AAEC 4302

ADVANCED STATISTICAL METHODS IN AGRICULTURAL RESEARCH

Chapter 13.3

Multicollinearity

Multicollinearity
Multicollinearity occurs when two or more independent variables in a regression model are highly correlated to each other Standard error of the OLS parameter estimate will be higher if the corresponding independent variable is more highly correlated to the other independent variables in the model

Multicollinearity
Independent variables show no statistical significance when conducting the basic significance test It is not a mistake in the model specification, but due to the nature of the data at hand

Perfect Multicollinearity
Perfect multicollinearity occurs when there is a perfect linear correlation between two or more independent variables

When independent variable takes a constant value in all observations

Severe Multicollinearity
The OLS method cannot produce parameter estimates A certain degree of correlation (multicollinearity) between the independent variables is normal and expected in most cases Severe multicollinearity

Symptoms of Multicollinearity
The symptoms of a multicollinearity problem 1. independent variable(s) considered critical in explaining the models dependent variable are not statistically significant according to the tests

Symptoms of Multicollinearity
2. High R2, highly significant F-test, but few or no statistically significant t tests 3. Parameter estimates drastically change values and become statistically significant when excluding some independent variables from the regression

Detecting Multicollinearity
A simple test for multicollinearity is to conduct artificial regressions between each independent variable (as the dependent variable) and the remaining independent variables

Variance Inflation Factors (VIFj) are calculated as:

VIFj

1 R
2 j

Detecting Multicollinearity
VIFj = 2, for example, means that variance is twice what it would be if Xj, was not affected by multicollinearity A VIFj>10 is clear evidence that the estimation of Bj is being affected by multicollinearity

Addressing Multicollinearity
Although it is useful to be aware of the presence of multicollinearity, it is not easy to remedy severe (non-perfect) multicollinearity If possible, adding observations or taking a new sample might help lessen multicollinearity

Addressing Multicollinearity
Exclude the independent variables that appear to be causing the problem Modifying the model specification sometimes help, for example:
using real instead of nominal economic data

using a reciprocal instead of a polynomial specification on a given independent variable