Concordia University

Department of Economics

ECON 222/4 - Sections A, AA

Instructor: G. Tsoublekas

Winter 2012 – ASSIGNMENT 3 – ANSWERS

Due at noon on Monday, March 19, 2012

Name: I.D. Section:

You are required to attach printouts of the regression results. The assignment worthies 100 marks if you use Excel, and 120 if
you use EViews for your estimations.

Question 1 (50 points)

You have been asked to develop a model to explain differences in costs of production for 123 electric utility companies in
the US in 1970. We are interested in understanding the factors that affect costs. Thus, the dependent variable is the total
cost of production. Download the file with data on “Utilities”. The data selected for this project include the following
variables:
COSTi : Total cost of production of the i-th utility expressed in millions of dollars;
OUTi : Total output of the i-th utility in thousands of KWH per year;
PLi : Price of labor (dollars per worker per year);
PKi : Price of capital (dollars per unit of capital per year);
PFi : Price of fuel (dollars per million BTUs).

You think that the following theoretical model would be appropriate for the prediction of the total cost of production:

Model A: COSTi : = βA0 + βA1*OUTi + βA2*PLi + βA3*PKi + εAi

a. Give a brief interpretation of the expected signs in this model. (4 points)

o The total quantity produced has a positive impact on total cost. Other things being equal, the more the output
the more the use of factors of production and the higher the cost.

o The price of labor is expected to affect the total production cost positively. Other things being equal, the
more expensive labor is the higher the total cost of production.
.
o The price of capital is expected to affect the total production cost positively. Other things being equal, the
more expensive capital is the higher the total cost of production.

b. Estimate the model indicated above, and present your estimates in full reporting mode (including standard errors,
t-ratios, Adjusted R2, F-ratio, number of observations, and sum of residuals). (4 points)

ˆ ST  68.4025  0.0047 * OUT  0.0053 * PL  0.3963 * PK

CO i i i i

St.E. (13.7776) (0.0001) (0.0011) (0.1381)

t-ratio – 4.9648 39.9724 4.8975 2.8708

R 2  0.9315 F = 553.8 n = 123 RES = 26088.2

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c. Without actually running individual significance tests, comment on the strength of the estimated coefficients and
the validity of the model. (4 points)

As implied in (a) above, the signs of all coefficients are unambiguously positive. Therefore, their strength would
be tested against a 1-sided hypothesis. The t-critical value for such a test for 119 degrees of freedom at the 5%
level of significance would be at +1.66. The estimated coefficients have the expected signs and their estimated t-
ratios exceed the critical t-ratio in all cases.

Similarly, the critical value for the F-test for 3 slope coefficients and 119 degrees of freedom at the 5% level of
significance is 2.70. The estimated F-ratio of 553.8 far exceeds the critical F-value. Therefore, the model passes
the validity test.

d. You want to make sure that the model is properly specified. In particular, you want to ensure that there is not any
important variable missing. Run a RESET equation and present your estimates in full reporting mode. (4 points)

COˆ STi  27.730  0.0023 * OUTi  0.0026 * PLi  0.1752 * PK i  0.0083 * COˆ STi 2  0.000 * COˆ STi 3  0.000 * COˆ STi
St.E. (13.915) (0.0007) (0.0011) (0.1214) (0.0025) (0.000) (0.000)
t-ratios – 1.9928 3.2651 2.3904 1.4433 3.2590 – 2.3209 1.4042

R 2  0.952 F = 404.5 n = 123 RSS = 17805.1

e. Run an F-test to check if there are missing variables in Model A above and state your conclusions. (5 points)

The model in (d) above is the unrestricted case of the model shown in (b). The F-test for missing variables is as
follows:

H0: βCOST-H^2 = βCOST-H^3 = βCOST-H^4 = 0

HA: βCOST-H^2 ≠ βCOST-H^3 ≠ βCOST-H^4 ≠ 0 Reject H0 if F est > F 3, 116, 0.05 = 2.70

RSS R  RSSUR RSS R  RSSUR 26088.2  17805.1

(n  k  1  m)  (n  k  1) m 3 2761.03
Fm,n  k 1      17.9872  2.70
RSSUR RSSUR 17805.1 153.5
(n  k  1) (n  k  1) 116

We reject H0, therefore the 3 coefficients are not collectively insignificant. Since the variables of these 3
coefficients are used as proxies for other unknown missing variables, it is concluded that the model shown in (b)
above is misspecified because it is missing some relevant variable(s).
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f. Assuming that your model is missing important variables, you decide to add to the explanatory variables the cost
of fuel. What could be the sign expected of this variable? (3 points)

o The cost of fuel is expected to be positive related to the total cost of production. Other things being equal, the
higher the cost of fuel the higher the total cost of production.

g. If the cost of fuel is in deed a missing variable, the implication would be that the coefficients estimated in (b) are
biased. What are your expectations about the direction of the bias in the coefficients of the model shown in (b)?
(Hint: This would depend on the type of relationships expected between the excluded variable and the included
independent variables in that model). (5 points)

As in the case of production of electricity, the cost of production of fuel should be dependent upon the cost of
capital and labor. Therefore, the price of fuel should be positively related to the price of labor and the price of
capital. This means that the estimated coefficients of the price of capital and labor are positively biased.

