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# RHODES UNIVERSITY EXAMINATION: NOVEMBER 2010 ECONOMICS HONOURS ECONOMETRICS (ECO404) Examiners: Prof C Van Walbeek Ms N S Cattaneo Answer

## all questions FINAL ANSWER GUIDE

Annual data on the South African motor vehicle industry, compiled for the period 1970 to 2004, is used for Questions 1, 2 and 3. Output and the capital stock are measured in millions of Rand (in constant 2000 prices), employment is the number of employees, and capacity utilisation is a percentage.

## Question 1 Consider the following model: OUTPUT*t = 0 + 1 CAPITALt + 2 EMPLOYt + ut

where OUTPUT* is the desired, or long-run, output of motor vehicles CAPITAL is the capital stock EMPLOY is the level of employment.

(25 marks)
(Equation 1.1)

1.1

Use the partial adjustment model to derive an estimatable short-run production function for motor vehicles in South Africa. Ensure that your answer clearly explains the underlying adjustment hypothesis. (4)

The partial adjustment hypothesis is specified as follows: (OUTPUTt OUTPUTt-1) = (OUTPUT*t OUTPUTt-1) where 0 < 1 is the coefficient of adjustment. This hypothesis suggests that the actual change in output between periods is some fraction of the desired change in output. To derive the function for estimation purposes the hypothesis is rewritten as: OUTPUTt = OUTPUT*t + (1-)OUTPUTt-1 Substitute Equation 1.1into this expression: OUTPUTt = [0 + 1 CAPITALt + 2 EMPLOYt + ut ] + (1-)OUTPUTt-1 This yields OUTPUTt = 0 + 1 CAPITALt + 2 EMPLOYt + (1-)OUTPUTt-1 + ut The results of an estimation of the parameters of the short-run function are given below.
Dependent Variable: OUTPUT Method: Least Squares Sample (adjusted): 1971 2004 Included observations: 34 after adjustments

Coefficient Std. Error C CAPITAL EMPLOY OUTPUT(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 3230.838 1.699242 -0.072882 0.778373 0.939354 0.933289 5828.256 1.02E+09 -340.9122 154.8908 0.000000 8427.103 0.869629 0.110038 0.152828

## t-Statistic 0.383387 1.953986 -0.662336 5.093134

Prob. 0.7041 0.0601 0.5128 0.0000 42632.47 22565.26 20.28895 20.46853 20.35019 1.437804

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

1.2

Write down the resulting estimated short-run equation. Compute and interpret the estimated coefficient of adjustment. (3)

UTPUTt = 3230.838+ 1.699 CAPITALt 0.073 EMPLOYt + 0.778 OUTPUTt-1 (1-) = 0.778373 so = 0.221627. This suggests that the actual change in output between periods is about 22% of the desired change. OR 22% of the gap between desired and actual output is closed each period. 1.3 Carefully interpret the estimated coefficients of the capital and employment variables in the shortrun equation, and comment on whether their signs accord with a priori expectations. (In your interpretation, recall the definition of a factors marginal product). (4)

1 = 1.699 is the short run MPK and suggests that if the capital stock rises by R1mn then output will increase by R1.699mn holding all else constant. Sign as expected. 2 = -0.073 is the short run MPL. However, the sign is not as expected, as it implies that an increase in employment would lower output cet par. 1.4 Comment on both the individual and overall statistical significance of the results. In the light of your answer, and the signs on the estimated coefficients, what econometric problem could be present in the model? (4)

Intercept coefficient insignificant; coefficient of capital stock significant at 10% level only; coefficient of employment not significant; coefficient of lagged output significant at 1% level. Overall regression is highly significant (see F-statistic and its p-value). May be multicollinearity between K and L. 1.5 Derive the long-run production function for the South African motor vehicle sector (Equation 1.1) using the regression results in Part 1.2. (3) = 0.221627 0 = 3230.838 1 = 1.699 2 = -0.073

Hence Est 0 = 14577.81768 Est 1 = 7.66713 Est 2 = -0.32885 LR function: UTPUT*t = 14577.812 + 7.667 CAPITALt - 0.3289 EMPLOYt 1.6 Compare the estimated coefficient of CAPITAL in the long-run function to the corresponding estimated coefficient in the short run function and comment. (2)

LR MPK is 7.667 suggesting higher capital stock raises desired LR output by R7.667mn holding all else constant. SR MPK is 1.699 suggesting that higher K stock raises actual SR output by R1.699mn cet par. (Larger response inLR function as expected). 1.7 Perform an appropriate test for the presence of autocorrelation in the data. (5)

