.7531 Schwarz criterion 1.674475
Log likelihood -1324.843 Hannan-Quinn criter. 1.148946
F-statistic 11.24956 Durbin-Watson stat 1.821184
Prob(F-statistic) 0.000000

Note that we could not include the years of education

and the race dummies, because they remain constant
through time for each cross section. Likewise we could
not include years of working experience, because they
change by the same amount for all cross sections, and
we included already a full set of year dummies.

The large changes in the premium estimates for mar-

riage and union membership suggests that ai is corre-
lated with some of the explanatory variables.
30
Fixed effects or first differencing?

If the number of periods is 2 (T = 2) FE and

FD give identical results.

When T ≥ 3 the FE and FD are not the same.

Both are unbiased as well as consistent for

fixed T as N → ∞ under the assumptions FE.1-
FE.4 below:

Assumptions:
FE.1: For each i, the model is

yit = β1xit1 + · · · + βk xitk + ai + uit, t = 1, . . . T .

FE.2: We have a random sample.
FE.3: All explanatory variables change over
time, and they are not perfectly collinear.
FE.4: E[uit|X i, ai] = 0 for all time periods
(X i stands for all explanatory variables).

31
If we add the following two assumptions, FE
is the best linear unbiased estimator:

FE.5: Var[uit|X i, ai] = σu2 for all t = 1, . . . , T .

FE.6: Cov[uit, uis|X i, ai] = 0 for all t 6= s.

In that case FD is worse than FE because

FD is linear and unbiased under FE.1–FE.4.

While this looks like a clear case for FE, it is

not, because often FE.6 is violated. If uit is
(highly) serially correlated, ∆uit may be less
serially correlated, which may favor FD over
FE. However, typically T is rather small, such
that serial correlation is difficult to observe.
Usually it is best to check both FE and FD.

If we add as a last assumption

FE.7: uit|X i, ai ∼ NID(0, σu2),
then we may use exact t and F-statistics.
Otherwise they hold only asymptotically for
large N and T .
32
Balanced and unbalanced panels

A data set is called a balanced panel if the

same number of time series observations are
available for each cross section units. That
is T is the same for all individuals. The total
number of observations in a balanced panel
is N T .

All the above examples are balanced panel

data sets.

If some cross section units have missing ob-

servations, which implies that for an individ-
ual i there are available Ti time period obser-
vations i = 1, . . . , N , Ti 6= Tj for some i and
j, we call the data set an unbalanced panel.
The total number of observations in an un-
balanced panel is T1 + · · · + TN .

In most cases unbalanced panels do not cause

major problems to fixed effect estimation.

Modern software packages make appropriate

adjustments to estimation results.
33
2.6 Random effects models

Consider the simple unobserved effects model

(25) yit = β0 + β1xit + ai + uit,

i = 1, . . . , n, t = 1, . . . , T .

Typically also time dummies are included in

(25).

Using FD or FE eliminates the unobserved

component ai. As discussed earlier, the idea
is to avoid omitted variable bias which arises
necessarily as soon as ai is correlated with
xit.

However, if ai is uncorrelated with xit, then

using a transformation to eliminate ai results
in inefficient estimators. So called random
effect (RE) estimators are more efficient in
that case.

34
Generally, we call the model in equation (25)
the random effects model if ai is uncorre-
lated with all explanatory variables, i.e.,

(26) Cov[xit, ai] = 0, t = 1, . . . , T .

How to estimate β1 efficiently?

If (26) holds, β1 can be estimated consis-

tently from a single cross section. So in prin-
ciple, there is no need for panel data at all.
But using a single cross section obviously dis-
cards a lot lot of useful information.

35
If the data set is simply pooled and the error
term is denoted as vit = ai + uit, we have the
regression

(27) yit = β0 + β1xit + vit.

Then E[vit 2 ] = σ 2 + σ 2 and E[v v ] = σ 2 for
a u it is a
t 6= s, such that
σa2
(28) Corr[vit, vis] = 2
σa + σu2
for t 6= s, where σa2 = Var[ai] and σu2 = Var[uit].

That is, the error terms vit are (positively)

autocorrelated, which biases the standard er-
rors of the OLS β̂1.