The level of electricity output should not be related to the price of fuel, as the production function is dependent
upon input quantities and not input prices.

h. Estimate a second Model B that includes the independent variables of Model A as well as the cost of fuel
expressed in dollars per one thousand of BTUs, and present your findings in a full reporting mode. (4 points)

Model B: COSTi : = βA0 + βA1*OUTi + βA2*PLi + βA3*PKi + βB4PFi + εBi

COˆ STi  70.4951  0.0047 * OUTi  0.0036 * PLi  0.2801 * PK i  0.7835 * PFi
St.E. (12.695) (0.0001) (0.0011) (0.1295) (0.1658)
t-ratio –5.553 43.226 3.4366 2.163 4.7257

R 2  0.9419 F = 495.41 n = 123 RES = 21936.7

i. Run a regression of the variable that has been excluded from Model A against the variables that are included in
Model A and report your results. (4 points)

PFi = α0 + α1*OUTi + α2*PLi + α3*PKi + ui

PFˆi  2.6709  0.0000 * OUTi  0.0021* PLi  0.1484 * PK i

St. E (7.0152) (0.0001) (0.0006) (0.0703)
t-ratio 0.3807 0.3637 3.8615 2.1108

R 2  0.1132 F = 6.2 n = 123 RSS = 6763.6

j. Using the results of the regression in (i), estimate the bias in the slope coefficients of Model A. (5 points)
 4

The bias on the estimated coefficients of Model A is estimated as follows:

Bias in the coefficient of Output is ˆ A1  ˆ B 4 * ˆ 1 = (0.7835)*(0.0000) = 0.0000

Bias in the coefficient of the Price of Labor is ˆ A2  ˆ B 4 * ˆ 2 = (0.7835)*(0.0021) = 0.00165

Bias in the coefficient of the Price of Capital is ˆ A3  ˆ B 4 * ˆ 3 = (0.7835)*(0.1484) = 011627

In deed, the estimated coefficient of the Price of Labor in Model A is positively biased by 0.17 or 47.2% of its
size in B; the estimated coefficient of the Price of Capital in Model A is positively biased by 0.1163 or 41.5% of
its size in B.

The estimated coefficient of output was not affected because of the lack of relationship between the quantity of
electricity output and the price of fuel.

k. Using the four specification criteria, evaluate the inclusion of the fourth variable (price of fuel) in Model B. (4
points)

The four criteria are as follows:

o Theory: In model purporting to predict total cost of production all prices of the factors of production
must be considered. Fuel is one of the important factors in the production of electricity. Therefore, its
price should be included.
o T-test: The coefficient of the Price of Fuel has the expected sign, positive, and is statistically significant,
compared to the critical t=1.66 at the 5% level of significance with 118 degrees of freedom.
o Adjusted R2: The adjusted R2 increased with the inclusion of the Price of Fuel
o Bias: Expected bias analysis shows that the coefficients of the variables that were initially included in
the Model have changed significantly with the inclusion of the new variable.

On the basis of the four specification criteria, we can say that the Price of Fuel belongs to the equation
purporting to explain variations in Total Production Costs of different electricity producing utilities.

l. Without running any additional regressions, could you say if you have solved the problem of misspecification (the
problem of missing important variables)? You will have to fully justify your answer. (4 points)

Since the dependent variable is the total cost of production, then it is not only the price of the factors of
production that influences the total cost but also the quantities of the factors that are used in the production, as
well as the fixed costs. Therefore, there must still be missing variables in our model.
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Question 2 (40 points)

You have been asked to study the formation of wages according to education levels as well as pay equity in an industrial
town in southern India in 1990. Download the file with data on “Salaries”. The file contains a sample of the
data that have been collected by the Indian Bureau of Statistics for 1990. The following variables are included:

WWIi : Weekly wage income of the i-th person (in rupees);

AGEi : Age of the i-th person in years;
EUSi : Level of education up to the Secondary School of the i-th person;
EHSi : Level of education higher than the Secondary School of 1 if the i-th person;
FEMi : A dummy variable taking the value of 1 if the i-th person is a female.