Since this is an autoregressive model the Durbin h statistic is used. Null hypothesis: no autocorrelation. DW = 1.437804 (from the regression results) n = 34 (adjusted sample size) = 1 (DW/2) = 0.281098 std error of lagged output coefficient is 0.152828 Thus var of lagged output coefficient is 0.0233564 h* = [n / (1 ( n x var))] = 0.281098 [34 / (1 (34 x 0.0233564))] = 3.612 Zcrit = 2.58 at the 1% level and 1.96 at the 5% level. So we reject the null and conclude that there is evidence of (positive) autocorrelation. Question 2 (33 marks)

Graphs of the output, employment, capital stock and capacity utilisation data are shown below.

OUTPUT
100,000 100,000 90,000 80,000 60,000 70,000 40,000 60,000 50,000 70 75 80 85 90 95 00 70 75 80

EMPLOY

80,000

20,000

85

90

95

00

CAPITAL
20,000 16,000 12,000 70 8,000 4,000 0 70 75 80 85 90 95 00 60 90

CAPACITY

80

50 70 75 80 85 90 95 00

2.1

Read Appendix A on Page 14. Comment on any particularly noticeable trends in each graph, bearing in mind the introduction of the Motor Industry Development Programme (MIDP) in the mid-1990s. In the light of your comments, do you think that the policy change should be explicitly accounted for in the model? Justify your answer. (4)

Output graph indicates an exponential increase in the value of production after the introduction of the MIDP. Capital stock also began to increase at a faster rate in the second half of the 1990s. There was not a correspondingly positive impact on employment post-1995. However employment had contracted sharply between the early 1980s and 1995, and appeared more stable post-1996 (although it was not increasing). Capacity utilisation depicts a more cyclical pattern. In the light of the patterns on the output and capital graphs in particular it may be worth testing for a structural break in the mid-1990s. 2.2 Regardless of your answer in Part 2.1, do you think that the data suggest significant cyclical instability for any (or all) of the variables? Justify your answer. (2)

Capacity utilisation shows the most pronounced cyclical pattern. Output has signs of cyclical pattern up to the mid-1990s and employment a bit between the early 1980s and mid-1990s. Consider the following Cobb-Douglas production function for the South African motor vehicle sector: OUTPUTt = 0 CAPITALt1 EMPLOYt2 eut (Equation 2.1)

2.3

Linearise the Cobb-Douglas production function by performing a double-log transformation on Equation 2.1. What is the advantage of the double-log model in terms of the interpretation of the partial slope parameters? (Ensure that you frame your answer in the context of the investigation) . (2)

lnOUTPUTt = ln0 + 1 lnCAPITALt + 2 lnEMPLOYt + ut 1 indicates partial elasticity of output with respect to the capital stock 2 indicates partial elasticity of output with respect to employment An OLS estimation of the double-log model yields the following results:
Dependent Variable: LOG(OUTPUT) Method: Least Squares Sample: 1970 2004 Included observations: 35 Coefficie nt Std. Error C LOG(CAPITAL) LOG(EMPLOY) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 6.039731 2.679156 0.959745 0.079978 0.357549 0.262342 0.842340 0.832486 0.183707 1.079949 11.20976 85.48419 0.000000 t-Statistic 2.254341 12.00004 -1.362912 Prob. 0.0312 0.0000 0.1824

## Mean dependent var S.D. dependent var

10.53722 0.448850 Akaike info criterion 0.469129 Schwarz criterion 0.335813 Hannan-Quinn criter. 0.423108 Durbin-Watson stat 0.579203

2.4

Comment on the individual and overall statistical significance of the results, as well as the DurbinWatson statistic. (3)

Intercept coefficient significant at 5% but not 1% level; coefficient of lnCAPITAL significant at 1% level; coefficient of lnEMPLOY not significant. Overall regression significant but DW very low. 2.5 Using the double-log results, calculate and comment on the estimated returns to scale property of the motor vehicle sector for the period under study. (Hint: Recall the importance of the sum of the exponents of a Cobb-Douglas production function). (1)

Est (1 + 2) = 0.602196 < 1 suggesting decreasing returns to scale (doubling inputs less than doubles output). [They could add that this is not a reliable finding, since 2 is not significant as part of their comment, but this is not essential to obtain the mark]. 5

2.6

The estimation results for the Cobb-Douglas production function indicate that DW < R 2. Explain what important phenomenon this may indicate. (1)

