1. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Lecture 24 Supplement (Chapter 16)

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 24S-2 Example: Production Functions Note: the French firm panel is balanced. A balanced panel includes observations for every firm in every time period. An unbalanced panel would include firms that entered or exited the data in the middle of the period. For example, a firm might exit the data because it went out of business.

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 24S-3 Example: Production Functions (cont.) Some data sets are naturally balanced. Some researchers choose to balance their panels artificially by discarding firms that are not present in every time period. This procedure is inefficient: it discards useful data. Much worse, artificially balancing panels can introduce severe biases.

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 24S-4 Example: Production Functions (cont.) Firms that are more productive (for unobserved reasons) are more likely to stay in business. Such firms also tend to enjoy higher marginal benefits from capital, so they choose to invest in higher capital levels. Unobserved productivity leads to omitted variables bias.

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 24S-5 Example: Production Functions (cont.) When we artificially balance a panel, we select firms that are particularly productive (and that tend to have higher capital levels). This sample selection bias can greatly exacerbate the omitted variables bias, depending on how much entry and exit is occurring during the period.

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 24S-6 Example: Production Functions (cont.) Olley and Pakes (Econometrica 1996) examined US telecommunications equipment manufacturers from 1974–1987. In this period there was a great deal of entry and exit. The balanced panel has 896 observations. The unbalanced panel has 2,592 observations.

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 24S-7 Example: Production Functions (cont.) Olley and Pakes compare the estimated coefficient on capital when they: 1.Use fixed effects on a balanced panel, 2.Use FE on the full dataset, and 3.Use advanced techniques to estimate the unobserved productivity and control for it. Balanced Panel FE: 0.067 Full Data FE: 0.150 No-OVB: 0.339 to 0.355

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 24S-8 Example: Production Functions (cont.) The balanced panel creates a large bias. Simply moving from a balanced panel to an unbalanced panel doubles the estimated capital coefficient. However, unobserved productivity that varies over time (and is thus not controlled by fixed effects) continue to bias the estimate in this sample. Eliminating OVB doubles the estimate.