3.

3 Omitted Variable Bias

-When a valid variable is excluded, we
UNDERSPECIFY THE MODEL and OLS
estimates are biased
-Consider the true population model:

y 0 1 x1 2 x2 u (3.40)

-Assume this satisfies all 4 assumptions

and that we are concerned with x1
-if we exclude x2, our estimation becomes:

~ ~
y 0 1 x1

3.3 Omitted Variable Bias

-From (3.23) we know that:

~ ~
1 1 2 (3.43)
-where Bhats come from regressing y on ALL xs and deltatilde comes
from regressing x2 on x1
-since deltatilde depends on independent variables, it is considered fixed
-we also know from Theorem 3.1 that Bhats are unbiased estimators,
therefore:

~
~
E ( 1 ) 1 2 (3.45)

3.3 Omitted Variable Bias

-From this we can calculate Btildes bias:
~
~
~

Bias ( 1 ) E ( 1 ) 1 2 (3.46)
-this bias is often called OMITTED VARIABLE BIAS
-From this equation, B1tilde is unbiased in two cases:
1) B2=0; x2 has no impact on y in the true model
2) deltatilde=0

3.3 Deltatilde=0
-deltatilde is equal to the covariance of x 1 and
x2 over the variance of x1, all in the sample
-deltatilde is equal to zero only if x 1 and x2 are
uncorrelated
-therefore if they are uncorrelated, B 1hat is
unbiased
-it is also unbiased if we can show that:

E ( x2 | x1 ) E ( x2 )

3.3 Omitted Variable Bias

-As B1hats bias depends on B2 and
deltatilde, the following table summarizes
the possible biases:
Corr(x ,x )>0
Corr(x ,x )<0
1

B2hat>0

Positive Bias

Negative Bias

B2hat<0

Negative Bias

Positive Bias

3.3 Omitted Variable Bias

-the SIZE of the bias is also important, as a small bias may
not be cause for concern
-therefore the SIZE of B2 and deltatilde are important
-although B2 is unknown, theory can give us a good idea
about its sign
-likewise, the direction of correlation between x 1 and x2 can
be guessed through theory
-a positive (negative) bias indicates that given random
sampling, on average your estimates will be too large
(small)

3.3 Example

Take the true regression:

Pasta 0 1Experience 2 Love u

(ie)

Where pasta taste depends on experience

making pasta and love
-While we can measure years of
experience, we cant measure love, so we
find that:

Pasta 5.3 0.4Experience

What is the bias?

(ie)

3.3 Example
Pasta 5.3 0.4Experience

(ie)

We know that the true B2 should be positive; love improves cooking

We can also support a positive correlation between experience and love, if you love someone you spend time cooking for them
Therefore B1hat will have a positive bias
However, since the correlation between experience and love is small, the bias will likewise be small

3.3 Bias Notes

-It is important to realize that the direction
of bias is ON AVERAGE
-a positive bias on average may
underestimate in a given sample
If E ( ~ )
1

There is an UPWARD BIAS

~
If

E ( 1 ) 1

There is a DOWNWARD BIAS

And B1tilde is BIASED TOWARDS ZERO if it
is closer to zero than B1

3.3
General
Omitted
Bias
Deriving the direction of omitted variable bias with more independent
variables is more difficult
-Note that correlation between any explanatory variable and the error causes
ALL OLS estimates to be biased.
-Consider the true and estimated models:

y 0 1x1 2 x 2 3 x 3 u
~ ~
~
~
y x x
0

1 1

(3.49)
(3.50)

x3 is omitted and correlated with x 1 but not x2

Both B1tilde and B2tilde will always be biased unless x 1 and x2 are uncorrelated

3.3
General
Omitted
Bias
Since our x values can be pairwise correlated, it is hard to derive the
bias for our OLS estimates
-If we assume that x1 and x2 are uncorrelated, we can analyze B1tildes
bias without x2 having an effect, similar to our 2 variable regression:

( xi1 x1 ) xi 3
~

E ( 1 ) 1 3
2
( xi1 x1 )
With this formula similar to (3.45), the previous table can be used to determine bias
-Note that much uncorrelation is needed to determine bias

3.4 The Variance of OLS

Estimators
-We now know the expected
value, or central tendency, of the OLS
estimators
-Next we need information on how much spread OLS has in its
sampling distribution
-To calculate variance, we impose a HOMOSKEDASTICITY (constant
error variance) assumption in order to
1) Simplify variance formulas
2) Give OLS an important efficiency property

Assumption MLR.5
(Homoskedasticity)
The error u has the same variance
given any values of the
explanatory variables. In other
words,

Var (u | x1 , x2 ,..., xk )

Assumption MLR.5
Notes
-MLR. 5 assumes that the
variance of the error term, u, is
the SAME for ANY combination of explanatory variables
-If ANY explanatory variable affects the errors variance,
HETEROSKEDASTICITY is present
-The above five assumptions are called the GAUSSMARKOV ASSUMPTIONS
-As listed above, they apply only to cross-sectional data
with random sampling
-time series and panel data analysis require more
complicated, related assumptions

Assumption MLR.5
Notes
If we let X represent
all x variables,
combining assumptions 1 through 4 give
us: E (y | X) 0 1x1 2 x 2 ... k x k
Or as an example:
E (U | X) 0 1 I 2 Time 3Love

MLR. 5 can be simplified to:

Var ( y | X )

Or for example:

Var (U | X )

3.4 MLR.4 vs. MLR.5

Assumption MRL. 4 says that the expected
value of y, given X, is linear in the parameters
but it certainly depends on x1, x2,.,xk.
Assumption MLR. 5 says that the variance of y,
given X, does not depend on the values of
the independent variables.
(bold added)

Theorem 3.2
(Sampling Variances of
the OLS Slope Estimators)
Under assumptions MLR. 1 through MRL. 5,
conditional on the sample values of the
independent variables,
2

Var ( j )
(3.51)
2
SST j (1 R j )

For j= 1, 2,,k, where Rj2 is the R-squared

from regressing xj on all other independent
variables (and including an intercept) and
2
SST is the total sample
variation
in
x
:
SST ( x x jj )
j

ij

Theorem 3.2 Notes

Note that all FIVE Gauss-Markov assumptions
were needed for this theorem
Homoskedasticity (MLR. 5) wasnt needed to
prove OLS bias
The size of Var(Bjhat) is very important
-a large variance leads to larger confidence
intervals and less accurate hypothesis tests