This may indicate a spurious regression. [Need to investigate stationarity or otherwise of the individual series]. The results of ADF unit root tests on the series are as follows:
ADF UNIT ROOT TEST RESULTS (t-statistics)
Variable Levels ln(OUTPUT) -1.63421 0.5387 ln(CAPITAL) -1.8532 0.8656 ln(EMPLOY) -1.4326 0.4376 p-values in italics 1st diffs -4.2134 0.0054 -3.8256 0.0098 -6.5343 0.0002

2.7

Indicate the null hypothesis for a unit root test. Use the results above to complete the unit root test for each series. Classify each series according to its order of integration (ie I(0), I(1) etc). (Note: You do not need to write out the whole test three times; summarise your findings instead). (4)

H0: the series has a unit root (is non-stationary) For each series the t-statistics are not significant in level terms but are significant at the 1% level at first differences. We therefore fail to reject the null hypothesis in level terms but reject it at first differences. We conclude that all the series are nonstationary in level terms but stationary at first differences. All series are therefore I(1). 2.8 Explain how the augmented Dickey-Fuller test is different from the ordinary Dickey-Fuller test and why one would want to perform this augmentation. (2)

The ADF test adds lagged difference terms of the series on the right hand side of the equation (if necessary) to deal with autocorrelation. 2.9 Explain what is meant by cointegration, and explain the rationale behind the Engle-Granger test for cointegration. Perform an Engle-Granger test for cointegration using the Eviews output below. (Note: The Engle-Granger critical values are -5.02 at the 1% level, -4.32 at the 5% level and -3.98 at the 10% level). (5)
Null Hypothesis: RES has a unit root Exogenous: None Lag Length: 8 (Automatic based on SIC, MAXLAG=8) t-Statistic Augmented Dickey-Fuller test statistic -3.9987665

Cointegration refers to the existence of a stable long run relationship between the variables in a regression. If two or more series are individually nonstationary but their linear combination is stationary, then the variables are cointegrated. The EG test for cointegration tests the residuals of the regression for a unit root. The residuals are a proxy for the error term. The error term is a linear combination of the variables in the regression. Hence if the residuals are found to be stationary then a linear combination of the variables is stationary and we have cointegration. H0: there is no cointegration (RES is nonstationary / has a unit root) The observed t lies between the critical values at the 5% and 10% significance levels. Thus there is no evidence of cointegration at the 5% level, but there is evidence of cointegration at the 10% level (weak result). The results of an ECM for the study are provided below.
Dependent Variable: D(LOG(OUTPUT)) Method: Least Squares Date: 10/14/10 Time: 09:47 Sample (adjusted): 1971 2004 Included observations: 34 after adjustments Coefficie nt Std. Error C D(LOG(CAPITAL)) D(LOG(EMPLOY)) RES(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 0.017612 1.030566 1.182444 0.366845 0.492559 0.441815 0.101830 0.311080 31.55520 9.706726 0.000123 0.024335 0.357650 0.345609 0.111856 t-Statistic -0.723735 2.881494 3.421337 -3.279617 Prob. 0.4748 0.0072 0.0018 0.0026

## Mean dependent var S.D. dependent var

0.044290 0.136297 Akaike info criterion 1.620894 Schwarz criterion 1.441322 Hannan-Quinn criter. 1.559655 Durbin-Watson stat 1.594491

2.10

Explain what an ECM is and interpret the coefficient of the lagged residual series in this context. (4)

This is an error correction model. Although there may be (in this case rather weak!) evidence of cointegration (a stable long-run relationship between the variables in the model) there may be SR disequilibrium around the LR relationship. The ECM ties the SR behaviour to the LR 7

relationship and allows us to say something about SR fluctuations and the speed of adjustment back to LR equilibrium. The coefficient of RES(-1) is the speed of adjustment coefficient. It is negative and statistically significant as expected. It therefore suggests that it takes about 2.7 periods for LR equilibrium to be restored. OR (put differently) 37% of the disequilibrium will be reverted each period. The results of adding two further variables to the double-log model previously estimated are given below. The new variables are the natural log of capacity utilisation (lnCAPACITY), and a dummy variable (DUM) set equal to 0 for the period 1970 to 1996 (before the MIDP) and equal to 1 for the period 1997 to 2004 (after the MIDP was introduced). This attempts to capture the effects of the policy change in the mid-1990s.
Dependent Variable: LOG(OUTPUT) Method: Least Squares Sample: 1970 2004 Included observations: 35 Coefficie nt Std. Error C LOG(CAPITAL) LOG(EMPLOY) LOG(CAPACITY) DUM R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 0.903631 0.487213 0.080602 1.003279 0.470869 0.923141 0.912893 0.132473 0.526474 23.78294 90.08122 0.000000 2.148926 0.104164 0.221115 0.291835 0.092972 t-Statistic 0.420504 4.677377 0.364527 3.437828 5.064648 Prob. 0.6771 0.0001 0.7180 0.0017 0.0000

