# Why I use Panel/Multilevel Methods

I don’t understand why any researcher would choose not to use panel/multilevel methods on panel/hierarchical data. Let’s take the following linear regression as an example:

$y_{it} = \beta_{0} + \beta_{1}x_{it} + a_{i} + \epsilon_{it}$,

where $a_{i}$ is a random effect for the i-th group. A pooled OLS regression model for the above is unbiased and consistent. However, it will be inefficient, unless $a_{i}=0$ for all $i$.

Let’s have a look at the consequences of this inefficiency using a simulation. I will simulate the following model:

$y_{it} = 1 + 5 x_{it} + a_{i} + \epsilon_{it}$,

with $a_{i} \sim N(0, 3)$ and $\epsilon_{it} \sim N(0, 1)$. I will do this simulation and compare the following 4 estimators: pooled OLS, random effects (RE) AKA a multilevel model with a mixed effect intercept, a correlated random effects (CRE) model (include group mean as regressor as in Mundlak (1978)), and finally the regular fixed effects (FE) model. I am doing this in R, so the first model I will use the simple lm() function, the second and third lmer() from the lme4 package, and finally the excellent felm() function from the lfe package. These models will be tested under two conditions. First, we will assume that the random effects assumption holds, the regressor is uncorrelated with the random effect. After looking at this, we will then allow the random effect to correlate with the regressor $x_{it}$.

The graph below shows the importance of using panel methods over pooled OLS. It shows boxplots of the 100 simulated estimates. Even when the random effects assumption is violated, the random effects estimator (RE) is far superior to simple pooled OLS. Both the CRE and FE estimators perform well. Both have lowest root mean square errors, even though the model satisfies the random effects assumption. Please see my R code below.

# clear ws
rm(list=ls())

library(lme4)
library(plyr)
library(lfe)
library(reshape)
library(ggplot2)
# from this:

### set number of individuals
n = 200
# time periods
t = 5

### model is: y=beta0_{i} +beta1*x_{it} + e_{it}
### average intercept and slope
beta0 = 1.0
beta1 = 5.0

### set loop reps
loop = 100
### results to be entered
results1 = matrix(NA, nrow=loop, ncol=4)
results2 = matrix(NA, nrow=loop, ncol=4)

for(i in 1:loop){
# basic data structure
data = data.frame(t = rep(1:t,n),
n = sort(rep(1:n,t)))
# random effect/intercept to add to each
rand = data.frame(n = 1:n,
a = rnorm(n,0,3))
data = join(data, rand, match="first")
# random error
data$u = rnorm(nrow(data), 0, 1) # regressor x data$x = runif(nrow(data), 0, 1)
# outcome y
data$y = beta0 + beta1*data$x + data$a + data$u
# make factor for i-units
data$n = as.character(data$n)
# group i mean's for correlated random effects
data$xn = ave(data$x, data$n, FUN=mean) # pooled OLS a1 = lm(y ~ x, data) # random effects a2 = lmer(y ~ x + (1|n), data) # correlated random effects a3 = lmer(y ~ x + xn + (1|n), data) # fixed effects a4 = felm(y ~ x | n, data) # gather results results1[i,] = c(coef(a1)[2], coef(a2)$n[1,2],
coef(a3)$n[1,2], coef(a4)[1]) ### now let random effects assumption be false ### ie E[xa]!=0 data$x = runif(nrow(data), 0, 1) + 0.2*data$a # the below is like above data$y = beta0 + beta1*data$x + data$a + data$u data$n = as.character(data$n) data$xn = ave(data$x, data$n, FUN=mean)
a1 = lm(y ~ x, data)
a2 = lmer(y ~ x + (1|n), data)
a3 = lmer(y ~ x + xn + (1|n), data)
a4 = felm(y ~ x | n, data)

results2[i,] = c(coef(a1)[2],
coef(a2)$n[1,2], coef(a3)$n[1,2],
coef(a4)[1])
}
# calculate rmse
apply(results1, 2, function(x) sqrt(mean((x-5)^2)))
apply(results2, 2, function(x) sqrt(mean((x-5)^2)))

