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Chapter 5 The Dummy Variable Trap (EC220)

Econometrics

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236 views15 pages

Chapter 5 The Dummy Variable Trap (EC220)

Econometrics

Uploaded by

yen
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPS, PDF, TXT or read online on Scribd
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Christopher Dougherty

EC220 - Introduction to econometrics


(chapter 5)
Slideshow: the dummy variable trap
Original citation:
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2012TheAuthor
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http://learningresources.lse.ac.uk/

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u

Suppose that you have a regression model with Y depending on a set of ordinary variables
X2, ..., Xk and a qualitative variable.
1

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u

Suppose that the qualitative variable has s categories. We choose one of them as the
omitted category (without loss of generality, category 1) and define dummy variables D2, ...,
Ds for the rest.
2

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

What would happen if we did not drop the reference category? Suppose we defined a
dummy variable D1 for it and included it in the specification. What would happen then?
3

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

We would fall into the dummy variable trap. I would be impossible to fit the model as
specified.
4

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

We will start with an intuitive explanation. The coefficient of each dummy variable
represents the increase in the intercept relative to that for the basic category. But there is
no basic category for such a comparison.
5

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

1 represents the fixed component of Y for the basic category. But again, there is no basic
category. Thus the model does not have any logical interpretation.
6

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 1 X 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

Observation

Category

1
2
3
4
5
6
7
8

4
3
1
2
2
3
1
4

X1

D1

D2

D3

D4

1
1
1
1
1
1
1
1

0
0
1
0
0
0
1
0

0
0
0
1
1
0
0
0

0
1
0
0
0
1
0
0

1
0
0
0
0
0
0
1

D
i 1

X1

Mathematically, we have a special case of exact multicollinearity. If there is no omitted


category, there is an exact linear relationship between X1 and the dummy variables. The
table gives an example where there are 4 categories.
7

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 1 X 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

Observation

Category

1
2
3
4
5
6
7
8

4
3
1
2
2
3
1
4

X1

D1

D2

D3

D4

1
1
1
1
1
1
1
1

0
0
1
0
0
0
1
0

0
0
0
1
1
0
0
0

0
1
0
0
0
1
0
0

1
0
0
0
0
0
0
1

D
i 1

X1

X1 is the variable whose coefficient is 1. It is equal to 1 in all observations. Usually we do


not write it explicitly because there is no need to do so.
8

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 1 X 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

Observation

Category

1
2
3
4
5
6
7
8

4
3
1
2
2
3
1
4

X1

D1

D2

D3

D4

1
1
1
1
1
1
1
1

0
0
1
0
0
0
1
0

0
0
0
1
1
0
0
0

0
1
0
0
0
1
0
0

1
0
0
0
0
0
0
1

D
i 1

X1

If there is an exact linear relationship among a set of the variables, it is impossible in


principle to estimate the separate coefficients of those variables. To understand this
properly, one needs to use linear algebra.
9

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 1 X 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

Observation

Category

1
2
3
4
5
6
7
8

4
3
1
2
2
3
1
4

X1

D1

D2

D3

D4

1
1
1
1
1
1
1
1

0
0
1
0
0
0
1
0

0
0
0
1
1
0
0
0

0
1
0
0
0
1
0
0

1
0
0
0
0
0
0
1

D
i 1

X1

If you tried to run the regression anyway, the regression application should detect the
problem and do one of two things. It may simply refuse to run the regression.
10

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 1 X 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u

Observation

Category

1
2
3
4
5
6
7
8

4
3
1
2
2
3
1
4

X1

D1

D2

D3

D4

1
1
1
1
1
1
1
1

0
0
1
0
0
0
1
0

0
0
0
1
1
0
0
0

0
1
0
0
0
1
0
0

1
0
0
0
0
0
0
1

D
i 1

X1

Alternatively, it may run it, dropping one of the variables in the linear relationship,
effectively defining the omitted category by itself.
11

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 1 X 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Observation

Category

1
2
3
4
5
6
7
8

4
3
1
2
2
3
1
4

X1

D1

D2

D3

D4

1
1
1
1
1
1
1
1

0
0
1
0
0
0
1
0

0
0
0
1
1
0
0
0

0
1
0
0
0
1
0
0

1
0
0
0
0
0
0
1

D
i 1

X1

There is another way of avoiding the dummy variable trap. That is to drop the intercept (and
X1). There is no longer a problem because there is no longer an exact linear relationship
linking the variables.
12

THE DUMMY VARIABLE TRAP

Y 1 2 X 2 ... k X k 2 D2 ... s Ds u
Y 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 1 X 1 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Y 2 X 2 ... k X k 1 D1 2 D2 ... s Ds u
Observation

Category

1
2
3
4
5
6
7
8

4
3
1
2
2
3
1
4

X1

D1

D2

D3

D4

1
1
1
1
1
1
1
1

0
0
1
0
0
0
1
0

0
0
0
1
1
0
0
0

0
1
0
0
0
1
0
0

1
0
0
0
0
0
0
1

D
i 1

X1

The parameters are now the intercepts in the relationship for the individual categories.
For example, if the observation relates to category 2, all the dummy variables except D2 will
be equal to 0. D2 = 1, and hence the relationship for that observation has intercept 2.
13

Copyright Christopher Dougherty 2011.


These slideshows may be downloaded by anyone, anywhere for personal use.
Subject to respect for copyright and, where appropriate, attribution, they may be
used as a resource for teaching an econometrics course. There is no need to
refer to the author.
The content of this slideshow comes from Section 5.2 of C. Dougherty,
Introduction to Econometrics, fourth edition 2011, Oxford University Press.
Additional (free) resources for both students and instructors may be
downloaded from the OUP Online Resource Centre
http://www.oup.com/uk/orc/bin/9780199567089/.
Individuals studying econometrics on their own and who feel that they might
benefit from participation in a formal course should consider the London School
of Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
20 Elements of Econometrics
www.londoninternational.ac.uk/lse.

11.07.25

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