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Summary Note

Chapter 5 discusses probability models, focusing on dummy variables in regression that represent qualitative factors. It outlines the use of dummy dependent variables in binary outcomes, comparing models like Linear Probability Model, Logit, and Probit, highlighting their advantages and limitations. The chapter also emphasizes the importance of interpreting coefficients through marginal effects and assessing model fit using appropriate metrics.

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3 views

Summary Note

Chapter 5 discusses probability models, focusing on dummy variables in regression that represent qualitative factors. It outlines the use of dummy dependent variables in binary outcomes, comparing models like Linear Probability Model, Logit, and Probit, highlighting their advantages and limitations. The chapter also emphasizes the importance of interpreting coefficients through marginal effects and assessing model fit using appropriate metrics.

Uploaded by

Eyob Yotor
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Summary Note: Chapter 5 - Probability Models

1. Dummy Variables in Regression


 Definition: Dummy variables are binary indicators (0 or 1) representing qualitative
factors such as gender, location, or profession.
 Purpose: They serve as proxies for qualitative variables that cannot be directly
measured.
 Usage:
o In regression without continuous variables, dummy variables capture category
differences (e.g., output from different machines or salary differences based on
gender).
o In models with continuous regressors, dummy variables control for categorical
factors while assessing the influence of quantitative variables.
2. Dummy Dependent Variables
 Used when the dependent variable is binary (e.g., labor force participation: 1 =
participates, 0 = does not).
 Probability models are employed for such cases:
1. Linear Probability Model (LPM):
 Models the probability of an event linearly using OLS.
 Issues:
 Non-normality of error terms.
 Heteroskedasticity.
 Predicted probabilities outside [0,1].
2. Logit Model:
 Uses the logistic function to constrain probabilities within [0,1].
 Interpreted via odds ratios or marginal effects.
3. Probit Model:
 Uses the standard normal cumulative distribution function (CDF).
 Similar to the logit model but assumes a normal distribution for errors.
3. Comparison of Models
 LPM:
o Simpler to estimate.
o Suffers from major limitations (e.g., unbounded probabilities, heteroskedastic
errors).
 Logit vs. Probit:
o Logit has slightly fatter tails; probabilities approach zero or one more gradually.
o Logit is often preferred for its mathematical simplicity.
o Both use maximum likelihood estimation.
o Probit coefficients can be approximated by multiplying logit coefficients by 0.625.
4. Key Features and Interpretation
 Logit/Probit Models:
o Ensure probabilities are strictly within [0,1].
o Interpret coefficients via marginal effects or odds ratios, rather than directly.
 Marginal Effects:
o Measure the change in probability for a unit change in a regressor.
o Computed differently for continuous and categorical variables.
5. Practical Examples
 Regression examples using dummy variables for regional effects and household
characteristics are provided, illustrating how to interpret coefficients, marginal effects,
and odds ratios.
6. Goodness of Fit
 For LPM: R² is generally lower and less reliable.
 For logit/probit models: Use pseudo-R² or compare predicted probabilities and
classification accuracy.

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