36
If σa2 and σu2 were known, optimal estimators
(BLUE) would be obtained by generalized
least squares (GLS), which in this case would
reduce to estimating the regression slope co-
efficients from the quasi demeaned equation
(29)
yit −λȳt = β0(1−λ) + β1(xit −λx̄i) + (vit −λv̄i),
where
!1
σu2 2
(30) λ=1− .
σu2 + T σa2
In practice σu2 and σa2 are unknown, but they
can be estimated for example as follows:

Estimate (27) from the pooled data set and

use the OLS residuals v̂it to estimate σa2 from
the average covariance of v̂it and v̂is for t 6= s.

In the second step, estimate σu2 from the vari-

ance of the OLS residuals v̂it as σ̂u2 = σ̂ν2 − σ̂a2.

Finally plug these estimates of σa2 and σu2 into

equation (30). Regression packages do this
automatically.
37
The resulting GLS estimators for the regres-
sion slope coefficients are called random
effects estimators (RE estimators). Other
estimators of σa2 and σu2 (and therefore λ)
are available. The particular version we dis-
cussed is the Swamy-Arora estimator.

Under the random effects assumptions∗ the

estimators are consistent, but not unbiased.

They are also asymptotically normal as N → ∞

for fixed T .

However, for small N and large T the proper-

ties of the RE estimator are largely unknown.

∗ The
ideal random effects assumptions include FE.1,
FE.2, FE.4–FE.6.
FE.3 is replaced with
RE.3: There are no perfect linear relationships
among the explanatory variables.
RE.4: In addition of FE.4, E[ai |Xi ] = 0.
38
Note that λ = 0 in (29) corresponds to pooled
regression and λ = 1 to FE, such that for
σu2  σa2 (λ ≈ 1) RE estimates will be sim-
iliar to FE estimates, whereas for σu2  σa2
(λ ≈ 0) RE estimates will resemble pooled
OLS estimates.

Example 7 (continued.)
Note that the constant dummies black and
hisp and the variable with constant change
exper, which dropped out with the FE method,
can be estimated with RE.
!1/2
0.3512
λ̂ = 1 − = 0.643,
0.3512 + 8 · 0.32462
such that the RE estimates lie closer to the
FE estimates than to the pooled OLS esti-
mates.
Applying RE is probably not appropriate in
this case, because, as discussed earlier, the
unobservable ai is probably correlated with
some of the explanatory variables.

39
EViews output for RE estimation:

Dependent Variable: LWAGE

Method: Panel EGLS (Cross-section random effects)
Date: 11/26/12 Time: 12:26
Sample: 1980 1987
Periods included: 8
Cross-sections included: 545
Total panel (balanced) observations: 4360
Swamy and Arora estimator of component variances

Variable Coefficient Std. Error t-Statistic Prob.

C 0.023586 0.150265 0.156965 0.8753

EDUC 0.091876 0.010631 8.642166 0.0000
BLACK -0.139377 0.047595 -2.928388 0.0034
HISP 0.021732 0.042492 0.511429 0.6091
EXPER 0.105755 0.015326 6.900482 0.0000
EXPERSQ -0.004724 0.000688 -6.869682 0.0000
MARRIED 0.063986 0.016729 3.824781 0.0001
UNION 0.106134 0.017806 5.960582 0.0000
D81 0.040462 0.024628 1.642894 0.1005
D82 0.030921 0.032255 0.958646 0.3378
D83 0.020281 0.041471 0.489036 0.6248
D84 0.043119 0.051179 0.842509 0.3995
D85 0.057815 0.061068 0.946733 0.3438
D86 0.091948 0.071039 1.294334 0.1956
D87 0.134929 0.081096 1.663821 0.0962

Effects Specification
S.D. Rho

Cross-section random 0.324603 0.4610

Idiosyncratic random 0.350990 0.5390

Weighted Statistics

R-squared 0.180618 Mean dependent var 0.588893

Adjusted R-squared 0.177977 S.D. dependent var 0.388166
S.E. of regression 0.351932 Sum squared resid 538.1558
F-statistic 68.41243 Durbin-Watson stat 1.589754
Prob(F-statistic) 0.000000

Unweighted Statistics

R-squared 0.182847 Mean dependent var 1.649147

Sum squared resid 1010.433 Durbin-Watson stat 0.846702

40
Random effects or fixed effects?

FE is widely considered preferable because it

allows correlation between ai and x variables.

