Introductory Econometrics - A Modern Approach - ch07.ppt

Economics 20 - Prof. Anderson Dummy Variables A dummy variable is a variable that takes on the value 1 or 0 Examples: male (= 1 if are male, 0 otherwise), south (= 1 if in the south, 0 otherwise), etc. Dummy variables are also called binary variables, for obvious reasons A Dummy Independent Variable Consider a simple model with one continuous variable (x) and one dummy (d) y = b0 + d0d + b1x + u This can be interpreted as an intercept shift If d = 0, then y = b0 + b1x + u If d = 1, then y = (b0 + d0) + b1x + u The case of d = 0 is the base group Dummies for Multiple Categories We can use dummy variables to control for something with multiple categories Suppose everyone in your data is either a HS dropout, HS grad only, or college grad To compare HS and college grads to HS dropouts, include 2 dummy variables hsgrad = 1 if HS grad only, 0 otherwise; and colgrad = 1 if college grad, 0 otherwise Multiple Categories (cont) Any categorical variable can be turned into a set of dummy variables Because the base group is represented by the intercept, if there are n categories there should be n – 1 dummy variables If there are a lot of categories, it may make sense to group some together Example: top 10 ranking, 11 – 25, etc. Interactions Among Dummies Interacting dummy variables is like subdividing the group Example: have dummies for male, as well as hsgrad and colgrad Add male*hsgrad and male*colgrad, for a total of 5 dummy variables – 6 categories Base group is female HS dropouts hsgrad is for female HS grads, colgrad is for female college grads The interactions reflect male HS grads and male college grads More on Dummy Interactions Formally, the model is y = b0 + d1male + d2hsgrad + d3colgrad + d4male*hsgrad + d5male*colgrad + b1x + u, then, for example: If male = 0 and hsgrad = 0 and colgrad = 0 y = b0 + b1x + u If male = 0 and hsgrad = 1 and colgrad = 0 y = b0 + d2hsgrad + b1x + u If male = 1 and hsgrad = 0 and colgrad = 1 y = b0 + d1male