# shape data and do ggplot
model.names = data.frame(X2 = c("1","2","3","4"),
estimator = c("OLS","RE","CRE","FE"))
res1 = melt(results1)
res1 = join(res1, model.names, match="first")
res2 = melt(results2)
res2 = join(res2, model.names, match="first")

res1$split = "RE Valid" res2$split = "RE Invalid"
res1 = rbind(res1, res2)

res1$split = factor(res1$split, levels =  c("RE Valid", "RE Invalid"))
res1$estimator = factor(res1$estimator, levels =  c("OLS","RE","CRE","FE"))

number_ticks = function(n) {function(limits) pretty(limits, n)}

ggplot(res1, aes(estimator, value)) +
geom_boxplot(fill="lightblue") +
#coord_flip() +
facet_wrap( ~ split, nrow = 2, scales = "free_y") +
geom_hline(yintercept = 5) +
scale_x_discrete('') +
scale_y_continuous(bquote(beta==5), breaks=number_ticks(3)) +
theme_bw() +
theme(axis.text=element_text(size=16),
axis.title=element_text(size=16),
legend.title = element_blank(),
legend.text = element_text(size=16),
strip.text.x = element_text(size = 16),
axis.text.x = element_text(angle = 45, hjust = 1))
ggsave("remc.pdf", width=8, height=6)

# Linear Models with Multiple Fixed Effects

Estimating a least squares linear regression model with fixed effects is a common task in applied econometrics, especially with panel data. For example, one might have a panel of countries and want to control for fixed country factors. In this case the researcher will effectively include this fixed identifier as a factor variable, and then proceed to estimate the model that includes as many dummy variables (minus one if an intercept is included in the modelling equation) as there are countries. Obviously, this approach is computationally problematic when there are many fixed factors. In our simple example, an extra country will add an extra column to the $X$ matrix used in the least squares calculation.

Fortunately, there are a number of data transformations that can be used in this panel setting. These include demeaning each within unit observation, using first differences, or including the group means as additional explanatory variables (as suggested by (Mundlak 1978)). However, these approaches only work well when there is one factor that the researcher wants to include fixed effects to account for.

Simen Gaure offers a solution this problem that allows for multiple fixed effects without resorting to a computationally burdensome methodology. Essentially the solution involves an elaboration of the group demeaning transformation mentioned in the above. More technical details can be found here or by referring to Gaure’s forthcoming article in Computational Statistics & Data Analysis. Those interested in implementing this estimation strategy in R can use the lfe package available on CRAN.

In the below, I have included a simple example of how the package works. In this example, the model needs to be set up to calculate fixed effects for two factor variables. Obviously, adding 2,000 columns to the data frame is not a convenient way to estimate the model that includes fixed effects for both the x2 and x3 variables. However, the felm function tackles this problem with ease. Stata has a similar function to feml, areg, although the areg function only allows for absorbed fixed effects in one variable.

# clear workspace
rm(list=ls())
library(lfe)

# create data frame
x1 <- rnorm(10000)
x2 <- rep(1:1000,10)
x3 <- rep(1:1000,10)
e1 <- sin(x2) + 0.02*x3^2 + rnorm(10000)
y <- 10 + 2.5*x1 + (e1-mean(e1))
dat <- data.frame(x1,x2,x3,y)

# simple lm
lm(y~x1)
# lm with fixed effects
felm(dat$y ~ dat$x1 + G(dat$x2) + G(dat$x3))

##############################################
# output
##############################################
# simple lm
> lm(y~x1)
Call: lm(formula = y ~ x1)
Coefficients:
(Intercept)           x1
10.47       -36.95
> # lm with fixed effects
> felm(dat$y ~ dat$x1 + G(dat$x2) + G(dat$x3))
dat\$x1
2.501