## Mean dependent var S.D. dependent var

10.53722 0.448850 Akaike info criterion 1.073311 Schwarz criterion 0.851118 Hannan-Quinn criter. 0.996610 Durbin-Watson stat 0.987799

2.11 Comment on the individual statistical significance of the coefficients of lnCAPACITY and DUM. Explain whether their signs conform to expectations. Comment on the adjusted R2, F-statistic and Durbin-Watson statistics of the extended model compared to the previous model. In the light of these comments, do you think that the addition of the new variables is justifiable? (5) lnCAPACITY: t-statistic is significant at the 1% level and signed according to a priori expectations. DUM: t-statistic is significant at the 1% level and its sign is also as expected given the policy changes instituted. Overall: adjusted R-squared improves a lot with the additional of the new variables, as does the 8

DW statistic. Model appears better specified and addition of new variables appears justifiable. [Could note that ln(EMPLOY) coefficient is now positively signed though still insignificant]

Question 3 3.1

(13 marks)

The data generating process underlying CAPITAL (the capital stock series in the motor vehicle sector) is investigated using the Box-Jenkins methodology. A unit root test on the series indicates that it is I(1). A correlogram of the capital stock series at first differences is shown below. Use this information to suggest an appropriate ARIMA model for the series. Justify your answer. (3)

Correlogram of D(CAPITAL)
Sample: 1970 2004 Included observations: 34 Autocorrelation . |******| . |**** | . |* .|. .*| . *| . .*| . .|. | | | | | | Partial Correlation . |******| *| . .*| . **| . .|. . |*. . |*. . |*. | | | | | | | 1 2 3 4 5 6 7 8 AC PAC Q-Stat Prob 23.209 0.000 33.536 0.000 36.318 0.000 36.319 0.000 37.608 0.000 39.469 0.000 40.246 0.000 40.254 0.000

0.791 0.791 0.520 0.284 0.265 0.110 0.006 0.268 0.175 0.068 0.206 0.117 0.131 0.157 0.013 0.099

The ARIMA model can be written as ARIMA(p,d,q). The unit root test results tell us that d=1. We look at the PACF for a clue to the number of autoregressive (AR) terms. One significant spike suggests p=1. We look at the ACF for a clue to the number of moving average (MA) terms. Two significant spikes suggest q=2. We therefore suggest ARIMA(1,1,2) for the CAPITAL series. 3.2 The results of an ARIMA(1,1,0) model for OUTPUT in the motor vehicle sector are given below. Use the results to forecast the value of output in this sector for 2005. (Note: the value of output in 2003 and 2004 was 91185 and 98526 respectively in Rmillions). (3)

Dependent Variable: D(OUTPUT) Method: Least Squares Date: 10/14/10 Time: 09:58 Sample (adjusted): 1972 2004

Included observations: 33 after adjustments Convergence achieved after 3 iterations Coefficie nt Std. Error C AR(1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 2443.767 1381.964 0.242486 0.105358 0.358098 0.327714 6003.813 1.12E+0 9 332.8983 6.912142 0.076606 t-Statistic Prob.

## 1.768329 0.0868 2.3015433 0.0665 2360.623 6088.779 20.29687 20.38757

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion

## We first have to undifference:

OTPUTt OTPUTt OTPUTt OTPUTt OTPUTt OUTPUTt-1 = 2443.767 + 0.242486 [ OUTPUTt-1 OUTPUTt-2 ] = 2443.767 + 0.242486 OUTPUTt-1 0.242486 OUTPUTt-2 + OUTPUTt-1 = 2443.767 + 1.242486 OUTPUTt-1 0.242486 OUTPUTt-2 = 2443.767 + 1.242486 (98526) 0.242486 (91185) = 2443.767 + 122417.1756 22111.08591 = 102749.8567

The forecast value of OUTPUT in 2005 is R102749.86mn 3.3 In order to investigate whether capital stock and output in the motor vehicle sector are jointly determined, a VAR model is set up, with CAPITAL as a function of lagged CAPITAL and lagged OUTPUT in one equation, and OUTPUT as a function of lagged OUTPUT and lagged CAPITAL in the other equation. The results of the VAR estimation at 2 lags are given overleaf. Comment on the individual and overall significance of the results. (2)