You think that the following theoretical model would be appropriate for the purpose of your study:

WWIi = β0 + β1*AGEi + β2*EUSi + β3* EHSi + β4* AGEi2 + β5*(EUSi*FEMi) + β6*(EHSi*FEMi) + β7*(AGEi*FEMi) + εi

a. Justify the choice of the variables used here (give a brief interpretation of what we are trying to test with these
variables) and state your expectations about the signs of the coefficients. (5 points)

o Age is used here as a proxy for Experience. Thus, the sign of the coefficient should be positive, as
experience (age in our case) has a positive influence on the salary size, other things being equal.
.
o Education is an important variable when trying to explain salary sizes. Education is presented here in
the form of two dummy variables: one marking those workers with an education level of up to secondary
school, and one marking those workers with an education level higher than secondary school. The
implication is that the missing option of the variable of education refers to those workers with an
education level below the secondary school. The signs of the coefficient for both education variables
used here should be positive, as education has a positive influence on the salary size, other things being
equal.

o Age-square is used here to check for the existence of turning points in salaries. Ageing (or accumulation
of experience here) does not necessarily imply unlimited salaries. A salary plateau should be expected to
prevail after a certain number of years. For this reason, the sign of the coefficient of the square term is
expected to be negative.

o The last three variables represent interaction effects between Age and Education with gender. They are
test variables and are entered here to test the gender discrimination hypothesis. Therefore, no prior
expectations can be set and the coefficients are considered to have ambiguous signs.

b. Create the necessary variables and estimate the model specified above and report your results including all
important statistics. (5 points)

WWˆ I = – 106.842 + 11.793*AGEi +53.913*EUSi + 213.187*EHSi – 0.102*AGEi2 – 9.906(EUS*Fi) – 128.891(EHS*Fi) – 2.556(AGE*Fi)

i
SE (72.507) (4.574) (32.494) (67.629) (0.063) (88.754) (97.174) (0.924)
t-ratio – 1.474 2.579 1.659 3.152 – 1.614 – 0.112 – 1.326 – 2.767

R 2  0.322 F = 8.68 n = 114 RSS = 1348532.3

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c. Without actually running significance tests, comment on the actual signs and the strength of the estimated
coefficients and the validity of the model. (5 points)

The signs for AGE, EUS, EHS, and AGE-square actually came as expected, positive for the first three and
negative for the fourth. The signs of the last three variables, which were ambiguous, actually came as negative.
This would be consistent with the existence of gender discrimination against women.

The critical t-ratio for 106 degrees of freedom for one-sided tests is |1.66| and for two-sided tests is |1.984|. Only
AGE, EHS, and AGE*F pass the significance test at the 5% level.

The critical value for the F-test for 7 slope coefficients and 106 degrees of freedom at the 5% level of significance
is 2.10. The estimated F-ratio at 8.68 exceeds the critical F-value. Therefore, the model passes the validity test.

d. Take the model that you have estimated in (b) above and write down separately the estimated equations for the
following categories:
i. men with a level of education below secondary school;
ii. men with a level of education of up to secondary school;
iii. men with a level of educational higher than secondary school;
iv. women with a level of education of up to primary school;
v. women with a level of education of up to secondary school;
vi. women with a level of educational higher than secondary school. (6 points)

Men with a level of education below secondary school

WW ˆ I = – 106.842 + 11.793*AGEi – 0.102*AGEi2
i

Men with a level of education of up to secondary school

WW ˆ I = – 106.842 + 11.793*AGEi +53.913*EUSi – 0.102*AGEi2
i

WWˆ I = – 52.929 + 11.793*AGEi – 0.102*AGEi2

i

Men with a level of educational higher than secondary school

WW ˆ I = – 106.842 + 11.793*AGEi + 213.187*EHSi – 0.102*AGEi2
i

WWˆ I = 106.345 + 11.793*AGEi – 0.102*AGEi2

i

Women with a level of education of up to primary school

WW ˆ I = – 106.842 + 11.793*AGEi – 0.102*AGEi2 – 2.556(AGE*Fi)
i

WWˆ I = – 106.842 + 9.237*AGEi – 0.102*AGEi2

i

Women with a level of education of up to secondary school

WW ˆ I = – 106.842 + 11.793*AGEi + 53.913*EUSi – 0.102*AGEi2 – 9.906(EUS*Fi) – 2.556(AGE*Fi)
i

WWˆ I = – 62.835 + 9.237*AGEi – 0.102*AGEi2

i

Women with a level of educational higher than secondary school

WW ˆ I = – 106.842 + 11.793*AGEi + 213.187*EHSi – 0.102*AGEi2 – 128.891(EHS*Fi) – 2.556(AGE*Fi)
i