Given that the common effects, aggregated

to ai is not correlated with x variables, an
obvious advantage of the RE is that it allows
also estimation of the effects of factors that
do not change in time (like education in the
above example).

Typically the condition that common effects

ai is not correlated with the regressors (x-
variables) should be considered more like an
exception than a rule, which favors FE.

Whether this condition is met, can be tested

with the Hausman test to be discussed in the
following.

41
Hausman specification test

Hausman (1978) devised a test for the or-

thogonality of the common effects (ai) and
the regressors.

The basic idea of the test relies on the fact

that under the null hypothesis of orthogonal-
ity both OLS and GLS are consistent, while
under the alternative hypothesis GLS is not
consistent. Thus, under the null hypothe-
sis OLS and GLS estimates should not differ
much from each other.

The Hausman test statistic is a transforma-

tion of the differences between the parame-
ter estimates obtained from RE and FE es-
timation, which becomes asymptotically χ2-
distributed under the null hypothesis (26)
H0 : Cov[xit, ai] = 0, t = 1, . . . , T.
The degrees of freedom are the number of re-
gressors, where only those regressors may be
included which are estimable with FE, that
is, time-constant variables must be dropped
(also constant time changes, if year dummies
are included).
42
In order to perform the Hausman test in EViews,
first estimate the model with RE including
only those regressors, which are estimable
with FE as well. Then select

View/ Fixed/Random Effects Testing/

Correlated Random Effects - Hausman Test.

The first part of the output is the Hausman

test statistic with degrees of freedom and p-
value. The second part lists the parameter
estimates for both FE and RE estimation.
The final third part is more detailed FE esti-
mation output.

Example 7 (continued.)
As expected, the Hausman test strongly re-
jects the null hypothesis, that ai would be
uncorrelated with all explanatory variables.
Therefore, RE is inappropriate and we must
use FE parameter estimates instead.

43
Correlated Random Effects - Hausman Test
Equation: HAUSMAN
Test cross-section random effects

Test Summary Chi-Sq. Statistic Chi-Sq. d.f. Prob.

Cross-section random 35.992523 10 0.0001

Cross-section random effects test comparisons:

Variable Fixed Random Var(Diff.) Prob.

EXPERSQ -0.005185 -0.003139 0.000000 0.0001

MARRIED 0.046680 0.078034 0.000054 0.0000
UNION 0.080002 0.103974 0.000051 0.0008
D81 0.151191 0.133626 0.000016 0.0000
D82 0.252971 0.214562 0.000081 0.0000
D83 0.354444 0.290904 0.000228 0.0000
D84 0.490115 0.398106 0.000491 0.0000
D85 0.617482 0.494105 0.000915 0.0000
D86 0.765497 0.606478 0.001553 0.0001
D87 0.925025 0.724616 0.002467 0.0001

Cross-section random effects test equation:

Dependent Variable: LWAGE
Method: Panel Least Squares
Date: 12/12/12 Time: 11:41
Sample: 1980 1987
Periods included: 8
Cross-sections included: 545
Total panel (balanced) observations: 4360

Variable Coefficient Std. Error t-Statistic Prob.

C 1.426019 0.018341 77.74835 0.0000

EXPERSQ -0.005185 0.000704 -7.361196 0.0000
MARRIED 0.046680 0.018310 2.549385 0.0108
UNION 0.080002 0.019310 4.142962 0.0000
D81 0.151191 0.021949 6.888319 0.0000
D82 0.252971 0.024418 10.35982 0.0000
D83 0.354444 0.029242 12.12111 0.0000
D84 0.490115 0.036227 13.52914 0.0000
D85 0.617482 0.045244 13.64797 0.0000
D86 0.765497 0.056128 13.63847 0.0000
D87 0.925025 0.068773 13.45039 0.0000

Effects Specification

Cross-section fixed (dummy variables)

R-squared 0.620912 Mean dependent var 1.649147

Adjusted R-squared 0.565718 S.D. dependent var 0.532609
S.E. of regression 0.350990 Akaike info criterion 0.862313
Sum squared resid 468.7531 Schwarz criterion 1.674475
Log likelihood -1324.843 Hannan-Quinn criter. 1.148946
F-statistic 11.24956 Durbin-Watson stat 1.821184
Prob(F-statistic) 0.000000

44