Vector Autoregression Estimates Date: 10/14/10 Time: 10:07 Sample (adjusted): 1972 2004 Included observations: 33 after adjustments Standard errors in ( ) & t-statistics in [ ] CAPITAL CAPITAL(-1) 1.697891 (0.18004) [ 9.43050] -0.713271 (0.16457) [-4.33417] OUTPUT 2.242444 (4.20720) [ 0.53300] -0.802356 (3.84562) [-0.20864]

CAPITAL(-2)

10

OUTPUT(-1)

0.012018 (0.00946) [ 1.27050] -0.003567 (0.00924) [-0.38595] -83.23913 (124.642) [-0.66782] 0.995620 0.994994 1872990. 258.6358 1591.218 -227.4429 14.08745 14.31419 8224.722 3655.625

1.115646 (0.22105) [ 5.04710] -0.328531 (0.21595) [-1.52131] -1154.946 (2912.62) [-0.39653] 0.937271 0.928310 1.02E+09 6043.745 104.5915 -331.4377 20.39016 20.61691 43299.34 22572.34 1.21E+12 8.70E+11 -547.2558 33.77308 34.22656

OUTPUT(-2)

R-squared Adj. R-squared Sum sq. resids S.E. equation F-statistic Log likelihood Akaike AIC Schwarz SC Mean dependent S.D. dependent

Determinant resid covariance (dof adj.) Determinant resid covariance Log likelihood Akaike information criterion Schwarz criterion

CAPITAL equation: Both lags of capital are significant; lags of output are not. Overall regression is significant. OUTPUT equation: Only the first lag of output is significant; both lags of capital are not. Overall regression is significant. 3.4 The regression output for the same VAR model run at 4 lags is given below. Comment on the individual and overall significance of the results as well as the adjusted R2 statistics compared to the two-lag model. With reference to this comment and the AIC and SIC, indicate which model you would choose amd why. (3)

Vector Autoregression Estimates Date: 10/14/10 Time: 10:08 Sample (adjusted): 1974 2004 Included observations: 31 after adjustments Standard errors in ( ) & t-statistics in [ ] CAPITAL OUTPUT

11

CAPITAL(-1)

2.432789 (0.24375) [ 9.98056] -2.267518 (0.58264) [-3.89180] 0.642288 (0.61645) [ 1.04191] 0.156766 (0.26476) [ 0.59211] -0.008883 (0.00799) [-1.11109] 0.014261 (0.01096) [ 1.30177] 0.004262 (0.01075) [ 0.39648] 0.012403 (0.00974) [ 1.27341] -303.1737 (116.293) [-2.60697] 0.998234 0.997592 693477.3 177.5435 1554.237 -199.2271 13.43401 13.85033 8486.174 3617.692

18.96541 (7.66870) [ 2.47309] -41.25321 (18.3304) [-2.25053] 29.78094 (19.3941) [ 1.53556] -5.868038 (8.32952) [-0.70449] 0.790431 (0.25152) [ 3.14256] 0.032939 (0.34467) [ 0.09557] 0.067874 (0.33819) [ 0.20070] -0.089851 (0.30643) [-0.29322] -2655.329 (3658.70) [-0.72576] 0.955472 0.939279 6.86E+08 5585.693 59.00837 -306.1383 20.33150 20.74782 44613.36 22667.80 6.37E+11 3.21E+11 -498.6386

CAPITAL(-2)

CAPITAL(-3)

CAPITAL(-4)

OUTPUT(-1)

OUTPUT(-2)

OUTPUT(-3)

OUTPUT(-4)

R-squared Adj. R-squared Sum sq. resids S.E. equation F-statistic Log likelihood Akaike AIC Schwarz SC Mean dependent S.D. dependent

Determinant resid covariance (dof adj.) Determinant resid covariance Log likelihood

