Fixed Effects and Random Effects Models

What do they do?

Fixed effects and random effects models work to remove omitted variable bias by measuring change within a group. By
measuring within a group (across time) you control for a number of potential omitted variables unique to the group.

Difference between Fixed Effects and Random Effects:

Perhaps the most fundamental difference between fixed and random effect is of inference. A fixed-effects analysis can
only support inference about the group of measurements (subjects, etc.) you actually have - the actual subject pool you
looked at. A random-effects analysis, by contrast, allows you to infer something about the population from which you
drew the sample. If the effect size in each subject relative to the variance between your subjects is large enough, you
can guess (given a large enough sample size) that your population exhibits that effect.
Bottom line If you use fixed effects on a random sample, you cannot make inferences outside your data set.
Random effects assume a normal distribution, so you can make inferences to a larger population.

Assumptions
- Fixed Effects assumes that the individual specific effect is correlated to the independent variable.
- Random Effects assumes the individual specific effects are uncorrelated with the independent variables.

What type of data do you use? Examples

Pooled Data: Food Desert Article (Panel Data):

Cross sectional AND time series data.
Observations from different cross-sectional
entities for different time periods.
Example: State populations (cross-sectional)
from 1971-2000 (time-series).
-OR-
Panel Data:
Cross sectional AND time series data.
Observations from the same cross-sectional
entities (countries, people, firms) over time.
More powerful than general pooled data.
CARDIA surveys of the same people over 15 years
asking the same questions at intervals.
As CARDIA surveys were conducted, grocery/fast
food data were taken at the same time
Internet on Inflation Article (Panel Data):
Cross-country data from 207 countries from 1991
through 2000
Variables included are Internet users, population,
CPI inflation rate and unemployment rate from
World Bank (2002) indicators and the West Texas
Intermediate price from the International Monetary
Fund (2002)

Fixed and Random Effects Regression:

Yit is the dependent variable observed for individual i in time t.
Xit is the time-variant regressor
Zi is the time-invariant regressor; observed and can not be estimated
directly by the fixed effect model but can be estimated by the random
effect model
i is the unobserved individual effect
uit is the error term
Fixed Effects Model
What the model does:
1. Assigns every cross-sectional entity a dummy variable.
a. 0 = this is NOT the cross-sectional entity (Food Desert: not an observation about you)
b. 1 = this IS the cross-sectional entity (Food Desert: an observation about you)
2. Use OLS to model the regression, LEAVING OUT THE CONSTANT TERM
a. Leave out the constant term to avoid the dummy variable trap!
3. The betas on the dummy variables are different intercepts for each cross-sectional entity
(Food Desert: each persons individual intercept)

Why would you use a Fixed Effects Model?

Controlling for unobserved heterogeneity when heterogeneity is constant over time and correlated with
independent variables. When there are certain non-random characteristics you dont want ending up in your
error term.
o Food Deserts: the person-ness of each respondent of the CARDIA survey that doesnt change from
time period to time period (tastes and preferences).
Smaller standard errors (more powerful)

Stata Commands:
xtreg y x1 x2 x3, fe (variable you are controlling for)
(reported intercept is the average value of the fixed effects, individual intercepts are the
coefficients on the cross-sectional entitys dummy variable)
predict yhat

Assumption:
The fixed effect model assumes that no other factors are effecting changes in data 1 over the period t0 to t1 not
including this will result in omitted variable bias.
Random Effects Model
In Concept:
Instead of thinking of each unit as having its own systematic baseline, we think of each intercept as the result of a
random deviation from some mean intercept. The intercept is a draw from some distribution for each unit, and it is
independent of the error for a particular observation. Instead of trying to estimate N parameters as in fixed effects, we
just need to estimate parameters describing the distribution from which each units intercept is drawn.

What the model does:

1. OLS regression is used on the entire pooled cross-section and time-series sample.
2. The error term observations from step 1 are used to estimate error variances and correlations between errors.
3. The estimates from step 2 are used to generate generalized least squares, giving estimates for the random
effects model.
4. Some econometrics programs then use the results from step 3 to estimate how far each cross-sectional entitys
intercept is from the mean intercept, 0.

Why would you use a Random Effects Model?

If you have reason to believe that differences across entities have some influence on your dependent variable
then you should use random effects. A group effect is random if we can think of the levels we observe in that
group to be samples from a larger population.
o Example: if collecting data from different medical centers, center might be thought of as random
o Example: if surveying students on different campuses, campus may be a random effect

Advantages
More degrees of freedom than fixed effects, because rather than estimating an intercept for virtually every
cross-sectional unit, you estimate the parameters that describe the distribution of the intercepts
Can estimate coefficents for explanatory variables that are constant over time (like race or gender)

Stata commands:
xtreg y x1 x2 x3, re
Add the option robust to control for heteroskedasticity

How Do I Choose Fixed or Random?

Which to pick?
Durbin-Wu Test OR
Hausman Specification Test
Random Effects Assumption - If the
Random Effects assumption holds
(individual effects NOT correlated to
independent variables) pick the Random
Effects model because it will be a more
efficient model.

Graph Source: Dougherty

Resources
Dougherty: Introduction to Econometrics 4e. Chapter 14, Introduction to Panel Data Models. Oxford University Press.
Available at http://www.oup.com/uk/orc/bin/9780199280964/dougherty_chap14.pdf

Mindhive. A Community Portal for MIT Brain Research. Random and Fixed Effects FAQ. Available at
http://mindhive.mit.edu/node/92

Studenmund, A. H. Econometrics PBAF 528. Pearson Custom. Chapter 14, Experimental and Panel Data. Pgs. 486-496.

Taylor, Jonathan. Statistics 203: Introduction to Regression and Analysis of Variance. Fixed vs. Random Effects.
Available at http://www-stat.stanford.edu/~jtaylo/courses/stats203/notes/fixed+random.pdf

Torres-Reyna, Oscar. Panel Data Analysis, Fixed & Random Effects (using Stata 10.x) (ver. 4.1). Princeton University.
Available at http://dss.princeton.edu/training/Panel101.pdf

Yaffee, Robert. A Primer for Panel Data Analysis. New York University Information Technology Services. Fall 2003.
Available at http://www.nyu.edu/its/pubs/connect/fall03/yaffee_primer.html

For more information on how to calculate a Hausman or Durbin-Wu Test in Stata see:
http://www.stata.com/support/faqs/stat/endogeneity.htm