WWˆ I = – 22.546 + 9.237*AGEi – 0.102*AGEi2

i
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e. Use the six equations found in (d) above to calculate the lifetime maximum average weekly wage earnings for
males and females for different levels of education and the age they will reach their respective maximum earnings
levels. (6 points)

Men with a level of education below secondary school

WW ˆ I = – 106.842 + 11.793*AGEi – 0.102*AGEi2
i

ˆ
WWI i 11 .793
 11 .793  2 * 0.102 AGE i  0 AGE   57.8
AGE i 2 * 0.102
Max Potential Wage WWˆ I = – 106.842 + 11.793*57.8 – 0.102*(57.8)2 = 234.0
i

Men with a level of education of up to secondary school

WW ˆ I = – 52.929 + 11.793*AGEi – 0.102*AGEi2
i

ˆ
WWI i 11 .793
 11 .793  2 * 0.102 AGE i  0 AGE   57.8
AGE i 2 * 0.102
Max Potential Wage WWˆ I = – 52.929 + 11.793*57.8 – 0.102*(57.8)2 = 287.9
i

Men with a level of educational higher than secondary school

WW ˆ I = 106.345 + 11.793*AGEi – 0.102*AGEi2
i

ˆ
WWI i 11 .793
 11 .793  2 * 0.102 AGE i  0 AGE   57.8
AGE i 2 * 0.102
Max Potential Wage WWˆ I = 106.345 + 11.793*57.8 – 0.102*(57.8)2 = 447.2
i

Women with a level of education of up to primary school

WW ˆ I = – 106.842 + 9.237*AGEi – 0.102*AGEi2
i

ˆ
WWI i 9.237
 9.237  2 * 0.102 AGEi  0 AGE   45.3
AGEi 2 * 0.102
Max Potential Wage WWˆ I = – 106.842 + 9.237*45.3 – 0.102*(45.3)2 = 102.3
i

Women with a level of education of up to secondary school

WW ˆ I = – 62.835 + 9.237*AGEi – 0.102*AGEi2
i

ˆ
WWI i 9.237
 9.237  2 * 0.102 AGEi  0 AGE   45.3
AGEi 2 * 0.102
Max Potential Wage WWˆ I = – 62.835 + 9.237*45.3 – 0.102*(45.3)2 = 146.3
i

Women with a level of educational higher than secondary school

WW ˆ I = – 22.546 + 9.237*AGEi – 0.102*AGEi2
i

ˆ
WWI i 9.237
 9.237  2 * 0.102 AGEi  0 AGE   45.3
AGEi 2 * 0.102
Max Potential Wage WWˆ I = – 22.546 + 9.237*45.3 – 0.102*(45.3)2 = 186.6
i

f. Make a rough graph of the six equations found in (d) above to show the relationship between (WWI) and (AGE)
for males and females, of different education levels. Make sure to mark on the graph the years that it takes to
reach the salary plateau (turning point) that you have found in (e) above). (5 points)
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g. On the basis of your findings, state briefly your conclusions with respect to the wage setting policy on the basis of
the levels of education. (4 points)

It is obvious that education plays a role in the compensation of workers. Thus, a male worker who has gone to
the secondary school makes on average 53.9 rupees per week more than those with a lower level of education.
Furthermore, a male worker with more than secondary school makes on average 213.2 rupees per week more
than those with only secondary school level.

In the case of women, the wage differentials for 3 different education levels follow the same pattern, although
with lower amounts. Thus, a female with secondary school education makes on average 44.0 rupees per week
more than those with a lower level of education and a female worker with more than secondary school makes on
average 84.2 rupees per week more than those with only secondary school level of education.

h. On the basis of your findings, state briefly your conclusions with respect to existence of gender discrimination in
the Indian industrial sector. (4 points)
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i. According to our findings, we conclude the following:

i. There was discrimination bias against women in the specific industrial sector.

ii. The discrimination bias against women is evident across all education levels both at the starting
salary level as well as at the progression level.

iii. Female workers reach a plateau in life earnings after about 45 years while male workers do so in
about 58 years.

iv. The discrimination is so strong against women that the potential life earnings for a highly
educated female worker are lower than the potential life earnings of the least educated male
worker.

Question 3 (10 points)

The following table comes from a multiple regression model that was run on Excel using time series data. In this model
we try to estimate a demand function for cotton fabric. The data used are as follows: The dependent variable represents
demand for domestically produced cotton fabric in tons. Wholesale price is an index of base 1967 = 100. Imports and
Exports of cotton fabric are also expressed in tons.

Fill the blanks.