12

## Akaike information criterion Schwarz criterion

33.33152 34.16416

The answer to this is not clear-cut. None of the Lag 3 and 4 coefficients is individually significant in the k=4 model. However, in the OUTPUT equation past lags of CAPITAL now help to explain OUTPUT at Lags 1&2. Adjusted R-squared is marginally higher in both equations at 4 lags than at 2 lags. The overall AIC and SIC are both lower in the VAR model with 4 lags, however the SIC for the OUTPUT equation is larger not smaller. Although the model with 4 lags may appear to perform better on some counts, a preference for parsimony would dictate a choice of k=2 rather than 4. This is a grey area however. 3.5 Comment on the variance decompositions below for the model run at 2 lags. (2)
Variance Decomposition of CAPITAL: Perio d S.E. CAPITAL OUTPUT 1 2 3 4 5 6 7 8 9 10 258.6358 557.1104 902.3425 1279.578 1678.714 2094.084 2523.765 2968.613 3431.336 3915.772 100.0000 99.15968 97.65076 96.05933 94.64819 93.49604 92.59591 91.90931 91.39173 91.00300 0.000000 0.840316 2.349241 3.940669 5.351810 6.503962 7.404091 8.090692 8.608272 8.997005

Variance decomposition of OUTPUT: Perio d S.E. CAPITAL OUTPUT 1 2 3 4 5 6 7 8 9 10 6043.745 9374.893 11573.67 13205.06 14641.56 16096.01 17683.51 19462.47 21458.80 23681.92 50.56603 53.88343 57.75210 61.81710 65.82659 69.62339 73.08206 76.10433 78.64610 80.72354 49.43397 46.11657 42.24790 38.18290 34.17341 30.37661 26.91794 23.89567 21.35390 19.27646

Variance decomposition of CAPITAL: Shocks impact on CAPITAL mostly through own lags (>90%) although the effect declines slowly as the lag length increases. Variance decomposition of OUTPUT: Shocks impact on OUTPUT through both CAPITAL and OUTPUT (in 50/50 rel) but 13

increasingly through CAPITAL as the lag length increases. Question 4 (26 marks)

Let LFP be a binary variable indicating labour force participation by a married woman in 2004, such that LFP = 1 if the woman worked for a wage outside the home at some stage during the year, and zero otherwise. LFP is assumed to be a function of family income other than the womans own earnings (FAMINC, measured in thousands of Rands), years of education (EDUC), years of working experience (EXPER), AGE, the number of children less than six years old (KIDZBELO6), and the number of children between 6 and 18 years old (KIDZABOV6). The table below shows the results of estimating a linear probability model, as well as maximum likelihood logit and probit models, based on a sample of 750 women.
Dependent variable: LFP LPM (weighted least squares estimation) 0.59 -0.003 0.04 0.04 -0.0006 -0.02 -0.26 0.01 0.264 Logit (maximum likelihood estimation) 0.43 -0.02 0.22 0.21 -0.003 -0.09 -1.44 0.06 0.220 Probit (maximum likelihood estimation) 0.27 -0.01 0.13 0.12 -0.002 -0.05 -0.87 0.04 0.221

Explanatory variable Constant FAMINC EDUC EXPER EXPER2 AGE KIDZBELO6 KIDZABOV6 R2 / McFadden R2

(Note: The EXPER2 variable is simply the years of working experience squared.)

All estimated slope parameters are significant at the 1% level across specifications, with the exception of the coefficient of the KIDZABOV6 variable, which is statistically insignificant. 4.1 Comment briefly on whether the signs of the estimated partial slope coefficients conform to a priori expectations across specifications. (3)

Inverse relationship between: income earned by the rest of the family (FAMINC) and the likelihood of LFP; AGE and likelihood of LFP; number of children younger than 6 and likelihood of LFP. These are all plausible. Positive relationship between: years of education (EDUC) and likelihood of LFP; years of experience (EXPER) and likelihood of LFP; number of children between 6 and 18 and the likelihood of LFP. These also sound plausible. 4.2 Interpret the estimated coefficient of the KIDZBELO6 variable in the LPM results.

(2) If number of children under 6 increases by one then the probability of being in the labour force will fall by 0.26 per cent holding everything else constant. 14

4.3

Interpret the estimated coefficient of the EDUC variable in the logit results, giving only the odds interpretation. (2) 0.22 Coefficient of EDUC in the logit specification is 0.22. Taking the antilog yields e = 1.246. This suggests that if years of education increase by one, the person is about 1.25 times more likely (or 25% more likely) to be in the labour force, holding all else constant. 4.4 Estimate the probability of a 40 year-old married woman participating in the labour force in the following circumstances: family income R60 000 (i.e. FAMINCi = 60); years of education = 15; past working experience = 10 years; no children below 6; two children aged 10 and 15. Compute the estimated probability for all three specifications, and compare the three results. (7)

