Chapter 6

Model Specification: Choosing

the Independent Variables

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 Specifying an Econometric Equation and
Specification Error

• Before any equation can be estimated, it must be completely

specified
• Specifying an econometric equation consists of three parts,
namely choosing the correct:
– independent variables
– functional form
– form of the stochastic error term
• A specification error results when one of these choices is
made
incorrectly
• This chapter will deal with the first of these choices (the two other
choices will be discussed in subsequent chapters)

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 Omitted Variables

• Two reasons why an important explanatory variable

might have been left out:
– we forgot…
– it is not available in the dataset, we are examining
• Either way, this may lead to omitted variable bias
(or, more generally, specification bias)
• The reason for this is that when a variable is not
included, it cannot be held constant
• Omitting a relevant variable usually is evidence that the
entire equation is a suspect, because of the likely bias of
the coefficients.

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 The Consequences of an Omitted Variable

• Suppose the true regression model is:

(6.1)
Where is a classical error term
• If X2 is omitted, the equation becomes instead:
(6.2)

Where:
(6.3)
• Hence, the explanatory variables in the estimated regression (6.2) are not
independent of the error term (unless the omitted variable is
uncorrelated with all the included variables—something which is very
unlikely)

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 The Consequences of an Omitted Variable (cont.)

• What happens if we estimate Equation 6.2 when Equation 6.1 is the truth?
• We get bias!
• What this means is that:
(6.4)
• Instead of having an expected value equal to the true β1 the estimate will compensate
for the fact that X2 is missing from the equation.
• If X1 and X2 are correlated and X2 is omitted from the equation, then the OLS
estimation procedure will attribute to X1 variations in Y actually caused by X2, and a
biased estimate of β1 will result.

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 The Consequences of an Omitted Variable (cont.)

• To see how a left-out variable can cause bias, picture a production function
that states that output depends on the amount of labor and capital used.
Y=f(K,L)
• What would happen if data on capital were unavailable for some reason and
K was omitted from the equation?
• In this case, we would be leaving out the impact of capital on output in our
model.
• This omission would almost surely bias the estimate of the coefficient of
labor because it is likely that capital and labor are positively correlated.
• As a result, the OLS program would attribute to labor the increase in output
actually caused by capital to the extent that labor and capital were
correlated.
• Thus the bias would be a function of the impact of capital on output and the
correlation between capital and labor.
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 The Consequences of an Omitted Variable (cont.)

• To generalize for a model with two independent variables, the expected value of the
coefficient of an included variable (X1) when a relevant variable (X2) is omitted from the
equation equals:

Where α1 is the slope coefficient of the secondary regression that relates X2 to X1:

Where ui is a classical error term. α1 can be expressed as a function of the correlation

between X1 and X2, the included and excluded variables, or f(r12).

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 The Consequences of an Omitted Variable (cont.)

In a nutshell

The amount of bias is a function of the impact of the omitted variable on the
dependent variable times a function of the correlation between the included and
the omitted variable
• So, the bias exists unless:
1. the true coefficient equals zero, or
2. the included and omitted variables are uncorrelated

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 An Example of Specification Bias

As an example of specification bias, let’s take a look at a simple model of the

annual consumption of chicken in the United States

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 Correcting for an Omitted Variable

• In theory, the solution to a problem of specification bias seems easy:

add the omitted variable to the equation!
• Unfortunately, that’s easier said than done, for a couple of reasons
1. Omitted variable bias is hard to detect: the amount of bias introduced can
be small and not immediately detectable
2. Even if it has been decided that a given equation is suffering from omitted
variable bias, how to decide exactly which variable to include?
• Note here that dropping a variable is not a viable strategy to help cure
omitted variable bias:
– If anything you’ll just generate even more omitted variable bias on the
remaining coefficients!

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 Correcting for an Omitted Variable (cont.)

• What if:
– You have an unexpected result, which leads you to believe that you have
an omitted variable
– You have two or more theoretically sound explanatory variables as
potential “candidates” for inclusion as the omitted variable to the equation is
to use
• How do you choose between these variables?
• One possibility is expected bias analysis
– Expected bias: the likely bias that omitting a particular variable would
have caused in the estimated coefficient of one of the included variables

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 Correcting for an Omitted Variable (cont.)

