1. Hypothesis Testing

1.  Hypothesis Testing

Suppose a skeptic suggests that reducing the number of students in a class has no effect on learning or, specifically, test scores. The skeptic thus asserts the hypothesis,

H0: b1 = 0

We wish to test this hypothesis using data – reach a tentative conclusion whether it is correct or incorrect.

Null hypothesis and two-sided alternative:

H0: b1 = 0 vs. H1: b1 ≠ 0

or, more generally,

H0: b1 = b1,0 vs. H1: b1 ≠ b1,0

where b1,0 is the hypothesized value under the null.

Null hypothesis and one-sided alternative:

H0: b1 = b1,0 vs. H1: b1 < b1,0

Recall hypothesis testing for population mean using :

t =

then reject the null hypothesis if |t| >1.96.

where the SE of the estimator is the square root of an estimator of the variance of the estimator.

Applied to a hypothesis about b1:

t =

so

t =

where b1 is the value of b1,0 hypothesized under the null (for example, if the null value is zero, then b1,0 = 0.

What is SE()?

SE() = the square root of an estimator of the variance of the sampling distribution of

Recall the expression for the variance of (large n):

var() = =

where vi = (Xi – )ui. Estimator of the variance of :

=

= .

= .

OK, this is a bit nasty, but:

·  There is no reason to memorize this

·  It is computed automatically by regression software

·  SE() = is reported by regression software

·  It is less complicated than it seems. The numerator estimates the var(v), the denominator estimates var(X).

Return to calculation of the t-statsitic:

t = =

·  Reject at 5% significance level if |t| > 1.96

·  p-value is p = Pr[|t| > |tact|] = probability in tails of normal outside |tact|

·  Both the previous statements are based on large-n approximation; typically n = 50 is large enough for the approximation to be excellent.

Example: Test Scores and STR, California data

Estimated regression line:

Test Score = 698.9 – 2.28STR

Regression software reports the standard errors:

SE() = 10.4 SE() = 0.52

t-statistic testing b1,0 = 0

= = = –4.38

·  The 1% 2-sided significance level is 2.58, so we reject the null at the 1% significance level.

·  Alternatively, we can compute the p-value…

The p-value based on the large-n standard normal approximation to the t-statistic is 0.00001 (10–4)

Confidence intervals

In general, if the sampling distribution of an estimator is normal for large n, then a 95% confidence interval can be constructed as

estimator ± 1.96×standard error.

So: a 95% confidence interval for is,

{ ± 1.96×SE()}

Example: Test Scores and STR, California data

Estimated regression line:

Test Score = 698.9 – 2.28STR

SE() = 10.4 SE() = 0.52

95% confidence interval for :

{ ± 1.96×SE()} = {–2.28 ±1.96×0.52}

= (–3.30, –1.26)

Equivalent statements:

·  The 95% confidence interval does not include zero;

·  The hypothesis b1 = 0 is rejected at the 5% level

A convention for reporting estimated regressions:

Put standard errors in parentheses below the estimates

Test Score = 698.9 – 2.28STR

(10.4) (0.52)

This expression means that:

·  The estimated regression line is

Test Score = 698.9 – 2.28STR

·  The standard error of is 10.4

·  The standard error of is 0.52

A Practical Note: Heteroskedasticity, Homoskedasticity, and the Formula for the Standard Errors of and (Section 4.9)

·  What do these two terms mean?

·  Consequences of homoskedasticity

·  Implication for computing standard errors

What do these two terms mean?

If var(u|X=x) is constant – that is, the variance of the conditional distribution of u given X does not depend on X, then u is said to be homoskedastic. Otherwise, u is said to be heteroskedastic.

Homoskedasticity in a picture:

·  E(u|X=x) = 0 (u satisfies Least Squares Assumption #1)

·  The variance of u does not change with (depend on) x

Heteroskedasticity in a picture:

·  E(u|X=x) = 0 (u satisfies Least Squares Assumption #1)

The variance of u depends on x – so u is heteroskedastic.

Is heteroskedasticity present in the class size data?

Hard to say…looks nearly homoskedastic, but the spread might be tighter for large values of STR.
So far we have (without saying so) assumed that u is heteroskedastic:

Recall the three least squares assumptions:

1.  The conditional distribution of u given X has mean zero, that is, E(u|X = x) = 0.

2.  (Xi,Yi), i =1,…,n, are i.i.d.

3.  X and u have four finite moments.

Heteroskedasticity and homoskedasticity concern var(u|X=x). Because we have not explicitly assumed homoskedastic errors, we have implicitly allowed for heteroskedasticity.

What if the errors are in fact homoskedastic?:

·  You can prove some theorems about OLS (in particular, the Gauss-Markov theorem, which says that OLS is the estimator with the lowest variance among all estimators that are linear functions of (Y1,…,Yn); see Section 15.5).

·  The formula for the variance of and the OLS standard error simplifies (App. 4.4): If var(ui|Xi=x) = , then

var() = = … =

Note: var() is inversely proportional to var(X): more spread in X means more information about .

General formula for the standard error of is the of:

= .

Special case under homoskedasticity:

= .

Sometimes it is said that the lower formula is simpler.

The homoskedasticity-only formula for the standard error of and the “heteroskedasticity-robust” formula (the formula that is valid under heteroskedasticity) differ – in general, you get different standard errors using the different formulas.

Homoskedasticity-only standard errors are the default setting in regression software – sometimes the only setting (e.g. Excel). To get the general “heteroskedasticity-robust” standard errors you must override the default.

If you don’t override the default and there is in fact heteroskedasticity, you will get the wrong standard errors (and wrong t-statistics and confidence intervals).
The critical points:

·  If the errors are homoskedastic and you use the heteroskedastic formula for standard errors (the one we derived), you are OK

·  If the errors are heteroskedastic and you use the homoskedasticity-only formula for standard errors, the standard errors are wrong.

·  The two formulas coincide (when n is large) in the special case of homoskedasticity

·  The bottom line: you should always use the heteroskedasticity-based formulas – these are conventionally called the heteroskedasticity-robust standard errors.

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