Linear probability model: est LFPi = 0.59 0.003 (60) + 0.04 (15) + 0.04 (10) 0.0006 (100) 0.02 (40) + 0.01 (2) = 0.59 0.18 + 0.6 + 0.4 0.06 0.8 + 0.02 = 0.57 Estimated probability of such a person being in the labour force using the LPM is 57% Logit model: est Li = 0.43 0.02 (60) + 0.22 (15) + 0.21 (10) 0.003 (100) 0.09 (40) + 0.06 (2) = 0.43 1.2 + 3.3 + 2.1 0.3 3.6 + 0.12 = 0.85 est prob = (e0.85) / (1+e0.85) = 2.339646852 / 3.339646852 = 0.700567 Estimated probability of such a person being in the labour force using the logit model is about 70% Probit model: est Ii = 0.27 0.01 (60) + 0.13 (15) + 0.12 (10) 0.002 (100) 0.05 (40) + 0.04 (2) = 0.27 0.6 + 1.95 + 1.2 0.2 2 + 0.08 = 0.7 est prob = F(Ii) from the standard cumulative normal tables = 0.7580 Estimated probability of such a person being in the labour force using the probit model is about 75.8% The estimated probabilities are much closer in the logit and probit case as one would expect given their underlying distributions. 4.5 Suppose that the family income of the woman in the circumstances described in Part 4.4 increased by R1000 (i.e. FAMINCi increased by one unit). Estimate the rate of change of probability of the womans participation in the labour force with respect to the level of family income for all three specifications & compare the three results. (6)

Linear probability model: Coefficient of FAMINC gives the rate of change of prob with respect to FAMINC directly in this model. Thus: dP / dFAMINC = -0.003. If FAMINC increases by R1000 then the probability of being in the labour force decreases by 0.3% holding all else constant. Logit model: dP / dFAMINC = coefficient of FAMINC x (est prob) x (1- est prob) 15

est prob = 0.700567 from before coeff of FAMINC = -0.02 in the logit case. So dP / dFAMINC = -0.02 (0.700567) (1-0.700567) = -0.004195457 If FAMINC increases by R1000 then the probability of being in the labour force decreases by 0.42% holding all else constant. Probit model: dP / dFAMINC = coefficient of FAMINC x f(Ii) from the ordinate normal tables est Ii = 0.7 from before coeff of FAMINC = -0.01 in the probit case. So dP / dFAMINC = -0.01 x f(0.7) = -0.01 (0.3123) = -0.003123 If FAMINC increases by R1000 then the probability of being in the labour force decreases by 0.31% holding all else constant. Estimated rates of change for probit and LPM are very close in this case. 4.6 Suppose that the same issue of labour force participation by married women was investigated using a grouped data-set instead of the individual data-set employed above. One line from the grouped data-set is given below:
No. of women with the given characteristics who are in the labour force ni No. of women with the given characteristics in the sample Ni

FAMINC

EDUC

EXPER

AGE

KIDZBELO6

KIDZABOV6

50

250

50

15

30

You wish to use weighted least squares in order to correct for the presence of heteroscedasticity. For the logit specification, compute the line of data that would be necessary to run the corrected model. Explain your workings fully. (6) Compute relative frequency measure of probability Pi = (ni / Ni) = (50 / 250) = 0.2 Compute the logit Li = ln( Pi / (1-Pi)) = ln(0.2/0.8) = -1.386294361 Compute the weighting wi = NiPi(1-Pi) [since var(Ui) = 1/ NiPi(1-Pi)] = 250 (0.2)(0.8) = 40 Compute the square root of the weighting: wstari = wi = 6.32455532 Multiply each variable in the equation by wstari to obtain the line of weighted data: Lstari = Liwstari = -1.386294361 x 6.32455532 = -8.768 FAMINCstari = FAMINCi wstari = 50 x 6.32455532 = 316.228 EDUCstari = EDUCiwstari = 15 x 6.32455532 = 94.868 EXPERstari = 5 x 6.32455532 = 31.623 AGEstari = 30 x 6.32455532 = 189.737 KIDZBELO6stari = 2 x 6.32455532 = 12.649 KIDZABOV6stari = 0 x 6.32455532 = 0 16