• Expected bias can be estimated with Equation 6.7:

(6.7)
• When do we have a viable candidate?
– When the sign of the expected bias is the same as the
sign
of the unexpected result
• Similarly, when these signs differ, the variable is
extremely unlikely to have caused the unexpected
result

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 Irrelevant
Variables
• This refers to the case of including a variable in an equation when it
does not belong there
• This is the opposite of the omitted variables case—and so the impact
can be illustrated using the same model
• Assume that the true regression specification is:
(6.10)
• But the researcher for some reason includes an extra variable:
(6.11)
• The misspecified equation’s error term then becomes:
(6.12)

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 Irrelevant Variables
(cont.)
• So, the inclusion of an irrelevant variable will not cause bias
(since the true coefficient of the irrelevant variable is zero, and so
the second term will drop out of Equation 6.12)
• However, the inclusion of an irrelevant variable will:
– Increase the variance of the estimated coefficients, and this
increased variance will tend to decrease the absolute
magnitude of their t-scores
– Decrease the R2 (but not the R2)
• Table 6.1 summarizes the consequences of the omitted variable
and the included irrelevant variable cases (unless r12 = 0)

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 Table 6.1 Effect of Omitted Variables and Irrelevant Variables on
the Coefficient Estimates

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 Four Important Specification Criteria

• We can summarize the previous discussion into four criteria to help

decide whether a given variable belongs in the equation:
1. Theory: Is the variable’s place in the equation unambiguous and theoretically
sound?
2. t-Test: Is the variable’s estimated coefficient significant in the expected
direction?
3. R2: Does the overall fit of the equation (adjusted for degrees of freedom) improve
when the variable is added to the equation?
4. Bias: Do other variables’ coefficients change significantly when the variable is
added to the equation?
• If all these conditions hold, the variable belongs in the equation
• If none of them hold, it does not belong
• The tricky part is the intermediate cases: use sound judgment!

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 Specification
Searches
• Almost any result can be obtained from a given
dataset, by simply specifying different regressions until
estimates with the desired properties are obtained
• Hence, the integrity of all empirical work is open to
question
• To counter this, the following three points of Best
Practices in Specification Searches are suggested:
1. Rely on theory rather than statistical fit as much as possible when
choosing variables, functional forms, and the like
2. Minimize the number of equations estimated (except for
sensitivity analysis, to be discussed later in this
section)
3. Reveal, in a footnote or appendix, all alternative
specifications estimated
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 Sequential Specification
Searches
• The sequential specification search technique allows a researcher to:
– Estimate an undisclosed number of regressions
– Subsequently present a final choice (which is based upon an unspecified
set of expectations about the signs and significance of the coefficients) as if
it were only a specification
• Such a method misstates the statistical validity of the regression
results for two reasons:
1. The statistical significance of the results is overestimated because the
estimations of the previous regressions are ignored
2. The expectations used by the researcher to choose between various
regression results rarely, if ever, are disclosed

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 Bias Caused by Relying on the
t-Test to Choose Variables

• Dropping variables solely based on low t-statistics may lead to two

different types of errors:
1. An irrelevant explanatory variable may sometimes be included in the
equation (i.e., when it does not belong there)
2. A relevant explanatory variables may sometimes be dropped from the
equation (i.e., when it does belong)
• In the first case, there is no bias but in the second case there is bias
• Hence, the estimated coefficients will be biased every time an excluded
variable belongs in the equation, and that excluded variable will be left out
every time its estimated coefficient is not statistically significantly different
from zero
• So, we will have systematic bias in our equation!

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 Sensitivity
Analysis
• Contrary to the advice of estimating as few equations as possible
(and based on theory, rather than fit!), sometimes we see journal article
authors listing results from five or more specifications
• What’s going on here:
• In almost every case, these authors have employed a technique called
sensitivity analysis
• This essentially consists of purposely running a number of alternative
specifications to determine whether particular results are robust (not
statistical flukes) to a change in specification
• Why is this useful? Because true specification isn’t known!

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 Data
Mining
• Data mining involves exploring a data set to try to uncover
empirical regularities that can inform economic theory
• That is, the role of data mining is opposite that of traditional
econometrics, which instead tests the economic theory on
a data set
• Be careful, however!
– a hypothesis developed using data mining techniques must be
tested on a different data set (or in a different context) than
the one used to develop the hypothesis
– Not doing so would be highly unethical: After all, the researcher
already knows ahead of time what the results will be!

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 Key Terms from
Chapter 6
• Omitted variable
• Irrelevant variable
• Specification bias
• Sequential specification search
• Specification error
• The four specification criteria
• Expected bias
• Sensitivity analysis

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