(12 marks) Question 5 (13 marks) A study of wages (WAGE) as a function of productivity (PROD) was conducted for the ten-year period from 1998 to 2007 across four firms: Dickeys Dishware (DD), Engles Earthenware (EE), Fullers Florists (FF) and Grangers Glassware (GG). In an initial attempt to estimate the relationship between wages and productivity, all 40 observations were stacked together and an OLS regression was run which disregarded the space and time dimensions of the pooled data. The regression results were as follows: WAGE = 1.546 + 0.5788PROD Equation (5.1) t (2.45) (8.34) prob (0.042) (0.000) R2 = 0.7545 DW = 0.1950 n = 40 F = 116.786 prob = 0.000 5.1 Comment on the significance of the results and on the Durbin-Watson statistic. What assumptions does the estimated model make about intercept and slope coefficients across firms and over time? (3) Intercept significant at 5%; coefficient of PROD is significant, as is the overall regression, but the DW statistic is very low indicating that there may be a model specification error. The model assumes intercept and slope coefficients are constant across firms and over time. As such it ignores heterogeneity between the subjects (firms) as well as the possibility of the wage function changing over time. In order to relax some of these assumptions, the following fixed effects LSDV panel data model was set up: WAGEit = 1 + 2EEi + 3FFi + 4GGi + 2PRODit + uit Equation (5.2) where EEi = 1 if the observation belonged to Engles Earthenware, 0 otherwise FFi = 1 if the observation belonged to Fullers Florists, 0 otherwise GGi = 1 if the observation belonged to Grangers Glassware, 0 otherwise (Dickeys Dishware is the base/comparator company) 5.2 Explain what the coefficients of the dummy variables indicate in this context. (2)

2 is a differential intercept coefficient and indicates by how much the intercept of the wage function of Engles Earthenware differs from that of the comparator firm (Dickeys Dishware). Similarly, 3 and 4 indicate by how much the intercepts of the wage functions of Fullers Florists and Grangers Glassware differ from that of the comparator firm. The results based on Equation (5.2) were as follows: WGEit = 1.223 + 0.432EEi + 0.331FFi + 0.289GGi + 0.5432PRODit t (6.86) (4.52) (4.53) (6.03) (6.16)
Equation (5.3)

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## DW = 1.234 prob(F)=0.000 (3)

The coefficients are all significant at the 1% level, the overall regression is significant and the DW stat has improved. The differential intercept coefficients are all significant indicating that there is a significant difference between the average wages of each firm (given productivity levels), relative to the comparator firm. 5.4 What are the intercept values of each of the four firms wage functions? (2)

Dickeys Dishware: 1.223 Engles Earthenware: 1.223 + 0.432 = 1.655 Fullers Florists: 1.223 + 0.331 = 1.554 Grangers Glassware: 1.223 + 0.289 = 1.512 5.5 Perform a restricted F test to comment on the validity of the model underlying Equation (5.1) compared to Equation (5.3). (Note: Fcrit = 2.92 at the 5% level and 4.51 at the 1% level). (3) F* = [ (R2UR R2R) / m ] / [ (1-R2UR) / (n-k) ] = [ (0.9245 0.7545) / 3] / [ (1-0.9245) / (40-5)] = 0.056666666 / 0.002157142 = 26.2693 This F* is statistically significant at the 1% level, so we reject the null and conclude that the unrestricted regression is more valid. END OF THE EXAMINATION Appendix A: The Motor Industry Development Plan (MIDP)
The MIDP was initiated in 1995 to help the motor industry adjust to South Africas reintegration into the global economy... The MIDP was designed to help the industry adjust and increase its competitiveness in the new post-apartheid trade policy environment. The program comprised four principal elements: a gradual reduction in import duties on both vehicles and components, an export-import complementation scheme under which vehicle and components exporters can earn tradable Import Rebate Credit Certificates (IRCCs) to offset duties on imported vehicles and components, access to the standard duty drawback program for exporters, under which all import duties paid on components and intermediate inputs used in exported vehicles and components can be rebated, and a duty free allowance on imported components of 27 percent of the value of vehicles produced for the domestic market...
Post-1995 Motor Industry Performance

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The general patterns of motor industry performance since 1995 are quite well known... Vehicle exports grew from negligible amounts in 1995/96 to well over 100,000 units per year (in 2005). Imports grew from about 20,000 units per year in 1995 to 120,000 in 2004. Investment in the vehicles sector has been substantial and has grown steadily, from less than R1 billion in 1995 to over R3.5 billion in 2004, and has exceeded R2.5 billion in every year since 2001. Components exports have grown in a similar fashion and are now in excess of R22 billion per year... Employment growth has been much less rapid... Flatters (2005: 1-3).

Reference Flatters, F., 2005. The Economics of MIDP and the South African Motor Industry. Paper prepared for TIPS/NEDLAC South Africa Trade and Poverty Programme (SATPP) Policy Dialogue Workshop, Johannesburg, 2 November. [Online] Available http://qed.econ.queensu.ca/faculty/flatters/writings/ff_economics_of_midp.pdf

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